Low-k Dielectrics at IBM Net Present Value (NPV) / MBA Resources

Introduction to Net Present Value (NPV) - What is Net Present Value (NPV) ? How it impacts financial decisions regarding project management?

NPV solution for Low-k Dielectrics at IBM case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Low-k Dielectrics at IBM case study is a Harvard Business School (HBR) case study written by Willy Shih, Giovanni Carraro. The Low-k Dielectrics at IBM (referred as “Ibm Color.innovations” from here on) case study provides evaluation & decision scenario in field of Technology & Operations. It also touches upon business topics such as - Value proposition, Financial markets, Product development, Strategy, Technology.

The net present value (NPV) of an investment proposal is the present value of the proposal’s net cash flows less the proposal’s initial cash outflow. If a project’s NPV is greater than or equal to zero, the project should be accepted.

NPV = Present Value of Future Cash Flows LESS Project’s Initial Investment

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Case Description of Low-k Dielectrics at IBM Case Study

To maximize their effectiveness, color cases should be printed in color.Innovations at the frontiers of technology carry enormous risk of making wrong choices. This case examines a decision made by IBM in its semiconductor process technology strategy: a material to use as a dielectric insulator in its leading edge silicon chip technology. While at the time of the decision it looked like a good choice, subsequent issues with material properties caused the company to have to switch to an alternative. Though a major disruption, the company was able to recover relatively quickly. The case probes the organizational capabilities and problem solving approaches that enabled that recovery. Missteps when making huge bets at the forefront of scientific innovation are increasingly costly, and the company in effect purchases real options for its R&D strategy by allowing a measured level of concurrent investment in competing alternatives.

Case Authors : Willy Shih, Giovanni Carraro

Topic : Technology & Operations

Related Areas : Financial markets, Product development, Strategy, Technology

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Calculating Net Present Value (NPV) at 6% for Low-k Dielectrics at IBM Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10004350)	-10004350	-	-
Year 1	3465568	-6538782	3465568	0.9434	3269404
Year 2	3966574	-2572208	7432142	0.89	3530237
Year 3	3957753	1385545	11389895	0.8396	3323006
Year 4	3240080	4625625	14629975	0.7921	2566447
TOTAL			14629975		12689093

The Net Present Value at 6% discount rate is 2684743

In isolation the NPV number doesn't mean much but put in right context then it is one of the best method to evaluate project returns. In this article we will cover -

Different methods of capital budgeting

What is NPV & Formula of NPV,
How it is calculated,
How to use NPV number for project evaluation, and
Scenario Planning given risks and management priorities.

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Capital Budgeting Approaches

Methods of Capital Budgeting

There are four types of capital budgeting techniques that are widely used in the corporate world –

1. Internal Rate of Return
2. Payback Period
3. Net Present Value
4. Profitability Index

Apart from the Payback period method which is an additive method, rest of the methods are based on Discounted Cash Flow technique. Even though cash flow can be calculated based on the nature of the project, for the simplicity of the article we are assuming that all the expected cash flows are realized at the end of the year.

Discounted Cash Flow approaches provide a more objective basis for evaluating and selecting investment projects. They take into consideration both –

1. Timing of the expected cash flows – stockholders of Ibm Color.innovations have higher preference for cash returns over 4-5 years rather than 10-15 years given the nature of the volatility in the industry.
2. Magnitude of both incoming and outgoing cash flows – Projects can be capital intensive, time intensive, or both. Ibm Color.innovations shareholders have preference for diversified projects investment rather than prospective high income from a single capital intensive project.

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Formula and Steps to Calculate Net Present Value (NPV) of Low-k Dielectrics at IBM

NPV = Net Cash In Flowt1 / (1+r)t1 + Net Cash In Flowt2 / (1+r)t2 + … Net Cash In Flowtn / (1+r)tn
Less Net Cash Out Flowt0 / (1+r)t0

Where t = time period, in this case year 1, year 2 and so on.
r = discount rate or return that could be earned using other safe proposition such as fixed deposit or treasury bond rate. Net Cash In Flow – What the firm will get each year.
Net Cash Out Flow – What the firm needs to invest initially in the project.

Step 1 – Understand the nature of the project and calculate cash flow for each year.
Step 2 – Discount those cash flow based on the discount rate.
Step 3 – Add all the discounted cash flow.
Step 4 – Selection of the project

Why Technology & Operations Managers need to know Financial Tools such as Net Present Value (NPV)?

In our daily workplace we often come across people and colleagues who are just focused on their core competency and targets they have to deliver. For example marketing managers at Ibm Color.innovations often design programs whose objective is to drive brand awareness and customer reach. But how that 30 point increase in brand awareness or 10 point increase in customer touch points will result into shareholders’ value is not specified.

To overcome such scenarios managers at Ibm Color.innovations needs to not only know the financial aspect of project management but also needs to have tools to integrate them into part of the project development and monitoring plan.

Calculating Net Present Value (NPV) at 15%

After working through various assumptions we reached a conclusion that risk is far higher than 6%. In a reasonably stable industry with weak competition - 15% discount rate can be a good benchmark.

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 15 %	Discounted Cash Flows
Year 0	(10004350)	-10004350	-	-
Year 1	3465568	-6538782	3465568	0.8696	3013537
Year 2	3966574	-2572208	7432142	0.7561	2999300
Year 3	3957753	1385545	11389895	0.6575	2602287
Year 4	3240080	4625625	14629975	0.5718	1852526
TOTAL					10467650

The Net NPV after 4 years is 463300

(10467650 - 10004350 )

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Calculating Net Present Value (NPV) at 20%

If the risk component is high in the industry then we should go for a higher hurdle rate / discount rate of 20%.

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 20 %	Discounted Cash Flows
Year 0	(10004350)	-10004350	-	-
Year 1	3465568	-6538782	3465568	0.8333	2887973
Year 2	3966574	-2572208	7432142	0.6944	2754565
Year 3	3957753	1385545	11389895	0.5787	2290366
Year 4	3240080	4625625	14629975	0.4823	1562539
TOTAL					9495444

The Net NPV after 4 years is -508906

At 20% discount rate the NPV is negative (9495444 - 10004350 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Ibm Color.innovations to discount cash flow at lower discount rates such as 15%.

Acceptance Criteria of a Project based on NPV

Simplest Approach – If the investment project of Ibm Color.innovations has a NPV value higher than Zero then finance managers at Ibm Color.innovations can ACCEPT the project, otherwise they can reject the project. This means that project will deliver higher returns over the period of time than any alternate investment strategy.

In theory if the required rate of return or discount rate is chosen correctly by finance managers at Ibm Color.innovations, then the stock price of the Ibm Color.innovations should change by same amount of the NPV. In real world we know that share price also reflects various other factors that can be related to both macro and micro environment.

In the same vein – accepting the project with zero NPV should result in stagnant share price. Finance managers use discount rates as a measure of risk components in the project execution process.

Sensitivity Analysis

Project selection is often a far more complex decision than just choosing it based on the NPV number. Finance managers at Ibm Color.innovations should conduct a sensitivity analysis to better understand not only the inherent risk of the projects but also how those risks can be either factored in or mitigated during the project execution. Sensitivity analysis helps in –

Understanding of risks involved in the project.

What are the uncertainties surrounding the project Initial Cash Outlay (ICO’s). ICO’s often have several different components such as land, machinery, building, and other equipment.

What are the key aspects of the projects that need to be monitored, refined, and retuned for continuous delivery of projected cash flows.

What can impact the cash flow of the project.

What will be a multi year spillover effect of various taxation regulations.

Some of the assumptions while using the Discounted Cash Flow Methods –

Projects are assumed to be Mutually Exclusive – This is seldom the came in modern day giant organizations where projects are often inter-related and rejecting a project solely based on NPV can result in sunk cost from a related project.

Independent projects have independent cash flows – As explained in the marketing project – though the project may look independent but in reality it is not as the brand awareness project can be closely associated with the spending on sales promotions and product specific advertising.

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Negotiation Strategy of Low-k Dielectrics at IBM

References & Further Readings

Willy Shih, Giovanni Carraro (2018), "Low-k Dielectrics at IBM Harvard Business Review Case Study. Published by HBR Publications.