STMicroelectronics E-Chain Optimization Project: Achieving Streamlined Operations Through Collaborative Forecasting and Inventory Management 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 STMicroelectronics E-Chain Optimization Project: Achieving Streamlined Operations Through Collaborative Forecasting and Inventory Management case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. STMicroelectronics E-Chain Optimization Project: Achieving Streamlined Operations Through Collaborative Forecasting and Inventory Management case study is a Harvard Business School (HBR) case study written by Barchi Peleg. The STMicroelectronics E-Chain Optimization Project: Achieving Streamlined Operations Through Collaborative Forecasting and Inventory Management (referred as “Echo Stmicroelectronics” from here on) case study provides evaluation & decision scenario in field of Technology & Operations. It also touches upon business topics such as - Value proposition, Business processes, Forecasting, Joint ventures, Strategic planning, Supply chain.

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 STMicroelectronics E-Chain Optimization Project: Achieving Streamlined Operations Through Collaborative Forecasting and Inventory Management Case Study

In 1998, STMicroelectronics initiated the e-Chain Optimization (eChO) project with one of its major customers in a joint effort to streamline the company's planning and replenishment operations. Prior to eChO, inefficient and disconnected manual processes were used to match customer demand with ST's fab capacity. This, combined with high demand uncertainty, resulted in inefficiencies in capacity utilization, inventory management, product-mix decisions, and capacity investments. As part of the eChO project, a new B2B system, based on RosettaNet standards, was put in place to enable collaborative planning and replenishments. The new solutions were to be based on a vendor-managed-inventory (VMI) model. The eChO project was successful, allowing both business partners to improve substantially the efficiency of their internal operations and increase customer satisfaction while simultaneously reducing their inventory-related and other operating costs. In addition, it helped foster greater customer loyalty. The discovery process for the first implementation project took a total of three years and required significant investments from both business partners. To reap the most benefits from this investment, ST had to apply the key findings and duplicate the RosettaNet-enabled business processes to other trading partners. However, ST was likely to face several major obstacles along the way, such as an unwillingness of other customers to make the required initial investments.

Case Authors : Barchi Peleg

Topic : Technology & Operations

Related Areas : Business processes, Forecasting, Joint ventures, Strategic planning, Supply chain

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Calculating Net Present Value (NPV) at 6% for STMicroelectronics E-Chain Optimization Project: Achieving Streamlined Operations Through Collaborative Forecasting and Inventory Management Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10005934)	-10005934	-	-
Year 1	3470419	-6535515	3470419	0.9434	3273980
Year 2	3973015	-2562500	7443434	0.89	3535969
Year 3	3943463	1380963	11386897	0.8396	3311008
Year 4	3224463	4605426	14611360	0.7921	2554077
TOTAL			14611360		12675034

The Net Present Value at 6% discount rate is 2669100

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

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

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Formula and Steps to Calculate Net Present Value (NPV) of STMicroelectronics E-Chain Optimization Project: Achieving Streamlined Operations Through Collaborative Forecasting and Inventory Management

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 Echo Stmicroelectronics 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 Echo Stmicroelectronics 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	(10005934)	-10005934	-	-
Year 1	3470419	-6535515	3470419	0.8696	3017756
Year 2	3973015	-2562500	7443434	0.7561	3004170
Year 3	3943463	1380963	11386897	0.6575	2592891
Year 4	3224463	4605426	14611360	0.5718	1843597
TOTAL					10458414

The Net NPV after 4 years is 452480

(10458414 - 10005934 )

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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	(10005934)	-10005934	-	-
Year 1	3470419	-6535515	3470419	0.8333	2892016
Year 2	3973015	-2562500	7443434	0.6944	2759038
Year 3	3943463	1380963	11386897	0.5787	2282097
Year 4	3224463	4605426	14611360	0.4823	1555007
TOTAL					9488158

The Net NPV after 4 years is -517776

At 20% discount rate the NPV is negative (9488158 - 10005934 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Echo Stmicroelectronics 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 Echo Stmicroelectronics has a NPV value higher than Zero then finance managers at Echo Stmicroelectronics 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 Echo Stmicroelectronics, then the stock price of the Echo Stmicroelectronics 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 Echo Stmicroelectronics 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 –

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

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

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.

Understanding of risks involved in the project.

What can impact the cash flow of the project.

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 STMicroelectronics E-Chain Optimization Project: Achieving Streamlined Operations Through Collaborative Forecasting and Inventory Management

References & Further Readings

Barchi Peleg (2018), "STMicroelectronics E-Chain Optimization Project: Achieving Streamlined Operations Through Collaborative Forecasting and Inventory Management Harvard Business Review Case Study. Published by HBR Publications.