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i2 Technologies, Inc. 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 i2 Technologies, Inc. case study


At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. i2 Technologies, Inc. case study is a Harvard Business School (HBR) case study written by Ananth Raman, Jasjit Singh. The i2 Technologies, Inc. (referred as “I2 Software” from here on) case study provides evaluation & decision scenario in field of Technology & Operations. It also touches upon business topics such as - Value proposition, IT, Manufacturing, 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




Case Description of i2 Technologies, Inc. Case Study


Describes the emergence and growth of i2 Technologies and the supply chain planning software industry. In December 1998, i2's market capitalization was in excess of $2 billion; the supply chain planning software industry had annual sales of approximately $1 billion and was expected to grow at 57% annually. By describing i2's products and the process that the company followed to sell and implement its software at companies, the case provides students with the background needed to understand why i2 was successful. This understanding enables students to address issues like what i2 should do in the future, and whether new competition such as SAP poses a substantial threat to i2's future success.


Case Authors : Ananth Raman, Jasjit Singh

Topic : Technology & Operations

Related Areas : IT, Manufacturing, Supply chain




Calculating Net Present Value (NPV) at 6% for i2 Technologies, Inc. Case Study


Years              Cash Flow     Net Cash Flow     Cumulative    
Cash Flow
Discount Rate
@ 6 %
Discounted
Cash Flows
Year 0 (10004907) -10004907 - -
Year 1 3463560 -6541347 3463560 0.9434 3267509
Year 2 3976334 -2565013 7439894 0.89 3538923
Year 3 3936047 1371034 11375941 0.8396 3304781
Year 4 3236705 4607739 14612646 0.7921 2563774
TOTAL 14612646 12674987


The Net Present Value at 6% discount rate is 2670080

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.




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 I2 Software 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. I2 Software shareholders have preference for diversified projects investment rather than prospective high income from a single capital intensive project.




Formula and Steps to Calculate Net Present Value (NPV) of i2 Technologies, Inc.

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 I2 Software 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 I2 Software 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 (10004907) -10004907 - -
Year 1 3463560 -6541347 3463560 0.8696 3011791
Year 2 3976334 -2565013 7439894 0.7561 3006680
Year 3 3936047 1371034 11375941 0.6575 2588015
Year 4 3236705 4607739 14612646 0.5718 1850597
TOTAL 10457082


The Net NPV after 4 years is 452175

(10457082 - 10004907 )






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 (10004907) -10004907 - -
Year 1 3463560 -6541347 3463560 0.8333 2886300
Year 2 3976334 -2565013 7439894 0.6944 2761343
Year 3 3936047 1371034 11375941 0.5787 2277805
Year 4 3236705 4607739 14612646 0.4823 1560911
TOTAL 9486359


The Net NPV after 4 years is -518548

At 20% discount rate the NPV is negative (9486359 - 10004907 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of I2 Software 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 I2 Software has a NPV value higher than Zero then finance managers at I2 Software 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 I2 Software, then the stock price of the I2 Software 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 I2 Software 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 will be a multi year spillover effect of various taxation regulations.

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

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 can impact the cash flow of the project.

Understanding of risks involved in 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.




References & Further Readings

Ananth Raman, Jasjit Singh (2018), "i2 Technologies, Inc. Harvard Business Review Case Study. Published by HBR Publications.