Hanging Up the (Old) Phone: IP Communications in 2004 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 Hanging Up the (Old) Phone: IP Communications in 2004 case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Hanging Up the (Old) Phone: IP Communications in 2004 case study is a Harvard Business School (HBR) case study written by Robert A. Burgelman, Les Vadasz, Philip Meza. The Hanging Up the (Old) Phone: IP Communications in 2004 (referred as “Voip Telephony” from here on) case study provides evaluation & decision scenario in field of Technology & Operations. It also touches upon business topics such as - Value proposition, .

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 Hanging Up the (Old) Phone: IP Communications in 2004 Case Study

The fundamental change to telephony service that Voice over Internet Protocol (VoIP) portended affected a number of constituencies. Start-up companies, as well as large, established phone companies and cable television providers, offered VoIP calling plans that could substitute many of the phone services sold by the same or other established providers. These same providers might also benefit from VoIP by using it to enter new markets. Other companies that previously had nothing to do with telephony could become VoIP telephone service providers: For example, the necessary software codes to make VoIP calls were written into Microsoft's XP operating system through its Instant Messaging feature. However, Internet Protocol communications represented a fundamental challenge to the complex web of federal and state regulations that governed telephony. Because VoIP telephony was not tied to physical telephony networks in specific geographic regions, it raised the question of whether federal or state regulators would have jurisdiction over VoIP services and how jurisdiction would be exercised.

Case Authors : Robert A. Burgelman, Les Vadasz, Philip Meza

Topic : Technology & Operations

Related Areas :

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Calculating Net Present Value (NPV) at 6% for Hanging Up the (Old) Phone: IP Communications in 2004 Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10009545)	-10009545	-	-
Year 1	3461157	-6548388	3461157	0.9434	3265242
Year 2	3973804	-2574584	7434961	0.89	3536671
Year 3	3964157	1389573	11399118	0.8396	3328383
Year 4	3238482	4628055	14637600	0.7921	2565181
TOTAL			14637600		12695478

The Net Present Value at 6% discount rate is 2685933

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. Payback Period
2. Profitability Index
3. Internal Rate of Return
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. Timing of the expected cash flows – stockholders of Voip Telephony 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. Voip Telephony 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 Hanging Up the (Old) Phone: IP Communications in 2004

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 Voip Telephony 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 Voip Telephony 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	(10009545)	-10009545	-	-
Year 1	3461157	-6548388	3461157	0.8696	3009702
Year 2	3973804	-2574584	7434961	0.7561	3004767
Year 3	3964157	1389573	11399118	0.6575	2606498
Year 4	3238482	4628055	14637600	0.5718	1851613
TOTAL					10472579

The Net NPV after 4 years is 463034

(10472579 - 10009545 )

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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	(10009545)	-10009545	-	-
Year 1	3461157	-6548388	3461157	0.8333	2884298
Year 2	3973804	-2574584	7434961	0.6944	2759586
Year 3	3964157	1389573	11399118	0.5787	2294072
Year 4	3238482	4628055	14637600	0.4823	1561768
TOTAL					9499724

The Net NPV after 4 years is -509821

At 20% discount rate the NPV is negative (9499724 - 10009545 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Voip Telephony 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 Voip Telephony has a NPV value higher than Zero then finance managers at Voip Telephony 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 Voip Telephony, then the stock price of the Voip Telephony 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 Voip Telephony 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.

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 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 Hanging Up the (Old) Phone: IP Communications in 2004

References & Further Readings

Robert A. Burgelman, Les Vadasz, Philip Meza (2018), "Hanging Up the (Old) Phone: IP Communications in 2004 Harvard Business Review Case Study. Published by HBR Publications.