Dubai Internet City: Serving Business 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 Dubai Internet City: Serving Business case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Dubai Internet City: Serving Business case study is a Harvard Business School (HBR) case study written by Jacques Horovitz, Anne-Valerie Ohlsson. The Dubai Internet City: Serving Business (referred as “Dic Dubai” 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.

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 Dubai Internet City: Serving Business Case Study

Dubai Internet City (DIC) was inaugurated in October 2000. Despite carrying the name "Internet," the free zone was designed as a hub for all information and communications technology companies. Although the original plan focused primarily on real estate, the shift to an innovative, one-stop approach was almost immediate. DIC not only offered its clients office space, but handled visas, incorporation, travel bookings, work permits, etc. To support clients further, DIC set up a state-of-the-art telecommunications company. This was the first in a series of businesses that DIC launched to serve customers and then spin-off as stand-alone entities. The park's objective was to help companies do business in the area while making it as easy as possible to operate out of Dubai. The fact that the park operated inside a free zone meant that it could offer clients attractive deals such as 100% foreign ownership, no tax, or 100% repatriation of capital. The large concentration of companies working from a single location (600 by 2004) also created networking opportunities, which the company further supported through organized events. By 2004, the company had reached the objectives it had set for 2007 and began looking at different options: internationalizing by either building, operating, or advising on similar parks abroad, or capturing other parts of the value chain (manufacturing, outsourcing, etc.). A 2004 EFMD award winner.

Case Authors : Jacques Horovitz, Anne-Valerie Ohlsson

Topic : Technology & Operations

Related Areas : IT

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Calculating Net Present Value (NPV) at 6% for Dubai Internet City: Serving Business Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10003214)	-10003214	-	-
Year 1	3450750	-6552464	3450750	0.9434	3255425
Year 2	3953272	-2599192	7404022	0.89	3518398
Year 3	3961863	1362671	11365885	0.8396	3326457
Year 4	3247264	4609935	14613149	0.7921	2572137
TOTAL			14613149		12672416

The Net Present Value at 6% discount rate is 2669202

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. Net Present Value
4. Payback Period

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 Dic Dubai 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. Dic Dubai 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 Dubai Internet City: Serving Business

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 Dic Dubai 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 Dic Dubai 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	(10003214)	-10003214	-	-
Year 1	3450750	-6552464	3450750	0.8696	3000652
Year 2	3953272	-2599192	7404022	0.7561	2989242
Year 3	3961863	1362671	11365885	0.6575	2604989
Year 4	3247264	4609935	14613149	0.5718	1856634
TOTAL					10451517

The Net NPV after 4 years is 448303

(10451517 - 10003214 )

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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	(10003214)	-10003214	-	-
Year 1	3450750	-6552464	3450750	0.8333	2875625
Year 2	3953272	-2599192	7404022	0.6944	2745328
Year 3	3961863	1362671	11365885	0.5787	2292745
Year 4	3247264	4609935	14613149	0.4823	1566003
TOTAL					9479701

The Net NPV after 4 years is -523513

At 20% discount rate the NPV is negative (9479701 - 10003214 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Dic Dubai 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 Dic Dubai has a NPV value higher than Zero then finance managers at Dic Dubai 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 Dic Dubai, then the stock price of the Dic Dubai 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 Dic Dubai 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 can impact the cash flow of 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.

Understanding of risks involved in 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 Dubai Internet City: Serving Business

References & Further Readings

Jacques Horovitz, Anne-Valerie Ohlsson (2018), "Dubai Internet City: Serving Business Harvard Business Review Case Study. Published by HBR Publications.