Breaking Down the Wall of Codes: Evaluating Non-Financial Performance Measurement 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 Breaking Down the Wall of Codes: Evaluating Non-Financial Performance Measurement case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Breaking Down the Wall of Codes: Evaluating Non-Financial Performance Measurement case study is a Harvard Business School (HBR) case study written by Aaron Chatterji, David Levine. The Breaking Down the Wall of Codes: Evaluating Non-Financial Performance Measurement (referred as “Codes Wall” from here on) case study provides evaluation & decision scenario in field of Technology & Operations. It also touches upon business topics such as - Value proposition, Cross-cultural management, Emerging markets, Ethics, Performance measurement, Social responsibility.

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 Breaking Down the Wall of Codes: Evaluating Non-Financial Performance Measurement Case Study

In some Third World factories, there is a literal wall of codes. Posted are dozens of codes of conduct as defined by dozens of customer, firm, and industry groups and a host of certifying organizations. The cost of this wall of codes is clear for managers: They must fill out streams of forms and host endless visits from compliance auditors. Less obviously, the wall of codes is costly for consumers and other stakeholders who care about the social performance of businesses. Not only must they pay the (passed on) costs of compliance, but with so many standards, they cannot always identify which standards and codes are valid measures of true social responsibility. Documents the proliferation of metrics and outlines some of the problems regarding reliability, validity, and comparability of existing codes. Examines two large sets of metrics: those used in the apparel industry and those created by socially responsible investment funds. Concludes with some practical suggestions to help reduce the burdens on managers and yield more reliable, valid, and comparable metrics.

Case Authors : Aaron Chatterji, David Levine

Topic : Technology & Operations

Related Areas : Cross-cultural management, Emerging markets, Ethics, Performance measurement, Social responsibility

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Calculating Net Present Value (NPV) at 6% for Breaking Down the Wall of Codes: Evaluating Non-Financial Performance Measurement Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10006014)	-10006014	-	-
Year 1	3472333	-6533681	3472333	0.9434	3275786
Year 2	3956507	-2577174	7428840	0.89	3521277
Year 3	3955419	1378245	11384259	0.8396	3321046
Year 4	3233536	4611781	14617795	0.7921	2561263
TOTAL			14617795		12679372

The Net Present Value at 6% discount rate is 2673358

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. Profitability Index
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. Magnitude of both incoming and outgoing cash flows – Projects can be capital intensive, time intensive, or both. Codes Wall 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 Codes Wall 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 Breaking Down the Wall of Codes: Evaluating Non-Financial Performance Measurement

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 Codes Wall 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 Codes Wall 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	(10006014)	-10006014	-	-
Year 1	3472333	-6533681	3472333	0.8696	3019420
Year 2	3956507	-2577174	7428840	0.7561	2991688
Year 3	3955419	1378245	11384259	0.6575	2600752
Year 4	3233536	4611781	14617795	0.5718	1848785
TOTAL					10460645

The Net NPV after 4 years is 454631

(10460645 - 10006014 )

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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	(10006014)	-10006014	-	-
Year 1	3472333	-6533681	3472333	0.8333	2893611
Year 2	3956507	-2577174	7428840	0.6944	2747574
Year 3	3955419	1378245	11384259	0.5787	2289016
Year 4	3233536	4611781	14617795	0.4823	1559383
TOTAL					9489583

The Net NPV after 4 years is -516431

At 20% discount rate the NPV is negative (9489583 - 10006014 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Codes Wall 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 Codes Wall has a NPV value higher than Zero then finance managers at Codes Wall 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 Codes Wall, then the stock price of the Codes Wall 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 Codes Wall 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 can impact the cash flow of the project.

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.

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

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 Breaking Down the Wall of Codes: Evaluating Non-Financial Performance Measurement

References & Further Readings

Aaron Chatterji, David Levine (2018), "Breaking Down the Wall of Codes: Evaluating Non-Financial Performance Measurement Harvard Business Review Case Study. Published by HBR Publications.