Using Simulated Experience to Make Sense of Big Data 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 Using Simulated Experience to Make Sense of Big Data case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Using Simulated Experience to Make Sense of Big Data case study is a Harvard Business School (HBR) case study written by Robin M. Hogarth, Emre Soyer. The Using Simulated Experience to Make Sense of Big Data (referred as “Statistical Makers” 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 Using Simulated Experience to Make Sense of Big Data Case Study

In an increasingly complex economic and social environment, access to vast amounts of data and information can help organizations and governments make better policies, predictions and decisions. Indeed, more and more decision makers rely on statistical findings and data-based decision models when tackling problems and forming strategies. So far, discussions of data-based decision making have centered mainly on analysis: data collection, technological infrastructures and statistical methods. Yet another vital issue receives far less scrutiny: how analytical results are communicated to decision makers. Data science, like medical diagnostics or scientific research, lies in the hands of expert analysts who must explain their findings to executive decision makers who are often less knowledgeable about formal, statistical reasoning. Yet many behavioral experiments have shown that when the same statistical information is conveyed in different ways, people make drastically different decisions. Description, the authors note, is the default mode of presenting statistical information. This typically involves a verbal statement or a written report, which might feature one or more tables summarizing the findings. But the authors'own research suggests that descriptions can mislead even the most knowledgeable decision makers. In a recent experiment, they asked 257 economics scholars to make judgments and predictions based on a simple regression analysis. To the authors'surprise, most of these experts had a hard time accurately deciphering and acting on the results of the kind of analysis they themselves frequently conduct. In particular, the authors found that their description of the findings, which mimicked the industry standard, led to an illusion of predictability -- an erroneous belief that the analyzed outcomes were more predictable than they actually were. The authors argue that simulated experience enables intuitive interpretation of statistical information, thereby communicating analytical results even to decision makers who are not knowledgeable about statistics. This is an MIT Sloan Management Review article.

Case Authors : Robin M. Hogarth, Emre Soyer

Topic : Technology & Operations

Related Areas :

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Calculating Net Present Value (NPV) at 6% for Using Simulated Experience to Make Sense of Big Data Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10004459)	-10004459	-	-
Year 1	3457769	-6546690	3457769	0.9434	3262046
Year 2	3981092	-2565598	7438861	0.89	3543158
Year 3	3964168	1398570	11403029	0.8396	3328392
Year 4	3251825	4650395	14654854	0.7921	2575750
TOTAL			14654854		12709346

The Net Present Value at 6% discount rate is 2704887

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. 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. Statistical Makers 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 Statistical Makers 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 Using Simulated Experience to Make Sense of Big Data

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 Statistical Makers 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 Statistical Makers 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	(10004459)	-10004459	-	-
Year 1	3457769	-6546690	3457769	0.8696	3006756
Year 2	3981092	-2565598	7438861	0.7561	3010278
Year 3	3964168	1398570	11403029	0.6575	2606505
Year 4	3251825	4650395	14654854	0.5718	1859241
TOTAL					10482779

The Net NPV after 4 years is 478320

(10482779 - 10004459 )

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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	(10004459)	-10004459	-	-
Year 1	3457769	-6546690	3457769	0.8333	2881474
Year 2	3981092	-2565598	7438861	0.6944	2764647
Year 3	3964168	1398570	11403029	0.5787	2294079
Year 4	3251825	4650395	14654854	0.4823	1568203
TOTAL					9508403

The Net NPV after 4 years is -496056

At 20% discount rate the NPV is negative (9508403 - 10004459 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Statistical Makers 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 Statistical Makers has a NPV value higher than Zero then finance managers at Statistical Makers 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 Statistical Makers, then the stock price of the Statistical Makers 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 Statistical Makers 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 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 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.

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 Using Simulated Experience to Make Sense of Big Data

References & Further Readings

Robin M. Hogarth, Emre Soyer (2018), "Using Simulated Experience to Make Sense of Big Data Harvard Business Review Case Study. Published by HBR Publications.