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Reynaldo Roche (A) 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 Reynaldo Roche (A) case study


At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Reynaldo Roche (A) case study is a Harvard Business School (HBR) case study written by Jeriel Chua, Elliott N. Weiss. The Reynaldo Roche (A) (referred as “Om Uva” 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




Case Description of Reynaldo Roche (A) Case Study


This four-case series follows a team through a weeklong kaizen event. The A case sets up the situation, and the B (UVA-OM-1259), C (UVA-OM-1260), and D (UVA-OM-1261) cases depict what happens on the successive days. The series teaches such concepts as takt time, line balancing, and managing change. The A case is intended to be handed out as an assignment, and the B, C, and D cases provide real-time exercises for the students.


Case Authors : Jeriel Chua, Elliott N. Weiss

Topic : Technology & Operations

Related Areas :




Calculating Net Present Value (NPV) at 6% for Reynaldo Roche (A) Case Study


Years              Cash Flow     Net Cash Flow     Cumulative    
Cash Flow
Discount Rate
@ 6 %
Discounted
Cash Flows
Year 0 (10004447) -10004447 - -
Year 1 3460825 -6543622 3460825 0.9434 3264929
Year 2 3968056 -2575566 7428881 0.89 3531556
Year 3 3955241 1379675 11384122 0.8396 3320897
Year 4 3231800 4611475 14615922 0.7921 2559888
TOTAL 14615922 12677270


The Net Present Value at 6% discount rate is 2672823

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. Payback Period
2. Internal Rate of Return
3. Profitability Index
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 Om Uva 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. Om Uva 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 Reynaldo Roche (A)

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 Om Uva 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 Om Uva 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 (10004447) -10004447 - -
Year 1 3460825 -6543622 3460825 0.8696 3009413
Year 2 3968056 -2575566 7428881 0.7561 3000420
Year 3 3955241 1379675 11384122 0.6575 2600635
Year 4 3231800 4611475 14615922 0.5718 1847792
TOTAL 10458261


The Net NPV after 4 years is 453814

(10458261 - 10004447 )






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 (10004447) -10004447 - -
Year 1 3460825 -6543622 3460825 0.8333 2884021
Year 2 3968056 -2575566 7428881 0.6944 2755594
Year 3 3955241 1379675 11384122 0.5787 2288913
Year 4 3231800 4611475 14615922 0.4823 1558546
TOTAL 9487073


The Net NPV after 4 years is -517374

At 20% discount rate the NPV is negative (9487073 - 10004447 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Om Uva 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 Om Uva has a NPV value higher than Zero then finance managers at Om Uva 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 Om Uva, then the stock price of the Om Uva 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 Om Uva 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 can impact the cash flow of 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 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.

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

Jeriel Chua, Elliott N. Weiss (2018), "Reynaldo Roche (A) Harvard Business Review Case Study. Published by HBR Publications.