The Pitfalls of Project Status Reporting 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 The Pitfalls of Project Status Reporting case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. The Pitfalls of Project Status Reporting case study is a Harvard Business School (HBR) case study written by Mark Keil, H. Jeff Smith, Charalambos L. Iacovou, Ronald L Thompson. The The Pitfalls of Project Status Reporting (referred as “Project Status” from here on) case study provides evaluation & decision scenario in field of Technology & Operations. It also touches upon business topics such as - Value proposition, Leadership.

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 The Pitfalls of Project Status Reporting Case Study

This is an MIT Sloan Management Review article. All too frequently, executives are caught by surprise when projects -especially complex IT projects -run into trouble. But complex projects do not fail overnight; they fail one day at a time, and generally only after numerous warning signs. The authors have been involved in 14 academic studies about the ways in which individuals report (and misreport) the status of IT projects and how the recipients of those reports respond to the information they receive.The authors' research suggests that understanding the underlying dynamics of project status reporting can help limit the chances of nasty surprises. In particular, they identify five "inconvenient truths" about project status reporting: 1. Executives can't rely on project staff and other employees to accurately report project status information and to speak up when they see problems. Many employees have a tendency to put a positive spin on anything they report to senior management. When the organizational climate is not receptive to bad news, truthful reporting can be inhibited 2. A variety of reasons can cause people to misreport about project status. Executives tend to attribute misreporting to poor ethical behavior on the employee's part. In fact, employees misreport for a variety of reasons; individual traits, work climate and cultural norms all can play a role. 3. An aggressive audit team can't counter the effects of project status misreporting and withholding of information by project staff. Executives may conclude that the best way to address the problem of misreporting is to rely on auditors to make sure that project status reports are accurate. However, once auditors are added to the mix, negative organizational dynamics can lead to a dysfunctional cycle that results in even less openness. 4. Putting a senior executive in charge of a project may increase misreporting. Although having a senior executive as a project sponsor often proves wise politically and can help in securing resources for a project, the involvement of senior leaders does not make it any easier to track project status. 5. Executives often ignore bad news if they do receive it. A number of the authors'studies found situations where employees went to share their concerns about a project with powerful decision makers who had the ability to change the course of the project (or stop it), but were unsuccessful. The authors propose solutions to reduce the risk of being blindsided by any of these inconvenient truths. They include a self-diagnostic survey to help you assess whether you may be at risk for an unpleasant project management surprise.

Case Authors : Mark Keil, H. Jeff Smith, Charalambos L. Iacovou, Ronald L Thompson

Topic : Technology & Operations

Related Areas : Leadership

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Calculating Net Present Value (NPV) at 6% for The Pitfalls of Project Status Reporting Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10021650)	-10021650	-	-
Year 1	3462360	-6559290	3462360	0.9434	3266377
Year 2	3972054	-2587236	7434414	0.89	3535114
Year 3	3968829	1381593	11403243	0.8396	3332305
Year 4	3250871	4632464	14654114	0.7921	2574994
TOTAL			14654114		12708791

The Net Present Value at 6% discount rate is 2687141

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. Net Present Value
3. Profitability Index
4. Internal Rate of Return

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. Project Status 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 Project Status 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 The Pitfalls of Project Status Reporting

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 Project Status 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 Project Status 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	(10021650)	-10021650	-	-
Year 1	3462360	-6559290	3462360	0.8696	3010748
Year 2	3972054	-2587236	7434414	0.7561	3003443
Year 3	3968829	1381593	11403243	0.6575	2609569
Year 4	3250871	4632464	14654114	0.5718	1858696
TOTAL					10482457

The Net NPV after 4 years is 460807

(10482457 - 10021650 )

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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	(10021650)	-10021650	-	-
Year 1	3462360	-6559290	3462360	0.8333	2885300
Year 2	3972054	-2587236	7434414	0.6944	2758371
Year 3	3968829	1381593	11403243	0.5787	2296776
Year 4	3250871	4632464	14654114	0.4823	1567743
TOTAL					9508189

The Net NPV after 4 years is -513461

At 20% discount rate the NPV is negative (9508189 - 10021650 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Project Status 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 Project Status has a NPV value higher than Zero then finance managers at Project Status 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 Project Status, then the stock price of the Project Status 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 Project Status 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.

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 will be a multi year spillover effect of various taxation regulations.

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 The Pitfalls of Project Status Reporting

References & Further Readings

Mark Keil, H. Jeff Smith, Charalambos L. Iacovou, Ronald L Thompson (2018), "The Pitfalls of Project Status Reporting Harvard Business Review Case Study. Published by HBR Publications.