Direct Response Advertising at Liberator Medical Holdings, Inc. 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 Direct Response Advertising at Liberator Medical Holdings, Inc. case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Direct Response Advertising at Liberator Medical Holdings, Inc. case study is a Harvard Business School (HBR) case study written by Graeme Rankine. The Direct Response Advertising at Liberator Medical Holdings, Inc. (referred as “Liberator Students” from here on) case study provides evaluation & decision scenario in field of Finance & Accounting. It also touches upon business topics such as - Value proposition, Communication, Marketing, Strategy.

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 Direct Response Advertising at Liberator Medical Holdings, Inc. Case Study

Students are asked to consider several issues in the case. First, students are asked to explain how Liberator Medical makes money, to evaluate its business strategy for accomplishing this objective, and to evaluate how successful execution of this strategy is likely to be observable from the company's financial performance. Second, students are asked to analyze the company's cash flow situation, and recent financial performance, including its profitability, asset management, and leverage. Third, students are asked to consider the quantitative impact on the company's financial statements of capitalizing and amortizing direct response advertising outlays. Students are also asked to evaluate whether Liberator Medical used accounting methods that were consistent with generally accepted accounting principles (GAAP). Finally, students are asked to consider the communication and disclosure issues the company faced in responding to analyst criticism of its method of accounting for direct response advertising. The case has been used successfully in MBA programs to cover corporate financial reporting issues, and in bank training programs focused on credit analysis and quality of earnings issues.

Case Authors : Graeme Rankine

Topic : Finance & Accounting

Related Areas : Communication, Marketing, Strategy

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Calculating Net Present Value (NPV) at 6% for Direct Response Advertising at Liberator Medical Holdings, Inc. Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10013778)	-10013778	-	-
Year 1	3446364	-6567414	3446364	0.9434	3251287
Year 2	3956104	-2611310	7402468	0.89	3520918
Year 3	3955652	1344342	11358120	0.8396	3321242
Year 4	3232718	4577060	14590838	0.7921	2560615
TOTAL			14590838		12654062

The Net Present Value at 6% discount rate is 2640284

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. Net Present Value
3. Internal Rate of Return
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 Liberator Students 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. Liberator Students 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 Direct Response Advertising at Liberator Medical Holdings, Inc.

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 Finance & Accounting 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 Liberator Students 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 Liberator Students 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	(10013778)	-10013778	-	-
Year 1	3446364	-6567414	3446364	0.8696	2996838
Year 2	3956104	-2611310	7402468	0.7561	2991383
Year 3	3955652	1344342	11358120	0.6575	2600905
Year 4	3232718	4577060	14590838	0.5718	1848317
TOTAL					10437444

The Net NPV after 4 years is 423666

(10437444 - 10013778 )

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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	(10013778)	-10013778	-	-
Year 1	3446364	-6567414	3446364	0.8333	2871970
Year 2	3956104	-2611310	7402468	0.6944	2747294
Year 3	3955652	1344342	11358120	0.5787	2289150
Year 4	3232718	4577060	14590838	0.4823	1558988
TOTAL					9467403

The Net NPV after 4 years is -546375

At 20% discount rate the NPV is negative (9467403 - 10013778 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Liberator Students 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 Liberator Students has a NPV value higher than Zero then finance managers at Liberator Students 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 Liberator Students, then the stock price of the Liberator Students 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 Liberator Students 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 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.

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 Direct Response Advertising at Liberator Medical Holdings, Inc.

References & Further Readings

Graeme Rankine (2018), "Direct Response Advertising at Liberator Medical Holdings, Inc. Harvard Business Review Case Study. Published by HBR Publications.