Netflix: Designing the Netflix Prize (A), Spanish Version 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 Netflix: Designing the Netflix Prize (A), Spanish Version case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Netflix: Designing the Netflix Prize (A), Spanish Version case study is a Harvard Business School (HBR) case study written by Karim R. Lakhani, Wesley M. Cohen, Kynon Ingram, Tushar Kothalkar. The Netflix: Designing the Netflix Prize (A), Spanish Version (referred as “Hastings Netflix” from here on) case study provides evaluation & decision scenario in field of Technology & Operations. It also touches upon business topics such as - Value proposition, Innovation, Knowledge management, Technology.

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 Netflix: Designing the Netflix Prize (A), Spanish Version Case Study

In 2006, Reed Hastings, CEO of Netflix, was looking for a way to solve Netflix's customer churn problem. Netflix used Cinematch, its proprietary movie recommendation software, to promote individually determined best-fit movies to customers. Hastings determined that a 10% improvement to the Cinematch algorithm would decrease customer churn and increase annual revenue by up to $89 million. However, traditional options for improving the algorithm, such as hiring and training new employees, were time intensive and costly. Hastings decided to improve Netflix's software by crowdsourcing, and began planning the Netflix Prize, an open contest searching for a 10% improvement on Cinematch. The case examines the dilemmas Hastings faced as he planned the contest, such as whether to use an existing crowdsourcing platform or create his own, what company information to expose, how to protect customer privacy while making internal datasets public, how to allocate IP, and how to manage the crowd.

Case Authors : Karim R. Lakhani, Wesley M. Cohen, Kynon Ingram, Tushar Kothalkar

Topic : Technology & Operations

Related Areas : Innovation, Knowledge management, Technology

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Calculating Net Present Value (NPV) at 6% for Netflix: Designing the Netflix Prize (A), Spanish Version Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10015930)	-10015930	-	-
Year 1	3461919	-6554011	3461919	0.9434	3265961
Year 2	3977789	-2576222	7439708	0.89	3540218
Year 3	3944031	1367809	11383739	0.8396	3311484
Year 4	3244506	4612315	14628245	0.7921	2569953
TOTAL			14628245		12687616

The Net Present Value at 6% discount rate is 2671686

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. Internal Rate of Return
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. Timing of the expected cash flows – stockholders of Hastings Netflix 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. Hastings Netflix 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 Netflix: Designing the Netflix Prize (A), Spanish Version

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 Hastings Netflix 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 Hastings Netflix 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	(10015930)	-10015930	-	-
Year 1	3461919	-6554011	3461919	0.8696	3010364
Year 2	3977789	-2576222	7439708	0.7561	3007780
Year 3	3944031	1367809	11383739	0.6575	2593264
Year 4	3244506	4612315	14628245	0.5718	1855057
TOTAL					10466466

The Net NPV after 4 years is 450536

(10466466 - 10015930 )

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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	(10015930)	-10015930	-	-
Year 1	3461919	-6554011	3461919	0.8333	2884933
Year 2	3977789	-2576222	7439708	0.6944	2762353
Year 3	3944031	1367809	11383739	0.5787	2282425
Year 4	3244506	4612315	14628245	0.4823	1564673
TOTAL					9494384

The Net NPV after 4 years is -521546

At 20% discount rate the NPV is negative (9494384 - 10015930 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Hastings Netflix 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 Hastings Netflix has a NPV value higher than Zero then finance managers at Hastings Netflix 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 Hastings Netflix, then the stock price of the Hastings Netflix 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 Hastings Netflix 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 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 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 will be a multi year spillover effect of various taxation regulations.

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 Netflix: Designing the Netflix Prize (A), Spanish Version

References & Further Readings

Karim R. Lakhani, Wesley M. Cohen, Kynon Ingram, Tushar Kothalkar (2018), "Netflix: Designing the Netflix Prize (A), Spanish Version Harvard Business Review Case Study. Published by HBR Publications.