The Best Response to Digital Disruption 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 Best Response to Digital Disruption case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. The Best Response to Digital Disruption case study is a Harvard Business School (HBR) case study written by Nicolas van Zeebroeck, Jacques Bughin. The The Best Response to Digital Disruption (referred as “Digital Disruption” from here on) case study provides evaluation & decision scenario in field of Strategy & Execution. It also touches upon business topics such as - Value proposition, 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 The Best Response to Digital Disruption Case Study

This is an MIT Sloan Management Review article. Few executives would dispute that digitization's disruptive influence is growing. But surprisingly little empirical evidence has captured either the magnitude of digital disruption or how incumbents are reacting. Leaders know they have a problem but lack guidance to determine the right course of action.In a global survey of 2,000 C-suite executives in more than 60 countries, McKinsey & Co. found that few companies are responding appropriately to digital disruption. While 90% of companies indicated that they are engaged in some form of digitization, only 16% said their companies have responded with a bold strategy and at scale; only 30% of companies are focusing on new ways to bundle demand or resegment their market. Based on these numbers, some leaders might assume that they have plenty of time to get their digital acts together. But the authors argue that this would be a dangerous assumption because new digital entrants are seizing a significant share of revenue across regions and industries. The authors highlight three bold tactics companies can use: 1. Develop new customer segments. Rather than just defending existing business lines through cost cutting, automation, or service improvements for existing customers, companies should focus on developing new customer segments. Medialaan NV, a leading free-to-air video broadcaster in Belgium, spotted young customers moving to platforms such as Netflix or YouTube. In response, it bought a mobile virtual operator with attractive data plans, thus becoming one of the few traditional broadcast companies to grow its TV audience in the youth segment. 2. Introduce new business models. Innovative companies are experimenting with business models intended to disrupt their own legacy strategies. When Schibsted Media Group of Oslo, Norway, saw that its print classified advertising was drying up, it moved the classified business to a free online marketplace. Today, more than 80% of the group's earnings come from commissions on sales from its consumer e-commerce platform. 3. Redefine the value chain. When digital entrants threatened its payment services business, Commonwealth Bank of Australia (CBA) chose to confront the disrupters head-on with a new open payments platform that hosts an ecosystem of applications and devices for merchants and is open to third-party developers. Although the platform and its ecosystem contribute to the disruption of the traditional banking value-add chain, it also positions CBA to compete with digital entrants.

Case Authors : Nicolas van Zeebroeck, Jacques Bughin

Topic : Strategy & Execution

Related Areas : Strategy

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Calculating Net Present Value (NPV) at 6% for The Best Response to Digital Disruption Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10015382)	-10015382	-	-
Year 1	3452320	-6563062	3452320	0.9434	3256906
Year 2	3965493	-2597569	7417813	0.89	3529275
Year 3	3962859	1365290	11380672	0.8396	3327293
Year 4	3226749	4592039	14607421	0.7921	2555887
TOTAL			14607421		12669361

The Net Present Value at 6% discount rate is 2653979

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. 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 Digital Disruption 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. Digital Disruption 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 The Best Response to Digital Disruption

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 Strategy & Execution 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 Digital Disruption 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 Digital Disruption 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	(10015382)	-10015382	-	-
Year 1	3452320	-6563062	3452320	0.8696	3002017
Year 2	3965493	-2597569	7417813	0.7561	2998482
Year 3	3962859	1365290	11380672	0.6575	2605644
Year 4	3226749	4592039	14607421	0.5718	1844904
TOTAL					10451048

The Net NPV after 4 years is 435666

(10451048 - 10015382 )

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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	(10015382)	-10015382	-	-
Year 1	3452320	-6563062	3452320	0.8333	2876933
Year 2	3965493	-2597569	7417813	0.6944	2753815
Year 3	3962859	1365290	11380672	0.5787	2293321
Year 4	3226749	4592039	14607421	0.4823	1556110
TOTAL					9480179

The Net NPV after 4 years is -535203

At 20% discount rate the NPV is negative (9480179 - 10015382 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Digital Disruption 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 Digital Disruption has a NPV value higher than Zero then finance managers at Digital Disruption 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 Digital Disruption, then the stock price of the Digital Disruption 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 Digital Disruption 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.

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.

Understanding of risks involved in the project.

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 Best Response to Digital Disruption

References & Further Readings

Nicolas van Zeebroeck, Jacques Bughin (2018), "The Best Response to Digital Disruption Harvard Business Review Case Study. Published by HBR Publications.