Using Scenario Planning to Reshape Strategy 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 Using Scenario Planning to Reshape Strategy case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Using Scenario Planning to Reshape Strategy case study is a Harvard Business School (HBR) case study written by Rafael Ramirez, Steve Churchhouse, Jonas Hoffman, Alejandra Palermo. The Using Scenario Planning to Reshape Strategy (referred as “Scenario Planning” from here on) case study provides evaluation & decision scenario in field of Strategy & Execution. 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

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Case Description of Using Scenario Planning to Reshape Strategy Case Study

This is an MIT Sloan Management Review article. In recent years, organizations have been caught off guard by economic volatility, unexpected political events, natural disasters, and disruptive innovations. In response, the authors note, executives are showing a new interest in scenario planning. Rather than tying their company's future to a strategy geared to one set of events, executives are coming to the view that smart management benefits from a richer understanding of the present possibilities afforded from multiple views about possible futures.Scenario planning came to prominence following World War II and gained recognition in the corporate world in the late 1960s and early 1970s. While several different approaches to scenario planning have emerged since then, this article focuses specifically on the Oxford scenario planning approach. Rather than taking a probabilistic stance (that is, making predictions in percentage terms or as best-case/worst-case scenarios) or a normative stance (that is, envisioning what a future should look like), the Oxford scenario methodology is based on plausibility. By recognizing the part of uncertainty that is unpredictable and by actively exploring the sources of the turbulence and uncertainty, the goal is to iteratively and interactively generate new knowledge and insights to help organizations reperceive their circumstances. During periods of turbulence, unpredictable uncertainty, novelty, and ambiguity (what the authors refer to as TUNA conditions), organizations frequently experience serious challenges that threaten existing value chains, communities, and even whole fields of endeavor. Such conditions can be unsettling and destabilizing on many different levels. A core feature in the Oxford scenario planning approach is making a distinction between the immediate business environment an organization inhabits (where business transactions take place) and the broader environment, or context, in which it operates. Different organizations go about scenario planning in different ways -there is no cookie-cutter methodology, the authors write. This article examines two cases. The first case involves Rolls-Royce plc, a leading supplier of power systems for aircraft and the marine and energy markets; the second case looks at the Royal Society of Chemistry, a London, U.K.-based international organization involved in advancing the field of chemical sciences. In addition to showing how these organizations used scenario planning, the authors discuss the challenges and opportunities of scenario planning more broadly.

Case Authors : Rafael Ramirez, Steve Churchhouse, Jonas Hoffman, Alejandra Palermo

Topic : Strategy & Execution

Related Areas :

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Calculating Net Present Value (NPV) at 6% for Using Scenario Planning to Reshape Strategy Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10014186)	-10014186	-	-
Year 1	3461607	-6552579	3461607	0.9434	3265667
Year 2	3965843	-2586736	7427450	0.89	3529586
Year 3	3945670	1358934	11373120	0.8396	3312861
Year 4	3243431	4602365	14616551	0.7921	2569101
TOTAL			14616551		12677215

The Net Present Value at 6% discount rate is 2663029

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. Payback Period
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. Scenario Planning 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 Scenario Planning 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 Using Scenario Planning to Reshape Strategy

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 Scenario Planning 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 Scenario Planning 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	(10014186)	-10014186	-	-
Year 1	3461607	-6552579	3461607	0.8696	3010093
Year 2	3965843	-2586736	7427450	0.7561	2998747
Year 3	3945670	1358934	11373120	0.6575	2594342
Year 4	3243431	4602365	14616551	0.5718	1854442
TOTAL					10457624

The Net NPV after 4 years is 443438

(10457624 - 10014186 )

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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	(10014186)	-10014186	-	-
Year 1	3461607	-6552579	3461607	0.8333	2884673
Year 2	3965843	-2586736	7427450	0.6944	2754058
Year 3	3945670	1358934	11373120	0.5787	2283374
Year 4	3243431	4602365	14616551	0.4823	1564155
TOTAL					9486259

The Net NPV after 4 years is -527927

At 20% discount rate the NPV is negative (9486259 - 10014186 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Scenario Planning 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 Scenario Planning has a NPV value higher than Zero then finance managers at Scenario Planning 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 Scenario Planning, then the stock price of the Scenario Planning 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 Scenario Planning 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 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.

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 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 Using Scenario Planning to Reshape Strategy

References & Further Readings

Rafael Ramirez, Steve Churchhouse, Jonas Hoffman, Alejandra Palermo (2018), "Using Scenario Planning to Reshape Strategy Harvard Business Review Case Study. Published by HBR Publications.