The Pitfalls of Non-GAAP Metrics 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 Non-GAAP Metrics case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. The Pitfalls of Non-GAAP Metrics case study is a Harvard Business School (HBR) case study written by H. David Sherman, S. David Young. The The Pitfalls of Non-GAAP Metrics (referred as “Gaap Adjusted” from here on) case study provides evaluation & decision scenario in field of Leadership & Managing People. It also touches upon business topics such as - Value proposition, Performance measurement.

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 Non-GAAP Metrics Case Study

This is an MIT Sloan Management Review article. For decades, companies have used custom metrics that don't conform to generally accepted accounting principles (GAAP) or international financial reporting standards (IFRS) as supplements to their official financial statements. Some common non-GAAP measures include adjusted earnings before interest, taxes, depreciation, and amortization (known as adjusted EBITDA), free cash flow, funds from operations, adjusted revenues, adjusted earnings, adjusted earnings per share, and net debt. However, as the authors point out, it's not unusual for these alternative measures to lead to problems. Since companies devise their own methods of calculation, it's difficult to compare the metrics from company to company -or, in many cases, from year to year within the same company. According to the authors, alternative measures, once used fairly sparingly and shared mostly with a small group of professional investors, have become more ubiquitous and further and further disconnected from reality. In 2013, McKinsey & Co. found that all of the 25 largest U.S.-based nonfinancial companies reported some form of non-GAAP earnings. Press releases and earnings-call summaries often present non-GAAP measures that are increasingly detached from their GAAP-based equivalents. In addition to creating potential problems for investors, the authors argue, alternative metrics can harm companies themselves by obscuring their financial health, overstating their growth prospects beyond what standard GAAP measures would support, and rewarding executives beyond what is justified. Board members, top executives, compliance officers, and corporate strategists need to make sure that whatever alternative measures companies use improve transparency and reduce bias in financial reports. Although no standard is perfect, the authors note that GAAP and IFRS standards provide a foundation for consistent measurement of corporate performance over time and across businesses.

Case Authors : H. David Sherman, S. David Young

Topic : Leadership & Managing People

Related Areas : Performance measurement

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Calculating Net Present Value (NPV) at 6% for The Pitfalls of Non-GAAP Metrics Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10017929)	-10017929	-	-
Year 1	3444582	-6573347	3444582	0.9434	3249606
Year 2	3963160	-2610187	7407742	0.89	3527198
Year 3	3939063	1328876	11346805	0.8396	3307313
Year 4	3226698	4555574	14573503	0.7921	2555847
TOTAL			14573503		12639964

The Net Present Value at 6% discount rate is 2622035

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

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 Gaap Adjusted 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. Gaap Adjusted 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 Pitfalls of Non-GAAP Metrics

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 Leadership & Managing People 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 Gaap Adjusted 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 Gaap Adjusted 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	(10017929)	-10017929	-	-
Year 1	3444582	-6573347	3444582	0.8696	2995289
Year 2	3963160	-2610187	7407742	0.7561	2996718
Year 3	3939063	1328876	11346805	0.6575	2589998
Year 4	3226698	4555574	14573503	0.5718	1844875
TOTAL					10426880

The Net NPV after 4 years is 408951

(10426880 - 10017929 )

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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	(10017929)	-10017929	-	-
Year 1	3444582	-6573347	3444582	0.8333	2870485
Year 2	3963160	-2610187	7407742	0.6944	2752194
Year 3	3939063	1328876	11346805	0.5787	2279550
Year 4	3226698	4555574	14573503	0.4823	1556085
TOTAL					9458315

The Net NPV after 4 years is -559614

At 20% discount rate the NPV is negative (9458315 - 10017929 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Gaap Adjusted 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 Gaap Adjusted has a NPV value higher than Zero then finance managers at Gaap Adjusted 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 Gaap Adjusted, then the stock price of the Gaap Adjusted 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 Gaap Adjusted 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 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.

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.

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 Non-GAAP Metrics

References & Further Readings

H. David Sherman, S. David Young (2018), "The Pitfalls of Non-GAAP Metrics Harvard Business Review Case Study. Published by HBR Publications.