Knightsbridge Custom Homebuilders Ltd.: Commitment to Core Values 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 Knightsbridge Custom Homebuilders Ltd.: Commitment to Core Values case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Knightsbridge Custom Homebuilders Ltd.: Commitment to Core Values case study is a Harvard Business School (HBR) case study written by Pernille Goodbrand, Jyoti Gondek, Cheryl Brazell. The Knightsbridge Custom Homebuilders Ltd.: Commitment to Core Values (referred as “Knightsbridge Calgary” 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, .

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 Knightsbridge Custom Homebuilders Ltd.: Commitment to Core Values Case Study

It was 2014, and the chief executive officer (CEO) of Knightsbridge Custom Homes Limited (Knightsbridge) had just purchased a site for his next project in the rapidly gentrifying East Village neighbourhood of Calgary, Alberta. He had built Knightsbridge on a commitment to three core values: finding great locations, catering to underserved markets, and providing niche products. Since it's founding in 1990, these values had remained the same, but the type of projects undertaken by Knightsbridge had changed dramatically. The company started by building infill homes in inner-city Calgary and estate homes on the city's outskirts. Then it built multi-family homes in the suburbs and tackled a transit-oriented development in an established area. Now, the CEO was considering developing a no parking, high-rise condominium tower close to the downtown core. High-rise living without parking would be an entirely new concept in car-centric Calgary. Was developing a residential site without parking a viable plan in this growing city? Knightsbridge's CEO needed to find an effective way to answer this question. Pernille Goodbrand is affiliated with University of Calgary. Jyoti Gondek is affiliated with Haskayne School of Business.

Case Authors : Pernille Goodbrand, Jyoti Gondek, Cheryl Brazell

Topic : Leadership & Managing People

Related Areas :

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Calculating Net Present Value (NPV) at 6% for Knightsbridge Custom Homebuilders Ltd.: Commitment to Core Values Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10008060)	-10008060	-	-
Year 1	3451574	-6556486	3451574	0.9434	3256202
Year 2	3959214	-2597272	7410788	0.89	3523686
Year 3	3957964	1360692	11368752	0.8396	3323183
Year 4	3222982	4583674	14591734	0.7921	2552904
TOTAL			14591734		12655975

The Net Present Value at 6% discount rate is 2647915

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. Timing of the expected cash flows – stockholders of Knightsbridge Calgary 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. Knightsbridge Calgary 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 Knightsbridge Custom Homebuilders Ltd.: Commitment to Core Values

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 Knightsbridge Calgary 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 Knightsbridge Calgary 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	(10008060)	-10008060	-	-
Year 1	3451574	-6556486	3451574	0.8696	3001369
Year 2	3959214	-2597272	7410788	0.7561	2993735
Year 3	3957964	1360692	11368752	0.6575	2602426
Year 4	3222982	4583674	14591734	0.5718	1842750
TOTAL					10440279

The Net NPV after 4 years is 432219

(10440279 - 10008060 )

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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	(10008060)	-10008060	-	-
Year 1	3451574	-6556486	3451574	0.8333	2876312
Year 2	3959214	-2597272	7410788	0.6944	2749454
Year 3	3957964	1360692	11368752	0.5787	2290488
Year 4	3222982	4583674	14591734	0.4823	1554293
TOTAL					9470547

The Net NPV after 4 years is -537513

At 20% discount rate the NPV is negative (9470547 - 10008060 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Knightsbridge Calgary 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 Knightsbridge Calgary has a NPV value higher than Zero then finance managers at Knightsbridge Calgary 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 Knightsbridge Calgary, then the stock price of the Knightsbridge Calgary 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 Knightsbridge Calgary 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 Knightsbridge Custom Homebuilders Ltd.: Commitment to Core Values

References & Further Readings

Pernille Goodbrand, Jyoti Gondek, Cheryl Brazell (2018), "Knightsbridge Custom Homebuilders Ltd.: Commitment to Core Values Harvard Business Review Case Study. Published by HBR Publications.