Building Scalable Business Models 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 Building Scalable Business Models case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Building Scalable Business Models case study is a Harvard Business School (HBR) case study written by Christian Nielsen, Morten Lund. The Building Scalable Business Models (referred as “Scalability Model” 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, Growth 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 Building Scalable Business Models Case Study

This is an MIT Sloan Management Review article. Business model innovation has become a hot topic in management circles, and understandably so. No management activity is more important than having clarity about how the organization creates, delivers, and captures value. It requires, among other things, knowing what customers want, how value can be best delivered, and how to enlist strategic partners to achieve maximum benefit. Although the ability to develop strong value propositions can enable companies to "get by, "the authors argue that many of today's most successful businesses are those that can place themselves in the "sweet spot" of business model scalability. If managers are incapable of factoring scalability attributes into their business model design, they risk being left behind, much the way bookstores owned by Borders Group Inc. were eclipsed by Amazon.com Inc. In the course of their research, the authors identified five patterns by which companies can achieve scalability. The first pattern involves adding new distribution channels. The second entails freeing the business from traditional capacity constraints. The third involves outsourcing capital investments to partners that, in effect, became participants in the business model. The fourth is having customers and other partners assume multiple roles in the business model. And the fifth pattern is to establish platform models in which even competitors may become customers. Based on these patterns, the authors developed a framework for identifying potential levers for business model scalability along with a road map that managers can use to improve their business models. Over and above the need to create value propositions that are difficult for competitors to replicate, managers need to develop business models that are capable of achieving positive returns and accelerating returns on the investments made. Merely identifying synergies, the authors note, doesn't necessarily lead to improvements in business model scalability. They write: "To achieve scalability, managers and entrepreneurs need to remove capacity constraints. They have opportunities to do this in a variety of ways: by collaborating with partners; by encouraging partners to play multiple roles in the business model; by creating platforms to attract new partners; or even by working with current competitors."

Case Authors : Christian Nielsen, Morten Lund

Topic : Leadership & Managing People

Related Areas : Growth strategy

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Calculating Net Present Value (NPV) at 6% for Building Scalable Business Models Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10020199)	-10020199	-	-
Year 1	3462217	-6557982	3462217	0.9434	3266242
Year 2	3961968	-2596014	7424185	0.89	3526137
Year 3	3951575	1355561	11375760	0.8396	3317819
Year 4	3235582	4591143	14611342	0.7921	2562884
TOTAL			14611342		12673082

The Net Present Value at 6% discount rate is 2652883

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. Net Present Value
3. Profitability Index
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. Scalability Model 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 Scalability Model 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 Building Scalable Business Models

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 Scalability Model 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 Scalability Model 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	(10020199)	-10020199	-	-
Year 1	3462217	-6557982	3462217	0.8696	3010623
Year 2	3961968	-2596014	7424185	0.7561	2995817
Year 3	3951575	1355561	11375760	0.6575	2598225
Year 4	3235582	4591143	14611342	0.5718	1849955
TOTAL					10454620

The Net NPV after 4 years is 434421

(10454620 - 10020199 )

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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	(10020199)	-10020199	-	-
Year 1	3462217	-6557982	3462217	0.8333	2885181
Year 2	3961968	-2596014	7424185	0.6944	2751367
Year 3	3951575	1355561	11375760	0.5787	2286791
Year 4	3235582	4591143	14611342	0.4823	1560369
TOTAL					9483708

The Net NPV after 4 years is -536491

At 20% discount rate the NPV is negative (9483708 - 10020199 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Scalability Model 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 Scalability Model has a NPV value higher than Zero then finance managers at Scalability Model 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 Scalability Model, then the stock price of the Scalability Model 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 Scalability Model 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 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.

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 Building Scalable Business Models

References & Further Readings

Christian Nielsen, Morten Lund (2018), "Building Scalable Business Models Harvard Business Review Case Study. Published by HBR Publications.