Decisions Brewing at Fire Roasted Coffee Company 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 Decisions Brewing at Fire Roasted Coffee Company case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Decisions Brewing at Fire Roasted Coffee Company case study is a Harvard Business School (HBR) case study written by Jeremiah De Sousa, Ian Dunn. The Decisions Brewing at Fire Roasted Coffee Company (referred as “Coffee Roasted” from here on) case study provides evaluation & decision scenario in field of Finance & Accounting. It also touches upon business topics such as - Value proposition, Pricing.

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 Decisions Brewing at Fire Roasted Coffee Company Case Study

The Fire Roasted Coffee Company (Fire Roasted) was a small regional roaster and seller of coffee in London, Ontario. The company sourced green coffee beans from over 20 different countries and managed the roasting process in house. Its coffee was primarily served at Fire Roasted's own coffee shop locations, but was sometimes sold wholesale to other cafes and interested parties. In 2017, as the company was about to update its point-of-sale system, the company's founder and president recognized the opportunity to implement a new set of prices for the premium coffee beverages on the menu. The list of beverages included Americano, cappuccino, drip coffee, latte, macchiato, and mocha. He considered a few different methods of costing selected items, intending to use these costs as an aid to his pricing decisions. He was also determined to incorporate industry and competitive dynamics into the decision.

Case Authors : Jeremiah De Sousa, Ian Dunn

Topic : Finance & Accounting

Related Areas : Pricing

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Calculating Net Present Value (NPV) at 6% for Decisions Brewing at Fire Roasted Coffee Company Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10009471)	-10009471	-	-
Year 1	3456833	-6552638	3456833	0.9434	3261163
Year 2	3963936	-2588702	7420769	0.89	3527889
Year 3	3956482	1367780	11377251	0.8396	3321939
Year 4	3239236	4607016	14616487	0.7921	2565778
TOTAL			14616487		12676769

The Net Present Value at 6% discount rate is 2667298

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. Internal Rate of Return
3. Payback Period
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 Coffee Roasted 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. Coffee Roasted 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 Decisions Brewing at Fire Roasted Coffee Company

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 Finance & Accounting 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 Coffee Roasted 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 Coffee Roasted 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	(10009471)	-10009471	-	-
Year 1	3456833	-6552638	3456833	0.8696	3005942
Year 2	3963936	-2588702	7420769	0.7561	2997305
Year 3	3956482	1367780	11377251	0.6575	2601451
Year 4	3239236	4607016	14616487	0.5718	1852044
TOTAL					10456742

The Net NPV after 4 years is 447271

(10456742 - 10009471 )

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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	(10009471)	-10009471	-	-
Year 1	3456833	-6552638	3456833	0.8333	2880694
Year 2	3963936	-2588702	7420769	0.6944	2752733
Year 3	3956482	1367780	11377251	0.5787	2289631
Year 4	3239236	4607016	14616487	0.4823	1562132
TOTAL					9485190

The Net NPV after 4 years is -524281

At 20% discount rate the NPV is negative (9485190 - 10009471 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Coffee Roasted 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 Coffee Roasted has a NPV value higher than Zero then finance managers at Coffee Roasted 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 Coffee Roasted, then the stock price of the Coffee Roasted 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 Coffee Roasted 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 will be a multi year spillover effect of various taxation regulations.

Understanding of risks involved in 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.

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 Decisions Brewing at Fire Roasted Coffee Company

References & Further Readings

Jeremiah De Sousa, Ian Dunn (2018), "Decisions Brewing at Fire Roasted Coffee Company Harvard Business Review Case Study. Published by HBR Publications.