Winning With Open Process Innovation 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 Winning With Open Process Innovation case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Winning With Open Process Innovation case study is a Harvard Business School (HBR) case study written by Georg von Krogh, Torbjorn Netland, Martin Worter. The Winning With Open Process Innovation (referred as “Ideas Authors” 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, Knowledge management.

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

---

Case Description of Winning With Open Process Innovation Case Study

This is an MIT Sloan Management Review article. Most research on open innovation has focused on the use of ideas and knowledge from outside the organization in the development of products and services. But openness can be useful for process innovation, too. The authors' research shows that manufacturers can benefit substantially when they look for ideas beyond the factory gates, especially when their operations are already advanced. In this article, the authors analyzed nine years of survey responses from 1,000 Swiss manufacturers, as well as 200 interviews with personnel at the Volvo Group (AB Volvo), a manufacturer of trucks, buses, construction equipment, and marine and industrial engines that is based in Gothenburg, Sweden. Although the authors concede that some companies have good reasons for keeping process innovations concealed, they found that for many manufacturers, such defensiveness deprives companies of a valuable source of ideas for productivity improvement. The authors present six ideas to help manufacturing companies open up their innovation process. The first idea is to encourage factories within a large company to share innovative practices and success stories with one another. Companies that already do this informally, the authors say, can extend their activities with a systematic effort inside their factory networks and lay the groundwork for other open information sharing about processes. The second idea is to focus on the pace of process improvement. The third idea is to recognize that increased use of data access systems leads to greater production cost reductions. Customer relationship management, supply chain management, and enterprise resource planning software systems all require codification of tacit knowledge, which enhances a company's capacity to spread external process ideas and technology to the people who need it. As a fourth step, the authors recommend improving the organization's ability to absorb and implement ideas from external sources. A good way to achieve this, they say, is to establish routines for gathering ideas from external sources and putting them to use. Fifth, the authors advise reaching beyond a company's internal factory networks for inspiration. Finally, they say companies should remember that "nontraditional sources of knowledge may spark process innovation and help overcome difficult problems."

Case Authors : Georg von Krogh, Torbjorn Netland, Martin Worter

Topic : Leadership & Managing People

Related Areas : Knowledge management

---

Calculating Net Present Value (NPV) at 6% for Winning With Open Process Innovation Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10024690)	-10024690	-	-
Year 1	3444447	-6580243	3444447	0.9434	3249478
Year 2	3960388	-2619855	7404835	0.89	3524731
Year 3	3954657	1334802	11359492	0.8396	3320406
Year 4	3247341	4582143	14606833	0.7921	2572198
TOTAL			14606833		12666814

The Net Present Value at 6% discount rate is 2642124

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.

---

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. Internal Rate of Return
4. Profitability Index

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. Ideas Authors 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 Ideas Authors have higher preference for cash returns over 4-5 years rather than 10-15 years given the nature of the volatility in the industry.

---

Formula and Steps to Calculate Net Present Value (NPV) of Winning With Open Process Innovation

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 Ideas Authors 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 Ideas Authors 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	(10024690)	-10024690	-	-
Year 1	3444447	-6580243	3444447	0.8696	2995171
Year 2	3960388	-2619855	7404835	0.7561	2994622
Year 3	3954657	1334802	11359492	0.6575	2600251
Year 4	3247341	4582143	14606833	0.5718	1856678
TOTAL					10446723

The Net NPV after 4 years is 422033

(10446723 - 10024690 )

---

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	(10024690)	-10024690	-	-
Year 1	3444447	-6580243	3444447	0.8333	2870373
Year 2	3960388	-2619855	7404835	0.6944	2750269
Year 3	3954657	1334802	11359492	0.5787	2288575
Year 4	3247341	4582143	14606833	0.4823	1566040
TOTAL					9475257

The Net NPV after 4 years is -549433

At 20% discount rate the NPV is negative (9475257 - 10024690 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Ideas Authors 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 Ideas Authors has a NPV value higher than Zero then finance managers at Ideas Authors 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 Ideas Authors, then the stock price of the Ideas Authors 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 Ideas Authors 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.

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 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.

---

Negotiation Strategy of Winning With Open Process Innovation

References & Further Readings

Georg von Krogh, Torbjorn Netland, Martin Worter (2018), "Winning With Open Process Innovation Harvard Business Review Case Study. Published by HBR Publications.