Feed Green Ethiopia Exports: Stabilizing Product Quality and Price 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 Feed Green Ethiopia Exports: Stabilizing Product Quality and Price case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Feed Green Ethiopia Exports: Stabilizing Product Quality and Price case study is a Harvard Business School (HBR) case study written by Nicole R.D. Haggerty, Carmen Leung, Jensen Liu, Katherine Tan. The Feed Green Ethiopia Exports: Stabilizing Product Quality and Price (referred as “Fge Fge's” from here on) case study provides evaluation & decision scenario in field of Strategy & Execution. It also touches upon business topics such as - Value proposition, Globalization, Operations 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

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Case Description of Feed Green Ethiopia Exports: Stabilizing Product Quality and Price Case Study

In mid-2015, the managing director of Feed Green Ethiopia Exports PLC (FGE), one of Ethiopia's leading export companies, faced a pivotal decision. FGE specialized in herbs and spices, and the price of one of FGE's major products, paprika, had skyrocketed in the past six months. As a result, FGE had sustained a massive loss. This problem had taken a toll on FGE's profitability, and the company's future was on the line. The managing director needed to mitigate this problem and prevent it from occurring again. He saw three alternatives: FGE could maintain the status quo, operate its own farm in one of two locations, or purchase its spices directly from local farmers. Maintaining the price and quality of the products and providing excellent customer service were the company's main priorities, regardless of which option it chose.

Case Authors : Nicole R.D. Haggerty, Carmen Leung, Jensen Liu, Katherine Tan

Topic : Strategy & Execution

Related Areas : Globalization, Operations management

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Calculating Net Present Value (NPV) at 6% for Feed Green Ethiopia Exports: Stabilizing Product Quality and Price Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10001503)	-10001503	-	-
Year 1	3450279	-6551224	3450279	0.9434	3254980
Year 2	3956014	-2595210	7406293	0.89	3520838
Year 3	3964140	1368930	11370433	0.8396	3328368
Year 4	3235248	4604178	14605681	0.7921	2562619
TOTAL			14605681		12666806

The Net Present Value at 6% discount rate is 2665303

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. Magnitude of both incoming and outgoing cash flows – Projects can be capital intensive, time intensive, or both. Fge Fge's 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 Fge Fge's 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 Feed Green Ethiopia Exports: Stabilizing Product Quality and Price

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 Strategy & Execution 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 Fge Fge's 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 Fge Fge's 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	(10001503)	-10001503	-	-
Year 1	3450279	-6551224	3450279	0.8696	3000243
Year 2	3956014	-2595210	7406293	0.7561	2991315
Year 3	3964140	1368930	11370433	0.6575	2606486
Year 4	3235248	4604178	14605681	0.5718	1849764
TOTAL					10447807

The Net NPV after 4 years is 446304

(10447807 - 10001503 )

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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	(10001503)	-10001503	-	-
Year 1	3450279	-6551224	3450279	0.8333	2875233
Year 2	3956014	-2595210	7406293	0.6944	2747232
Year 3	3964140	1368930	11370433	0.5787	2294063
Year 4	3235248	4604178	14605681	0.4823	1560208
TOTAL					9476735

The Net NPV after 4 years is -524768

At 20% discount rate the NPV is negative (9476735 - 10001503 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Fge Fge's 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 Fge Fge's has a NPV value higher than Zero then finance managers at Fge Fge's 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 Fge Fge's, then the stock price of the Fge Fge's 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 Fge Fge's 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 will be a multi year spillover effect of various taxation regulations.

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.

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 Feed Green Ethiopia Exports: Stabilizing Product Quality and Price

References & Further Readings

Nicole R.D. Haggerty, Carmen Leung, Jensen Liu, Katherine Tan (2018), "Feed Green Ethiopia Exports: Stabilizing Product Quality and Price Harvard Business Review Case Study. Published by HBR Publications.