Science Technology Co.--1985 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 Science Technology Co.--1985 case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Science Technology Co.--1985 case study is a Harvard Business School (HBR) case study written by Thomas R. Piper. The Science Technology Co.--1985 (referred as “Forecasts Financing” from here on) case study provides evaluation & decision scenario in field of Finance & Accounting. It also touches upon business topics such as - Value proposition, Change management, Forecasting, Managing uncertainty, Risk management, Strategic planning.

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 Science Technology Co.--1985 Case Study

The CEO of a U.S. electronics firm is assessing the financial forecasts and the financing plan prepared by the chief financial officer. Given the cyclicality of the industry and the volatility of the firm's performance, the CEO is unsure as to the usefulness of forecasts based on straight line extrapolation of rapid sales growth and stable relationships of profits and assets to sales. The teaching objectives include: 1) how many years into the future should the forecasts run given the level of uncertainty, 2) how can one deal with the high uncertainty when preparing the forecasts or designing a financing plan, and 3) how to estimate the financing needs under conditions of adversity.

Case Authors : Thomas R. Piper

Topic : Finance & Accounting

Related Areas : Change management, Forecasting, Managing uncertainty, Risk management, Strategic planning

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Calculating Net Present Value (NPV) at 6% for Science Technology Co.--1985 Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10022066)	-10022066	-	-
Year 1	3464330	-6557736	3464330	0.9434	3268236
Year 2	3962848	-2594888	7427178	0.89	3526921
Year 3	3972550	1377662	11399728	0.8396	3335430
Year 4	3243028	4620690	14642756	0.7921	2568782
TOTAL			14642756		12699368

The Net Present Value at 6% discount rate is 2677302

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. Internal Rate of Return
3. Profitability Index
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 Forecasts Financing 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. Forecasts Financing 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 Science Technology Co.--1985

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 Forecasts Financing 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 Forecasts Financing 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	(10022066)	-10022066	-	-
Year 1	3464330	-6557736	3464330	0.8696	3012461
Year 2	3962848	-2594888	7427178	0.7561	2996482
Year 3	3972550	1377662	11399728	0.6575	2612016
Year 4	3243028	4620690	14642756	0.5718	1854212
TOTAL					10475171

The Net NPV after 4 years is 453105

(10475171 - 10022066 )

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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	(10022066)	-10022066	-	-
Year 1	3464330	-6557736	3464330	0.8333	2886942
Year 2	3962848	-2594888	7427178	0.6944	2751978
Year 3	3972550	1377662	11399728	0.5787	2298929
Year 4	3243028	4620690	14642756	0.4823	1563960
TOTAL					9501809

The Net NPV after 4 years is -520257

At 20% discount rate the NPV is negative (9501809 - 10022066 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Forecasts Financing 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 Forecasts Financing has a NPV value higher than Zero then finance managers at Forecasts Financing 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 Forecasts Financing, then the stock price of the Forecasts Financing 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 Forecasts Financing 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 key aspects of the projects that need to be monitored, refined, and retuned for continuous delivery of projected cash flows.

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.

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 Science Technology Co.--1985

References & Further Readings

Thomas R. Piper (2018), "Science Technology Co.--1985 Harvard Business Review Case Study. Published by HBR Publications.