Venture Capital or Private Equity? The Asian Experience 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 Venture Capital or Private Equity? The Asian Experience case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Venture Capital or Private Equity? The Asian Experience case study is a Harvard Business School (HBR) case study written by Sayed Ahmed Naqi, Samanthala Hettihewa. The Venture Capital or Private Equity? The Asian Experience (referred as “Venture Capital” from here on) case study provides evaluation & decision scenario in field of Finance & Accounting. It also touches upon business topics such as - Value proposition, Venture capital.

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 Venture Capital or Private Equity? The Asian Experience Case Study

Venture capital in Asia has exhibited remarkable growth over the last two decades. Researchers and practitioners have, however, expressed doubts as to whether what is being reported as venture capital in Asia can really be classified as such. Authors of scholarly studies often avoid this debate and, consequently, fail to caution readers about the applicability of their research findings. Through an exploration of the history, development, and composition of venture capital in Asia, not only confirms significant differences between Asian and traditional venture capital, but also finds that venture capital in Asia differs little from what is commonly called private equity. As such, a need exists within the venture capital literature to recognize this peculiarity of the Asian venture capital market. Moreover, venture capitalists considering expansion into Asia must comprehend the nature of the Asian market in order to avoid disillusionment and frustrations which may result from inadequate understanding.

Case Authors : Sayed Ahmed Naqi, Samanthala Hettihewa

Topic : Finance & Accounting

Related Areas : Venture capital

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Calculating Net Present Value (NPV) at 6% for Venture Capital or Private Equity? The Asian Experience Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10014010)	-10014010	-	-
Year 1	3450482	-6563528	3450482	0.9434	3255172
Year 2	3975483	-2588045	7425965	0.89	3538166
Year 3	3971291	1383246	11397256	0.8396	3334373
Year 4	3231121	4614367	14628377	0.7921	2559350
TOTAL			14628377		12687060

The Net Present Value at 6% discount rate is 2673050

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. Net Present Value
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. Venture Capital 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 Venture Capital 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 Venture Capital or Private Equity? The Asian Experience

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 Venture Capital 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 Venture Capital 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	(10014010)	-10014010	-	-
Year 1	3450482	-6563528	3450482	0.8696	3000419
Year 2	3975483	-2588045	7425965	0.7561	3006036
Year 3	3971291	1383246	11397256	0.6575	2611188
Year 4	3231121	4614367	14628377	0.5718	1847404
TOTAL					10465048

The Net NPV after 4 years is 451038

(10465048 - 10014010 )

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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	(10014010)	-10014010	-	-
Year 1	3450482	-6563528	3450482	0.8333	2875402
Year 2	3975483	-2588045	7425965	0.6944	2760752
Year 3	3971291	1383246	11397256	0.5787	2298201
Year 4	3231121	4614367	14628377	0.4823	1558218
TOTAL					9492573

The Net NPV after 4 years is -521437

At 20% discount rate the NPV is negative (9492573 - 10014010 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Venture Capital 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 Venture Capital has a NPV value higher than Zero then finance managers at Venture Capital 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 Venture Capital, then the stock price of the Venture Capital 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 Venture Capital 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 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.

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 Venture Capital or Private Equity? The Asian Experience

References & Further Readings

Sayed Ahmed Naqi, Samanthala Hettihewa (2018), "Venture Capital or Private Equity? The Asian Experience Harvard Business Review Case Study. Published by HBR Publications.