Prime Micro Inc. 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 Prime Micro Inc. case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Prime Micro Inc. case study is a Harvard Business School (HBR) case study written by Kenneth Eades, Jay Thaker. The Prime Micro Inc. (referred as “Pmi's Sb's” from here on) case study provides evaluation & decision scenario in field of Finance & Accounting. It also touches upon business topics such as - Value proposition, .

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 Prime Micro Inc. Case Study

The vice president in SouthBank's Corporate Banking Group was reviewing an opportunity for SouthBank (SB) to bid to become the agent bank in a $120 million revolving credit facility for Prime Micro Inc. (PMI). SB's competition for the agent's position would be Texas Trade Bank (TTB), which had been PMI's lead bank for many years. Despite SB's attempts to displace TTB over the past several years, this was SB's first real opportunity to gain agent status. As agent bank on this deal, SB would likely be viewed by PMI as its lead bank, which, due to PMI's considerable banking needs, would allow SB to realize significant fee income in the future. Although delighted with the prospect of getting PMI as a new client, the vice president was worried about PMI's creditworthiness.

Case Authors : Kenneth Eades, Jay Thaker

Topic : Finance & Accounting

Related Areas :

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Calculating Net Present Value (NPV) at 6% for Prime Micro Inc. Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10007625)	-10007625	-	-
Year 1	3449915	-6557710	3449915	0.9434	3254637
Year 2	3976724	-2580986	7426639	0.89	3539270
Year 3	3975104	1394118	11401743	0.8396	3337574
Year 4	3229284	4623402	14631027	0.7921	2557895
TOTAL			14631027		12689376

The Net Present Value at 6% discount rate is 2681751

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. Net Present Value
4. Payback Period

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. Pmi's Sb'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 Pmi's Sb'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 Prime Micro Inc.

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 Pmi's Sb'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 Pmi's Sb'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	(10007625)	-10007625	-	-
Year 1	3449915	-6557710	3449915	0.8696	2999926
Year 2	3976724	-2580986	7426639	0.7561	3006975
Year 3	3975104	1394118	11401743	0.6575	2613695
Year 4	3229284	4623402	14631027	0.5718	1846354
TOTAL					10466950

The Net NPV after 4 years is 459325

(10466950 - 10007625 )

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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	(10007625)	-10007625	-	-
Year 1	3449915	-6557710	3449915	0.8333	2874929
Year 2	3976724	-2580986	7426639	0.6944	2761614
Year 3	3975104	1394118	11401743	0.5787	2300407
Year 4	3229284	4623402	14631027	0.4823	1557332
TOTAL					9494283

The Net NPV after 4 years is -513342

At 20% discount rate the NPV is negative (9494283 - 10007625 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Pmi's Sb'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 Pmi's Sb's has a NPV value higher than Zero then finance managers at Pmi's Sb'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 Pmi's Sb's, then the stock price of the Pmi's Sb'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 Pmi's Sb'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 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.

Understanding of risks involved in 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.

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 Prime Micro Inc.

References & Further Readings

Kenneth Eades, Jay Thaker (2018), "Prime Micro Inc. Harvard Business Review Case Study. Published by HBR Publications.