Hydrochem, 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 Hydrochem, Inc. case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Hydrochem, Inc. case study is a Harvard Business School (HBR) case study written by E. Richard Brownlee II. The Hydrochem, Inc. (referred as “Costing Hydrochem” from here on) case study provides evaluation & decision scenario in field of Finance & Accounting. It also touches upon business topics such as - Value proposition, Manufacturing.

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 Hydrochem, Inc. Case Study

Hydrochem, Inc. produces only one product - condutronic plates. The company uses an actual process costing system but is considering changing to a standard costing system. Manufacturing costs consist of raw material, direct labor and manufacturing overhead, and the company uses full absorption costing. Students are provided with account balance information at the beginning of the month and with information regarding the company's events and transactions during the month. Students are asked to prepare two income statements for the month and balance sheets as of the end of the month. One set of financial statements is to be prepared using the company's actual costing system, and the other set of financial statements is to be prepared using the proposed standard costing system. Students are asked to explain the differences between these two sets of financial statements and to take a position as to which set of financial information they prefer.

Case Authors : E. Richard Brownlee II

Topic : Finance & Accounting

Related Areas : Manufacturing

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Calculating Net Present Value (NPV) at 6% for Hydrochem, Inc. Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10024877)	-10024877	-	-
Year 1	3444530	-6580347	3444530	0.9434	3249557
Year 2	3955365	-2624982	7399895	0.89	3520261
Year 3	3961903	1336921	11361798	0.8396	3326490
Year 4	3234156	4571077	14595954	0.7921	2561754
TOTAL			14595954		12658062

The Net Present Value at 6% discount rate is 2633185

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. 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. Timing of the expected cash flows – stockholders of Costing Hydrochem 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. Costing Hydrochem 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 Hydrochem, 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 Costing Hydrochem 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 Costing Hydrochem 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	(10024877)	-10024877	-	-
Year 1	3444530	-6580347	3444530	0.8696	2995243
Year 2	3955365	-2624982	7399895	0.7561	2990824
Year 3	3961903	1336921	11361798	0.6575	2605016
Year 4	3234156	4571077	14595954	0.5718	1849139
TOTAL					10440222

The Net NPV after 4 years is 415345

(10440222 - 10024877 )

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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	(10024877)	-10024877	-	-
Year 1	3444530	-6580347	3444530	0.8333	2870442
Year 2	3955365	-2624982	7399895	0.6944	2746781
Year 3	3961903	1336921	11361798	0.5787	2292768
Year 4	3234156	4571077	14595954	0.4823	1559682
TOTAL					9469673

The Net NPV after 4 years is -555204

At 20% discount rate the NPV is negative (9469673 - 10024877 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Costing Hydrochem 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 Costing Hydrochem has a NPV value higher than Zero then finance managers at Costing Hydrochem 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 Costing Hydrochem, then the stock price of the Costing Hydrochem 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 Costing Hydrochem 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 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 can impact the cash flow of 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.

What will be a multi year spillover effect of various taxation regulations.

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 Hydrochem, Inc.

References & Further Readings

E. Richard Brownlee II (2018), "Hydrochem, Inc. Harvard Business Review Case Study. Published by HBR Publications.