Great Eastern Toys (C) 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 Great Eastern Toys (C) case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Great Eastern Toys (C) case study is a Harvard Business School (HBR) case study written by Gabriel Hawawini, Lee Remmers. The Great Eastern Toys (C) (referred as “Ratios Dcf” from here on) case study provides evaluation & decision scenario in field of Finance & Accounting. It also touches upon business topics such as - Value proposition, Financial management, Risk 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 Great Eastern Toys (C) Case Study

Supplement to case IN1047. A major concern of the family owners was whether to try to sell their company. The "C" case gives students the opportunity to consider many approaches to valuing a firm: comparative valuation (P/E ratios, price-to-book ratios, price to cash flow ratios, and price to sales ratios) or a DCF valuation. Both approaches present considerable analytical problems. A major weakness of the comparative approach is to find a similar company. Hong Kong, a relatively small stock market, has no firm in the toy business to use as a guide. Other publically traded firms of similar size, markets, and product-lines are found in the Japanese and the American stock markets. But given the differences among the companies and also the markets, how useful are these? There is enough data in the case to allow the student to make a DCF valuation, although projection of the cash flows is subject to a wide range of possibilities. An estimate of a reasonable discount rate also is required, raising questions (assuming use of the CAPM) such as what should be the firm's beta, the risk-free rate, and the equity market premium. Students will need at least two hours of preparation plus a full class session.

Case Authors : Gabriel Hawawini, Lee Remmers

Topic : Finance & Accounting

Related Areas : Financial management, Risk management

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Calculating Net Present Value (NPV) at 6% for Great Eastern Toys (C) Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10004092)	-10004092	-	-
Year 1	3470599	-6533493	3470599	0.9434	3274150
Year 2	3978756	-2554737	7449355	0.89	3541079
Year 3	3966821	1412084	11416176	0.8396	3330619
Year 4	3246104	4658188	14662280	0.7921	2571218
TOTAL			14662280		12717066

The Net Present Value at 6% discount rate is 2712974

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. Internal Rate of Return
2. Net Present Value
3. Payback Period
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 Ratios Dcf 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. Ratios Dcf 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 Great Eastern Toys (C)

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 Ratios Dcf 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 Ratios Dcf 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	(10004092)	-10004092	-	-
Year 1	3470599	-6533493	3470599	0.8696	3017912
Year 2	3978756	-2554737	7449355	0.7561	3008511
Year 3	3966821	1412084	11416176	0.6575	2608249
Year 4	3246104	4658188	14662280	0.5718	1855970
TOTAL					10490643

The Net NPV after 4 years is 486551

(10490643 - 10004092 )

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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	(10004092)	-10004092	-	-
Year 1	3470599	-6533493	3470599	0.8333	2892166
Year 2	3978756	-2554737	7449355	0.6944	2763025
Year 3	3966821	1412084	11416176	0.5787	2295614
Year 4	3246104	4658188	14662280	0.4823	1565444
TOTAL					9516249

The Net NPV after 4 years is -487843

At 20% discount rate the NPV is negative (9516249 - 10004092 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Ratios Dcf 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 Ratios Dcf has a NPV value higher than Zero then finance managers at Ratios Dcf 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 Ratios Dcf, then the stock price of the Ratios Dcf 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 Ratios Dcf 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.

Understanding of risks involved in 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 can impact the cash flow of the project.

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 Great Eastern Toys (C)

References & Further Readings

Gabriel Hawawini, Lee Remmers (2018), "Great Eastern Toys (C) Harvard Business Review Case Study. Published by HBR Publications.