The Xiangyang Market 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 The Xiangyang Market case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. The Xiangyang Market case study is a Harvard Business School (HBR) case study written by Wei Li, Jean Yuan. The The Xiangyang Market (referred as “Xiangyang Shopping” from here on) case study provides evaluation & decision scenario in field of Finance & Accounting. It also touches upon business topics such as - Value proposition, Negotiations.

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 The Xiangyang Market Case Study

This is a Darden case study.This crossfunctional case in economics and finance highlights the concerns about protection of intellectual property rights as well as competition from traditional retailers in Shanghai's prime shopping venue. It begins with the history that led to Xiangyang Market's development, and concludes with a description of the future of the market. Located at the center of the shopping district in the trendy former French concession in Shanghai, the market is considered a shopper's paradise by many foreign visitors. This open-air bazaar is known for the incredible deals on quality knockoffs of designer products. The case includes an account of the shopping experience of two American tourists, giving details of their discoveries and bargaining sessions in the market.

Case Authors : Wei Li, Jean Yuan

Topic : Finance & Accounting

Related Areas : Negotiations

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Calculating Net Present Value (NPV) at 6% for The Xiangyang Market Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10026679)	-10026679	-	-
Year 1	3450920	-6575759	3450920	0.9434	3255585
Year 2	3974579	-2601180	7425499	0.89	3537361
Year 3	3942361	1341181	11367860	0.8396	3310082
Year 4	3227737	4568918	14595597	0.7921	2556670
TOTAL			14595597		12659698

The Net Present Value at 6% discount rate is 2633019

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. Profitability Index
3. Internal Rate of Return
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 Xiangyang Shopping 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. Xiangyang Shopping 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 The Xiangyang Market

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 Xiangyang Shopping 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 Xiangyang Shopping 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	(10026679)	-10026679	-	-
Year 1	3450920	-6575759	3450920	0.8696	3000800
Year 2	3974579	-2601180	7425499	0.7561	3005353
Year 3	3942361	1341181	11367860	0.6575	2592166
Year 4	3227737	4568918	14595597	0.5718	1845469
TOTAL					10443788

The Net NPV after 4 years is 417109

(10443788 - 10026679 )

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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	(10026679)	-10026679	-	-
Year 1	3450920	-6575759	3450920	0.8333	2875767
Year 2	3974579	-2601180	7425499	0.6944	2760124
Year 3	3942361	1341181	11367860	0.5787	2281459
Year 4	3227737	4568918	14595597	0.4823	1556586
TOTAL					9473936

The Net NPV after 4 years is -552743

At 20% discount rate the NPV is negative (9473936 - 10026679 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Xiangyang Shopping 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 Xiangyang Shopping has a NPV value higher than Zero then finance managers at Xiangyang Shopping 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 Xiangyang Shopping, then the stock price of the Xiangyang Shopping 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 Xiangyang Shopping 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 will be a multi year spillover effect of various taxation regulations.

What can impact the cash flow of the project.

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 are the key aspects of the projects that need to be monitored, refined, and retuned for continuous delivery of projected cash flows.

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 The Xiangyang Market

References & Further Readings

Wei Li, Jean Yuan (2018), "The Xiangyang Market Harvard Business Review Case Study. Published by HBR Publications.