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Arbor City Community Foundation: Executive Education Version 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 Arbor City Community Foundation: Executive Education Version case study


At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Arbor City Community Foundation: Executive Education Version case study is a Harvard Business School (HBR) case study written by Karl Schmedders, Russell Walker, Michael Stritch. The Arbor City Community Foundation: Executive Education Version (referred as “Accf Var” from here on) case study provides evaluation & decision scenario in field of Finance & Accounting. It also touches upon business topics such as - Value proposition, Risk management, Social enterprise.

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






Case Description of Arbor City Community Foundation: Executive Education Version Case Study


The Arbor City Community Foundation (ACCF) was a medium-sized endowment established in Illinois in the late 1970s through the hard work of several local families. The vision of the ACCF was to be a comprehensive center for philanthropy in the greater Arbor City region. ACCF had a fund balance (known collectively as "the fund") of just under $240 million. The ACCF board of trustees had appointed a committee to oversee investment decisions relating to the foundation assets. The investment committee, under the guidance of the board, pursued an active risk-management policy for the fund. The committee members were primarily concerned with the volatility and distribution of portfolio returns. They relied on the value-at-risk (VaR) methodology as a measurement of the risk of both short- and mid-term investment losses. In its report for the investment committee, the ACCF risk analytics team recommended the daily VaR at 95% confidence as a measure for short-term risk and reported the corresponding numbers. It is now the task of the investment committee to interpret these figures. The case questions guide the executive students to a critical evaluation of both the reported VaR figures as well as of the VaR methodology.


Case Authors : Karl Schmedders, Russell Walker, Michael Stritch

Topic : Finance & Accounting

Related Areas : Risk management, Social enterprise




Calculating Net Present Value (NPV) at 6% for Arbor City Community Foundation: Executive Education Version Case Study


Years              Cash Flow     Net Cash Flow     Cumulative    
Cash Flow
Discount Rate
@ 6 %
Discounted
Cash Flows
Year 0 (10021162) -10021162 - -
Year 1 3466184 -6554978 3466184 0.9434 3269985
Year 2 3982205 -2572773 7448389 0.89 3544148
Year 3 3960028 1387255 11408417 0.8396 3324916
Year 4 3235416 4622671 14643833 0.7921 2562753
TOTAL 14643833 12701802




The Net Present Value at 6% discount rate is 2680640

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.




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. Timing of the expected cash flows – stockholders of Accf Var 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. Accf Var shareholders have preference for diversified projects investment rather than prospective high income from a single capital intensive project.






Formula and Steps to Calculate Net Present Value (NPV) of Arbor City Community Foundation: Executive Education Version

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 Accf Var 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 Accf Var 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 (10021162) -10021162 - -
Year 1 3466184 -6554978 3466184 0.8696 3014073
Year 2 3982205 -2572773 7448389 0.7561 3011119
Year 3 3960028 1387255 11408417 0.6575 2603783
Year 4 3235416 4622671 14643833 0.5718 1849860
TOTAL 10478834


The Net NPV after 4 years is 457672

(10478834 - 10021162 )








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 (10021162) -10021162 - -
Year 1 3466184 -6554978 3466184 0.8333 2888487
Year 2 3982205 -2572773 7448389 0.6944 2765420
Year 3 3960028 1387255 11408417 0.5787 2291683
Year 4 3235416 4622671 14643833 0.4823 1560289
TOTAL 9505879


The Net NPV after 4 years is -515283

At 20% discount rate the NPV is negative (9505879 - 10021162 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Accf Var 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 Accf Var has a NPV value higher than Zero then finance managers at Accf Var 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 Accf Var, then the stock price of the Accf Var 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 Accf Var 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 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 will be a multi year spillover effect of various taxation regulations.

Understanding of risks involved in the project.

What can impact the cash flow of 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.






Negotiation Strategy of Arbor City Community Foundation: Executive Education Version

References & Further Readings

Karl Schmedders, Russell Walker, Michael Stritch (2018), "Arbor City Community Foundation: Executive Education Version Harvard Business Review Case Study. Published by HBR Publications.


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