Sino-Ocean Land: Responding to Change 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 Sino-Ocean Land: Responding to Change case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Sino-Ocean Land: Responding to Change case study is a Harvard Business School (HBR) case study written by Nicolas P. Retsinas, Jeffrey Hu, Runjiao Xu. The Sino-Ocean Land: Responding to Change (referred as “Sino Ocean” from here on) case study provides evaluation & decision scenario in field of Finance & Accounting. It also touches upon business topics such as - Value proposition, Business law, Change management, Entrepreneurship, Financial management, Marketing, Policy, Risk management, Strategic planning, Strategy execution.

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 Sino-Ocean Land: Responding to Change Case Study

In 2010, Sino-Ocean Land Holdings Limited was a highly successful, large real estate developer based in Beijing, China. Sino-Ocean Land had three main business segments-property development, property investment/management, and other real estate related businesses. From 2005-2009, the company focused on becoming a leading regional developer with a multiproduct offering. That strategy was successful, riding the wave of spectacular growth in the Chinese real estate sector from 1998-2008, following a loosening of Chinese state real estate regulations. Although Sino-Ocean Land had gone public in 2007, its key shareholders were still state owned enterprises. The state maintained significant influence on the company and the real estate market, in general. The case explores the interactions between the company and the state, examining land acquisition, financing, and corporate governance. Following the global financial crisis of 2008, Sino-Ocean Land must devise a new five year strategic plan. CEO Li Ming must grapple with the changing market dynamics and regulatory environment, to decide the best course for the company. Key issues that he must determine are: whether the focus should be local or national; whether to continue with multiproduct offerings, or specialize in one product type; and whether to continue to pursue primarily development, or to shift to property investment and holding.

Case Authors : Nicolas P. Retsinas, Jeffrey Hu, Runjiao Xu

Topic : Finance & Accounting

Related Areas : Business law, Change management, Entrepreneurship, Financial management, Marketing, Policy, Risk management, Strategic planning, Strategy execution

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Calculating Net Present Value (NPV) at 6% for Sino-Ocean Land: Responding to Change Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10016518)	-10016518	-	-
Year 1	3471438	-6545080	3471438	0.9434	3274942
Year 2	3958497	-2586583	7429935	0.89	3523048
Year 3	3966361	1379778	11396296	0.8396	3330233
Year 4	3230708	4610486	14627004	0.7921	2559023
TOTAL			14627004		12687246

The Net Present Value at 6% discount rate is 2670728

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. Magnitude of both incoming and outgoing cash flows – Projects can be capital intensive, time intensive, or both. Sino Ocean 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 Sino Ocean 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 Sino-Ocean Land: Responding to Change

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 Sino Ocean 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 Sino Ocean 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	(10016518)	-10016518	-	-
Year 1	3471438	-6545080	3471438	0.8696	3018642
Year 2	3958497	-2586583	7429935	0.7561	2993192
Year 3	3966361	1379778	11396296	0.6575	2607947
Year 4	3230708	4610486	14627004	0.5718	1847168
TOTAL					10466949

The Net NPV after 4 years is 450431

(10466949 - 10016518 )

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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	(10016518)	-10016518	-	-
Year 1	3471438	-6545080	3471438	0.8333	2892865
Year 2	3958497	-2586583	7429935	0.6944	2748956
Year 3	3966361	1379778	11396296	0.5787	2295348
Year 4	3230708	4610486	14627004	0.4823	1558019
TOTAL					9495188

The Net NPV after 4 years is -521330

At 20% discount rate the NPV is negative (9495188 - 10016518 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Sino Ocean 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 Sino Ocean has a NPV value higher than Zero then finance managers at Sino Ocean 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 Sino Ocean, then the stock price of the Sino Ocean 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 Sino Ocean 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 –

Understanding of risks involved in the project.

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

What can impact the cash flow of 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 Sino-Ocean Land: Responding to Change

References & Further Readings

Nicolas P. Retsinas, Jeffrey Hu, Runjiao Xu (2018), "Sino-Ocean Land: Responding to Change Harvard Business Review Case Study. Published by HBR Publications.