Option Valuation and Dividend Payments 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 Option Valuation and Dividend Payments case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Option Valuation and Dividend Payments case study is a Harvard Business School (HBR) case study written by Robert S. Harris, Robert M. Conroy. The Option Valuation and Dividend Payments (referred as “Dividend Payments” 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 analysis, Financial management, Financial markets, Strategy.

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 Option Valuation and Dividend Payments Case Study

This is a Darden case study.This note shows how dividend payments affect option values owing to the effects of dividend payments on share price and resulting investor behavior. In addition to discussing the underlying logic, the note shows how to value options for dividend-paying stocks by adapting the Black-Scholes option-pricing model. The note addresses issues of early exercise and the underlying incentives of investors who own call or put options.

Case Authors : Robert S. Harris, Robert M. Conroy

Topic : Finance & Accounting

Related Areas : Financial analysis, Financial management, Financial markets, Strategy

Calculating Net Present Value (NPV) at 6% for Option Valuation and Dividend Payments Case Study

Years              Cash Flow     Net Cash Flow     Cumulative    
Cash Flow
Discount Rate
@ 6 %
Cash Flows
Year 0 (10024215) -10024215 - -
Year 1 3443288 -6580927 3443288 0.9434 3248385
Year 2 3965416 -2615511 7408704 0.89 3529206
Year 3 3955670 1340159 11364374 0.8396 3321257
Year 4 3232342 4572501 14596716 0.7921 2560318
TOTAL 14596716 12659165

The Net Present Value at 6% discount rate is 2634950

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. Payback Period
2. Net Present Value
3. Profitability Index
4. Internal Rate of Return

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. Dividend Payments 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 Dividend Payments have higher preference for cash returns over 4-5 years rather than 10-15 years given the nature of the volatility in the industry.

Formula and Steps to Calculate Net Present Value (NPV) of Option Valuation and Dividend Payments

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 Dividend Payments 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 Dividend Payments 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 %
Cash Flows
Year 0 (10024215) -10024215 - -
Year 1 3443288 -6580927 3443288 0.8696 2994163
Year 2 3965416 -2615511 7408704 0.7561 2998424
Year 3 3955670 1340159 11364374 0.6575 2600917
Year 4 3232342 4572501 14596716 0.5718 1848102
TOTAL 10441607

The Net NPV after 4 years is 417392

(10441607 - 10024215 )

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 %
Cash Flows
Year 0 (10024215) -10024215 - -
Year 1 3443288 -6580927 3443288 0.8333 2869407
Year 2 3965416 -2615511 7408704 0.6944 2753761
Year 3 3955670 1340159 11364374 0.5787 2289161
Year 4 3232342 4572501 14596716 0.4823 1558807
TOTAL 9471136

The Net NPV after 4 years is -553079

At 20% discount rate the NPV is negative (9471136 - 10024215 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Dividend Payments 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 Dividend Payments has a NPV value higher than Zero then finance managers at Dividend Payments 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 Dividend Payments, then the stock price of the Dividend Payments 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 Dividend Payments 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 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.

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

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.

References & Further Readings

Robert S. Harris, Robert M. Conroy (2018), "Option Valuation and Dividend Payments Harvard Business Review Case Study. Published by HBR Publications.