Transfer Pricing for Aligning Divisional and Corporate Decisions 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 Transfer Pricing for Aligning Divisional and Corporate Decisions case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Transfer Pricing for Aligning Divisional and Corporate Decisions case study is a Harvard Business School (HBR) case study written by Laurel Adams, Ralph Drtina. The Transfer Pricing for Aligning Divisional and Corporate Decisions (referred as “Transfer Pricing” from here on) case study provides evaluation & decision scenario in field of Finance & Accounting. It also touches upon business topics such as - Value proposition, Manufacturing, Organizational structure, Pricing.

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 Transfer Pricing for Aligning Divisional and Corporate Decisions Case Study

Discussions about transfer pricing normally presume the firm's objective is to maximize profit while making the best use of existing capacity. This article differs by exploring the impact of transfer pricing on capital budget decisions. In decentralized firms, decision authority for investment is assigned to division managers whose capital budgets include revenues from internal transfers. When a selling division is under capacity, economic theory recommends a transfer price based on differential cost. Here the seller generates sufficient revenues to recoup operating costs, but not enough to recover capital costs. Consequently, division managers will reject some investments that otherwise would have increased corporate shareholder value. Market-based transfer pricing overcomes this conflict by allocating savings on inter-company transactions to the selling division. However, market transfer pricing may result in shortfalls to corporate profit. Nonetheless, we argue in favor of the use of transfer pricing on the presumption that long-term value creation takes precedence over short-term profit.

Case Authors : Laurel Adams, Ralph Drtina

Topic : Finance & Accounting

Related Areas : Manufacturing, Organizational structure, Pricing

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Calculating Net Present Value (NPV) at 6% for Transfer Pricing for Aligning Divisional and Corporate Decisions Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10017539)	-10017539	-	-
Year 1	3445994	-6571545	3445994	0.9434	3250938
Year 2	3973927	-2597618	7419921	0.89	3536781
Year 3	3949228	1351610	11369149	0.8396	3315848
Year 4	3245409	4597019	14614558	0.7921	2570668
TOTAL			14614558		12674235

The Net Present Value at 6% discount rate is 2656696

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 Transfer Pricing 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. Transfer Pricing 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 Transfer Pricing for Aligning Divisional and Corporate Decisions

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 Transfer Pricing 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 Transfer Pricing 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	(10017539)	-10017539	-	-
Year 1	3445994	-6571545	3445994	0.8696	2996517
Year 2	3973927	-2597618	7419921	0.7561	3004860
Year 3	3949228	1351610	11369149	0.6575	2596682
Year 4	3245409	4597019	14614558	0.5718	1855573
TOTAL					10453631

The Net NPV after 4 years is 436092

(10453631 - 10017539 )

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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	(10017539)	-10017539	-	-
Year 1	3445994	-6571545	3445994	0.8333	2871662
Year 2	3973927	-2597618	7419921	0.6944	2759672
Year 3	3949228	1351610	11369149	0.5787	2285433
Year 4	3245409	4597019	14614558	0.4823	1565109
TOTAL					9481875

The Net NPV after 4 years is -535664

At 20% discount rate the NPV is negative (9481875 - 10017539 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Transfer Pricing 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 Transfer Pricing has a NPV value higher than Zero then finance managers at Transfer Pricing 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 Transfer Pricing, then the stock price of the Transfer Pricing 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 Transfer Pricing 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 can impact the cash flow of the project.

Understanding of risks involved in 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 Transfer Pricing for Aligning Divisional and Corporate Decisions

References & Further Readings

Laurel Adams, Ralph Drtina (2018), "Transfer Pricing for Aligning Divisional and Corporate Decisions Harvard Business Review Case Study. Published by HBR Publications.