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North West Company: Analyzing Financial Performance 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 North West Company: Analyzing Financial Performance case study


At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. North West Company: Analyzing Financial Performance case study is a Harvard Business School (HBR) case study written by Jennifer Alex, Mark MacIsaac, Neil Maltby. The North West Company: Analyzing Financial Performance (referred as “Nwc Nwc's” 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 management, Performance measurement.

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 North West Company: Analyzing Financial Performance Case Study


In June 2015, a new analyst at an investment fund company had to review the financial performance of a potential investment target, the North West Company Inc. (NWC), and make a recommendation. NWC was a food retailer operating in underserved markets. The company operated retail locations in Western and Northern Canada, Alaska, the South Pacific, and the Caribbean, reporting total sales of CA$1.6 billion in 2014. Twelve years after NWC's initial push outside of Canada, international sales accounted for 35.8 per cent of the company's business. Whereas rivalry among competitors and consumer choice defined the mainstream Canadian market, food retail in Northern Canadian markets was characterized by limited offerings, high prices, and few competitors.The analyst's report needed to include an assessment of NWC's profitability, liquidity, and financial structure. The analyst was particularly interested in NWC's international operations; although international expansion carried with it the potential for significant revenue growth, she wondered whether the profit potential was as great as that of NWC's operations in Northern and Western Canada. She also knew that if NWC did choose to expand its international operations, it would require significant capital investment. Was NWC a good investment opportunity? Jennifer Alex is affiliated with St. Francis Xavier University. Mark MacIsaac is affiliated with St. Francis Xavier University. Neil Maltby is affiliated with St. Francis Xavier University.


Case Authors : Jennifer Alex, Mark MacIsaac, Neil Maltby

Topic : Finance & Accounting

Related Areas : Financial management, Performance measurement




Calculating Net Present Value (NPV) at 6% for North West Company: Analyzing Financial Performance Case Study


Years              Cash Flow     Net Cash Flow     Cumulative    
Cash Flow
Discount Rate
@ 6 %
Discounted
Cash Flows
Year 0 (10000859) -10000859 - -
Year 1 3454689 -6546170 3454689 0.9434 3259141
Year 2 3967449 -2578721 7422138 0.89 3531015
Year 3 3972209 1393488 11394347 0.8396 3335143
Year 4 3250740 4644228 14645087 0.7921 2574891
TOTAL 14645087 12700190




The Net Present Value at 6% discount rate is 2699331

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. Magnitude of both incoming and outgoing cash flows – Projects can be capital intensive, time intensive, or both. Nwc Nwc's 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 Nwc Nwc's 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 North West Company: Analyzing Financial Performance

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 Nwc Nwc's 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 Nwc Nwc's 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 (10000859) -10000859 - -
Year 1 3454689 -6546170 3454689 0.8696 3004077
Year 2 3967449 -2578721 7422138 0.7561 2999961
Year 3 3972209 1393488 11394347 0.6575 2611792
Year 4 3250740 4644228 14645087 0.5718 1858621
TOTAL 10474452


The Net NPV after 4 years is 473593

(10474452 - 10000859 )








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 (10000859) -10000859 - -
Year 1 3454689 -6546170 3454689 0.8333 2878908
Year 2 3967449 -2578721 7422138 0.6944 2755173
Year 3 3972209 1393488 11394347 0.5787 2298732
Year 4 3250740 4644228 14645087 0.4823 1567679
TOTAL 9500492


The Net NPV after 4 years is -500367

At 20% discount rate the NPV is negative (9500492 - 10000859 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Nwc Nwc's 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 Nwc Nwc's has a NPV value higher than Zero then finance managers at Nwc Nwc's 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 Nwc Nwc's, then the stock price of the Nwc Nwc's 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 Nwc Nwc's 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 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.

Understanding of risks involved in 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 North West Company: Analyzing Financial Performance

References & Further Readings

Jennifer Alex, Mark MacIsaac, Neil Maltby (2018), "North West Company: Analyzing Financial Performance Harvard Business Review Case Study. Published by HBR Publications.


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