Germany in the 1990s: Managing Reunification 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 Germany in the 1990s: Managing Reunification case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Germany in the 1990s: Managing Reunification case study is a Harvard Business School (HBR) case study written by George C. Lodge, James W. Ragsdale. The Germany in the 1990s: Managing Reunification (referred as “Ems Reunification” from here on) case study provides evaluation & decision scenario in field of Global Business. It also touches upon business topics such as - Value proposition, International business, Mergers & acquisitions, Policy.

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 Germany in the 1990s: Managing Reunification Case Study

In October 1990, eastern Germany was incorporated into the Federal Republic of Germany. The German people rewarded the architect of these changes, Helmut Kohl, with an enhanced majority in national elections. But only two years later it was hard to remember these heady times. Re-unified Germany's external and internal economic situation were out of balance. The current account fell from a large surplus to deficit. Inflation rose as the German government ran a mounting deficit to finance reconstruction. In June 1992, the Bundesbank council, the interest-rate-setting body of Germany's central bank, raised interest rates to combat this inflation. Other members of the EMS were less willing to raise interest rates as they feared recession rather than overheating. Within months, Italy devalued and the United Kingdom dropped out of the EMS. Had Kohl's reunification strategy caused the EMS crisis? What did this crisis imply about the hopes for closer European integration?

Case Authors : George C. Lodge, James W. Ragsdale

Topic : Global Business

Related Areas : International business, Mergers & acquisitions, Policy

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Calculating Net Present Value (NPV) at 6% for Germany in the 1990s: Managing Reunification Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10024125)	-10024125	-	-
Year 1	3450650	-6573475	3450650	0.9434	3255330
Year 2	3953092	-2620383	7403742	0.89	3518238
Year 3	3970747	1350364	11374489	0.8396	3333916
Year 4	3229303	4579667	14603792	0.7921	2557910
TOTAL			14603792		12665394

The Net Present Value at 6% discount rate is 2641269

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. Net Present Value
2. Internal Rate of Return
3. Profitability Index
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 Ems Reunification 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. Ems Reunification 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 Germany in the 1990s: Managing Reunification

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 Global Business 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 Ems Reunification 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 Ems Reunification 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	(10024125)	-10024125	-	-
Year 1	3450650	-6573475	3450650	0.8696	3000565
Year 2	3953092	-2620383	7403742	0.7561	2989105
Year 3	3970747	1350364	11374489	0.6575	2610831
Year 4	3229303	4579667	14603792	0.5718	1846364
TOTAL					10446866

The Net NPV after 4 years is 422741

(10446866 - 10024125 )

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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	(10024125)	-10024125	-	-
Year 1	3450650	-6573475	3450650	0.8333	2875542
Year 2	3953092	-2620383	7403742	0.6944	2745203
Year 3	3970747	1350364	11374489	0.5787	2297886
Year 4	3229303	4579667	14603792	0.4823	1557341
TOTAL					9475972

The Net NPV after 4 years is -548153

At 20% discount rate the NPV is negative (9475972 - 10024125 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Ems Reunification 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 Ems Reunification has a NPV value higher than Zero then finance managers at Ems Reunification 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 Ems Reunification, then the stock price of the Ems Reunification 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 Ems Reunification 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 can impact the cash flow of the project.

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

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 Germany in the 1990s: Managing Reunification

References & Further Readings

George C. Lodge, James W. Ragsdale (2018), "Germany in the 1990s: Managing Reunification Harvard Business Review Case Study. Published by HBR Publications.