Raju Omlet: Expanding in the United Arab Emirates 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 Raju Omlet: Expanding in the United Arab Emirates case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Raju Omlet: Expanding in the United Arab Emirates case study is a Harvard Business School (HBR) case study written by Kirti Khanzode, Sandeep Puri. The Raju Omlet: Expanding in the United Arab Emirates (referred as “Omlet Raju” from here on) case study provides evaluation & decision scenario in field of Global Business. It also touches upon business topics such as - Value proposition, Customers.

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 Raju Omlet: Expanding in the United Arab Emirates Case Study

Raju Omlet is a restaurant in Dubai that is famous for making egg preparations that appeal to the Indian expatriate population. A father and his son jointly manage the venture, and they are both very happy with the way the business has shaped up in the last two years. An expansion is inevitable, but how should it be carried out? The partners are also exploring the option of offering home delivery service. A meeting has been called to try to find answers to two questions: Would it be possible to sustain the expansion with a single product offering, and would diversifying the product range kill the restaurant's unique competitive advantage? Kirti Khanzode is affiliated with Institute of Management Technology Dubai. Sandeep Puri is affiliated with Institute of Management Technology, Ghaziabad.

Case Authors : Kirti Khanzode, Sandeep Puri

Topic : Global Business

Related Areas : Customers

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Calculating Net Present Value (NPV) at 6% for Raju Omlet: Expanding in the United Arab Emirates Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10004305)	-10004305	-	-
Year 1	3445026	-6559279	3445026	0.9434	3250025
Year 2	3965907	-2593372	7410933	0.89	3529643
Year 3	3967581	1374209	11378514	0.8396	3331258
Year 4	3232803	4607012	14611317	0.7921	2560683
TOTAL			14611317		12671608

The Net Present Value at 6% discount rate is 2667303

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. Payback Period
3. Net Present Value
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. Omlet Raju 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 Omlet Raju 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 Raju Omlet: Expanding in the United Arab Emirates

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 Omlet Raju 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 Omlet Raju 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	(10004305)	-10004305	-	-
Year 1	3445026	-6559279	3445026	0.8696	2995675
Year 2	3965907	-2593372	7410933	0.7561	2998795
Year 3	3967581	1374209	11378514	0.6575	2608749
Year 4	3232803	4607012	14611317	0.5718	1848366
TOTAL					10451585

The Net NPV after 4 years is 447280

(10451585 - 10004305 )

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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	(10004305)	-10004305	-	-
Year 1	3445026	-6559279	3445026	0.8333	2870855
Year 2	3965907	-2593372	7410933	0.6944	2754102
Year 3	3967581	1374209	11378514	0.5787	2296054
Year 4	3232803	4607012	14611317	0.4823	1559029
TOTAL					9480040

The Net NPV after 4 years is -524265

At 20% discount rate the NPV is negative (9480040 - 10004305 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Omlet Raju 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 Omlet Raju has a NPV value higher than Zero then finance managers at Omlet Raju 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 Omlet Raju, then the stock price of the Omlet Raju 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 Omlet Raju 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 can impact the cash flow of the project.

What are the key aspects of the projects that need to be monitored, refined, and retuned for continuous delivery of projected cash flows.

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 Raju Omlet: Expanding in the United Arab Emirates

References & Further Readings

Kirti Khanzode, Sandeep Puri (2018), "Raju Omlet: Expanding in the United Arab Emirates Harvard Business Review Case Study. Published by HBR Publications.