Political Risk in the Kaesong Industrial Complex 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 Political Risk in the Kaesong Industrial Complex case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Political Risk in the Kaesong Industrial Complex case study is a Harvard Business School (HBR) case study written by Condoleezza Rice, Amy Zegart, Torey L. McMurdo. The Political Risk in the Kaesong Industrial Complex (referred as “Kaesong Korean” 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, Labor, Risk management, Security & privacy.

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 Political Risk in the Kaesong Industrial Complex Case Study

The Kaesong Industrial Complex (KIC) is a 1.25-square-mile industrial park six miles north of the Demilitarized Zone in the Democratic People's Republic of Korea. The complex includes both North and South Korean workers, and is subsidized by Seoul. The result of an agreement between North and South Korea in 2000, Kaesong stood as the sole beacon of hope for economic cooperation between the divided states, and remained open for business despite a number of hostilities over the ensuing decade. This case reviews the political and economic risks and opportunities of entering Kaesong through the lens of Bright Ray Apparel, a hypothetical South Korean textile manufacturing firm. Jihoon Lee, Bright Ray's CEO, is encouraged by his CFO and a trusted senior economist to enter Kaesong. But risks abound. North Korea's nuclear threats and leadership transition have brought a new wave of uncertainty to the Korean Peninsula. Facing its own upcoming presidential election, much remains to be determined in Seoul regarding future economic policy and outreach toward Pyongyang. As Jihoon Lee's meeting with his financial adviser nears, Bright Ray's leadership must consider a variety of influences and factors involved in entering Kaesong, from political instability to economic opportunity, and the potential to improve the working condition of North Korean employees.

Case Authors : Condoleezza Rice, Amy Zegart, Torey L. McMurdo

Topic : Global Business

Related Areas : International business, Labor, Risk management, Security & privacy

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Calculating Net Present Value (NPV) at 6% for Political Risk in the Kaesong Industrial Complex Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10023466)	-10023466	-	-
Year 1	3452895	-6570571	3452895	0.9434	3257448
Year 2	3970728	-2599843	7423623	0.89	3533934
Year 3	3973904	1374061	11397527	0.8396	3336566
Year 4	3243384	4617445	14640911	0.7921	2569064
TOTAL			14640911		12697012

The Net Present Value at 6% discount rate is 2673546

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. Profitability Index
2. Payback Period
3. Net Present Value
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. Timing of the expected cash flows – stockholders of Kaesong Korean 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. Kaesong Korean 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 Political Risk in the Kaesong Industrial Complex

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 Kaesong Korean 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 Kaesong Korean 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	(10023466)	-10023466	-	-
Year 1	3452895	-6570571	3452895	0.8696	3002517
Year 2	3970728	-2599843	7423623	0.7561	3002441
Year 3	3973904	1374061	11397527	0.6575	2612906
Year 4	3243384	4617445	14640911	0.5718	1854415
TOTAL					10472280

The Net NPV after 4 years is 448814

(10472280 - 10023466 )

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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	(10023466)	-10023466	-	-
Year 1	3452895	-6570571	3452895	0.8333	2877413
Year 2	3970728	-2599843	7423623	0.6944	2757450
Year 3	3973904	1374061	11397527	0.5787	2299713
Year 4	3243384	4617445	14640911	0.4823	1564132
TOTAL					9498707

The Net NPV after 4 years is -524759

At 20% discount rate the NPV is negative (9498707 - 10023466 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Kaesong Korean 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 Kaesong Korean has a NPV value higher than Zero then finance managers at Kaesong Korean 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 Kaesong Korean, then the stock price of the Kaesong Korean 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 Kaesong Korean 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 will be a multi year spillover effect of various taxation regulations.

Understanding of risks involved in 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.

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.

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 Political Risk in the Kaesong Industrial Complex

References & Further Readings

Condoleezza Rice, Amy Zegart, Torey L. McMurdo (2018), "Political Risk in the Kaesong Industrial Complex Harvard Business Review Case Study. Published by HBR Publications.