Thriving in an Increasingly Digital Ecosystem 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 Thriving in an Increasingly Digital Ecosystem case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Thriving in an Increasingly Digital Ecosystem case study is a Harvard Business School (HBR) case study written by Peter Weill, Stephanie Woerner. The Thriving in an Increasingly Digital Ecosystem (referred as “Ecosystems Authors” from here on) case study provides evaluation & decision scenario in field of Global Business. It also touches upon business topics such as - Value proposition, Disruptive innovation, Supply chain.

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 Thriving in an Increasingly Digital Ecosystem Case Study

This is an MIT Sloan Management Review article. The business world is rapidly digitizing, breaking down industry barriers and creating new opportunities while destroying long-successful business models. Given the amount of turmoil digital disruption is causing, authors Peter Weill and Stephanie L. Woerner of the MIT Center for Information Systems Research say it's time for companies to evaluate these threats and opportunities and create new business options for the more-connected future of digital ecosystems. In recent research, board members at large companies estimated that 32% of their company's revenue would be under threat from digital disruption in the next five years; 60% of board members felt their boards should spend significantly more time on this issue next year. Despite the threats from companies including Uber, Airbnb and Amazon, increasing digitization offers opportunities for companies to leverage strong customer relationships and increase cross-selling, the authors argue. The authors offer a framework, supported by examples, for helping managers think about their competitive environments. "The combination of moving from value chains to ecosystems and increasing consumer knowledge,"the authors write, "provides business leaders with four distinct business models, each with associated capabilities and relationships."Companies can choose to operate as (1) suppliers, (2) omnichannel businesses, (3) modular producers or (4) ecosystem drivers. The authors found that businesses focused narrowly on value chains were at a disadvantage compared with those that thought more broadly about their business ecosystems. Companies that had 50% or more of their revenues from digital ecosystems and understood their end customers better than their average competitor saw 32% higher revenue growth and 27% higher profit margins than their industry averages. As they prepare for growing digital disruption, companies have two major decisions to make. First, they need to decide the extent to which they want to control the value chain or become part of a more complex ecosystem. Second, they need to decide how much they want to invest in knowing their end customers. Companies with ecosystem drivers as their dominant business model had the highest margins and growth of all the four options in the companies the authors studied.

Case Authors : Peter Weill, Stephanie Woerner

Topic : Global Business

Related Areas : Disruptive innovation, Supply chain

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Calculating Net Present Value (NPV) at 6% for Thriving in an Increasingly Digital Ecosystem Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10023499)	-10023499	-	-
Year 1	3449088	-6574411	3449088	0.9434	3253857
Year 2	3954946	-2619465	7404034	0.89	3519888
Year 3	3975301	1355836	11379335	0.8396	3337739
Year 4	3235779	4591615	14615114	0.7921	2563040
TOTAL			14615114		12674524

The Net Present Value at 6% discount rate is 2651025

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. Ecosystems Authors 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 Ecosystems Authors 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 Thriving in an Increasingly Digital Ecosystem

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 Ecosystems Authors 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 Ecosystems Authors 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	(10023499)	-10023499	-	-
Year 1	3449088	-6574411	3449088	0.8696	2999207
Year 2	3954946	-2619465	7404034	0.7561	2990507
Year 3	3975301	1355836	11379335	0.6575	2613825
Year 4	3235779	4591615	14615114	0.5718	1850067
TOTAL					10453606

The Net NPV after 4 years is 430107

(10453606 - 10023499 )

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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	(10023499)	-10023499	-	-
Year 1	3449088	-6574411	3449088	0.8333	2874240
Year 2	3954946	-2619465	7404034	0.6944	2746490
Year 3	3975301	1355836	11379335	0.5787	2300521
Year 4	3235779	4591615	14615114	0.4823	1560464
TOTAL					9481716

The Net NPV after 4 years is -541783

At 20% discount rate the NPV is negative (9481716 - 10023499 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Ecosystems Authors 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 Ecosystems Authors has a NPV value higher than Zero then finance managers at Ecosystems Authors 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 Ecosystems Authors, then the stock price of the Ecosystems Authors 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 Ecosystems Authors 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 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.

Understanding of risks involved in the project.

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 Thriving in an Increasingly Digital Ecosystem

References & Further Readings

Peter Weill, Stephanie Woerner (2018), "Thriving in an Increasingly Digital Ecosystem Harvard Business Review Case Study. Published by HBR Publications.