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China's Journey to the West: Xi Yong Micro-electronics Industrial Park, Chongqing 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 China's Journey to the West: Xi Yong Micro-electronics Industrial Park, Chongqing case study


At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. China's Journey to the West: Xi Yong Micro-electronics Industrial Park, Chongqing case study is a Harvard Business School (HBR) case study written by Siriwan Chutikamoltham, Feng Wang, Xiaoxiao Liu. The China's Journey to the West: Xi Yong Micro-electronics Industrial Park, Chongqing (referred as “Xi Yong” from here on) case study provides evaluation & decision scenario in field of Global Business. It also touches upon business topics such as - Value proposition, Government, Labor, Risk management.

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 China's Journey to the West: Xi Yong Micro-electronics Industrial Park, Chongqing Case Study


Since the opening up of its economy in 1979, China has followed an export-led growth policy and transformed the country into a 'Factory of the World' with its labour-intensive manufacturing. Since then, many factories were set up and concentrated mostly in the south-eastern coastal provinces. Although this policy resulted in consistently high annual growth and creation rates, negative side effects such as environmental, economic and social problems became increasingly evident. To address these challenges, in 2012, China's policymakers changed the policy direction to focus more on domestic consumption-led growth. One strategy to achieve the goal was to expand its manufacturing base into the hinterland. To attract investors to move to the inner regions, the government developed gigantic industrial parks and basic infrastructure to accommodate the new policy. This case depicts Xi Yong Micro-electronics Industrial Park in Chongqing, the largest municipality in Western China. It discusses the implementation of the government's development strategy at Xi Yong and presents an opportunity to examine whether Xi Yong and other similar industrial parks would provide the solution that the government is looking for.


Case Authors : Siriwan Chutikamoltham, Feng Wang, Xiaoxiao Liu

Topic : Global Business

Related Areas : Government, Labor, Risk management




Calculating Net Present Value (NPV) at 6% for China's Journey to the West: Xi Yong Micro-electronics Industrial Park, Chongqing Case Study


Years              Cash Flow     Net Cash Flow     Cumulative    
Cash Flow
Discount Rate
@ 6 %
Discounted
Cash Flows
Year 0 (10018581) -10018581 - -
Year 1 3447465 -6571116 3447465 0.9434 3252325
Year 2 3978108 -2593008 7425573 0.89 3540502
Year 3 3944342 1351334 11369915 0.8396 3311746
Year 4 3248238 4599572 14618153 0.7921 2572909
TOTAL 14618153 12677482




The Net Present Value at 6% discount rate is 2658901

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. Payback Period
4. Net Present Value

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. Xi Yong 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 Xi Yong 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 China's Journey to the West: Xi Yong Micro-electronics Industrial Park, Chongqing

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 Xi Yong 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 Xi Yong 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 (10018581) -10018581 - -
Year 1 3447465 -6571116 3447465 0.8696 2997796
Year 2 3978108 -2593008 7425573 0.7561 3008021
Year 3 3944342 1351334 11369915 0.6575 2593469
Year 4 3248238 4599572 14618153 0.5718 1857191
TOTAL 10456476


The Net NPV after 4 years is 437895

(10456476 - 10018581 )








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 (10018581) -10018581 - -
Year 1 3447465 -6571116 3447465 0.8333 2872888
Year 2 3978108 -2593008 7425573 0.6944 2762575
Year 3 3944342 1351334 11369915 0.5787 2282605
Year 4 3248238 4599572 14618153 0.4823 1566473
TOTAL 9484541


The Net NPV after 4 years is -534040

At 20% discount rate the NPV is negative (9484541 - 10018581 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Xi Yong 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 Xi Yong has a NPV value higher than Zero then finance managers at Xi Yong 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 Xi Yong, then the stock price of the Xi Yong 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 Xi Yong 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.






Negotiation Strategy of China's Journey to the West: Xi Yong Micro-electronics Industrial Park, Chongqing

References & Further Readings

Siriwan Chutikamoltham, Feng Wang, Xiaoxiao Liu (2018), "China's Journey to the West: Xi Yong Micro-electronics Industrial Park, Chongqing Harvard Business Review Case Study. Published by HBR Publications.


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