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Danfoss RC in China (B): Big Challenges 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 Danfoss RC in China (B): Big Challenges case study


At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Danfoss RC in China (B): Big Challenges case study is a Harvard Business School (HBR) case study written by Natasha Lee-Evans, Jonathan Story. The Danfoss RC in China (B): Big Challenges (referred as “Danfoss Rc” from here on) case study provides evaluation & decision scenario in field of Global Business. It also touches upon business topics such as - Value proposition, Economics, Financial management, Globalization, Government, Manufacturing, Strategy.

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 Danfoss RC in China (B): Big Challenges Case Study


Danfoss is one of Denmark's largest family firms, producing components for a wide range of industrial control activity. Spanning the period 1996-2004, the case begins by looking at Danfoss' globalisation strategy, then focuses on its specific experience and learning in China, before returning to the wider challenges that globalisation in China poses for Danfoss as a whole. The focus is on the Refrigeration & Controls (RC) division, the key Danfoss division to enter China.


Case Authors : Natasha Lee-Evans, Jonathan Story

Topic : Global Business

Related Areas : Economics, Financial management, Globalization, Government, Manufacturing, Strategy




Calculating Net Present Value (NPV) at 6% for Danfoss RC in China (B): Big Challenges Case Study


Years              Cash Flow     Net Cash Flow     Cumulative    
Cash Flow
Discount Rate
@ 6 %
Discounted
Cash Flows
Year 0 (10016000) -10016000 - -
Year 1 3456277 -6559723 3456277 0.9434 3260639
Year 2 3962395 -2597328 7418672 0.89 3526517
Year 3 3950111 1352783 11368783 0.8396 3316589
Year 4 3242496 4595279 14611279 0.7921 2568361
TOTAL 14611279 12672106




The Net Present Value at 6% discount rate is 2656106

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. Payback Period
2. Profitability Index
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 Danfoss Rc 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. Danfoss Rc shareholders have preference for diversified projects investment rather than prospective high income from a single capital intensive project.






Formula and Steps to Calculate Net Present Value (NPV) of Danfoss RC in China (B): Big Challenges

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 Danfoss Rc 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 Danfoss Rc 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 (10016000) -10016000 - -
Year 1 3456277 -6559723 3456277 0.8696 3005458
Year 2 3962395 -2597328 7418672 0.7561 2996140
Year 3 3950111 1352783 11368783 0.6575 2597262
Year 4 3242496 4595279 14611279 0.5718 1853908
TOTAL 10452768


The Net NPV after 4 years is 436768

(10452768 - 10016000 )








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 (10016000) -10016000 - -
Year 1 3456277 -6559723 3456277 0.8333 2880231
Year 2 3962395 -2597328 7418672 0.6944 2751663
Year 3 3950111 1352783 11368783 0.5787 2285944
Year 4 3242496 4595279 14611279 0.4823 1563704
TOTAL 9481542


The Net NPV after 4 years is -534458

At 20% discount rate the NPV is negative (9481542 - 10016000 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Danfoss Rc 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 Danfoss Rc has a NPV value higher than Zero then finance managers at Danfoss Rc 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 Danfoss Rc, then the stock price of the Danfoss Rc 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 Danfoss Rc 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.

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.

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.

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 Danfoss RC in China (B): Big Challenges

References & Further Readings

Natasha Lee-Evans, Jonathan Story (2018), "Danfoss RC in China (B): Big Challenges Harvard Business Review Case Study. Published by HBR Publications.


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