Navigating China's Changing Economy: Strategies for Private Firms 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 Navigating China's Changing Economy: Strategies for Private Firms case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Navigating China's Changing Economy: Strategies for Private Firms case study is a Harvard Business School (HBR) case study written by David Ahlstrom, Garry D. Bruton, Steven S.Y. Lui. The Navigating China's Changing Economy: Strategies for Private Firms (referred as “Firms Private” 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.

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 Navigating China's Changing Economy: Strategies for Private Firms Case Study

Despite China's rapid economic growth and the role private firms have played in it, many such companies have experienced numerous problems. At the root of many of these problems is the lack of well-established ground rules for commerce and the absence of institutions that support and legitimize private enterprise. Moreover, reforms in the Peoples Republic of China in the late 1970s transferred much of the government's role in economic decision-making to the provincial and local level. The result for private firms is vulnerability to arbitrary and capricious interventions, intrusions, and orders. This study of 12 private firms illustrates these problems and shows how such firms make use of guanxi to manage these challenges. The different forms of guanxi include coopting strategies, such as offering shares to local officials, hiring people from within the government who already have connections, or hiring former village elders. Another strategy takes the form of trust-building in dealings with suppliers and distributors and in giving small favors, such as holding regular banquets for local officials. Finally, the firms studied here have assiduously engaged in charitable giving at the local level, making donations to construct educational facilities and community centers and to aid families affected by floods. These strategies reflect the reality that private firms' transactions in China are not based on pure market or pure planning, but on influence.

Case Authors : David Ahlstrom, Garry D. Bruton, Steven S.Y. Lui

Topic : Global Business

Related Areas : Government

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Calculating Net Present Value (NPV) at 6% for Navigating China's Changing Economy: Strategies for Private Firms Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10029930)	-10029930	-	-
Year 1	3466312	-6563618	3466312	0.9434	3270106
Year 2	3977507	-2586111	7443819	0.89	3539967
Year 3	3958678	1372567	11402497	0.8396	3323782
Year 4	3236745	4609312	14639242	0.7921	2563805
TOTAL			14639242		12697660

The Net Present Value at 6% discount rate is 2667730

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. Payback Period
2. Net Present Value
3. Internal Rate of Return
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. Firms Private 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 Firms Private 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 Navigating China's Changing Economy: Strategies for Private Firms

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 Firms Private 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 Firms Private 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	(10029930)	-10029930	-	-
Year 1	3466312	-6563618	3466312	0.8696	3014184
Year 2	3977507	-2586111	7443819	0.7561	3007567
Year 3	3958678	1372567	11402497	0.6575	2602895
Year 4	3236745	4609312	14639242	0.5718	1850619
TOTAL					10475266

The Net NPV after 4 years is 445336

(10475266 - 10029930 )

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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	(10029930)	-10029930	-	-
Year 1	3466312	-6563618	3466312	0.8333	2888593
Year 2	3977507	-2586111	7443819	0.6944	2762158
Year 3	3958678	1372567	11402497	0.5787	2290902
Year 4	3236745	4609312	14639242	0.4823	1560930
TOTAL					9502583

The Net NPV after 4 years is -527347

At 20% discount rate the NPV is negative (9502583 - 10029930 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Firms Private 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 Firms Private has a NPV value higher than Zero then finance managers at Firms Private 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 Firms Private, then the stock price of the Firms Private 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 Firms Private 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.

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 will be a multi year spillover effect of various taxation regulations.

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 Navigating China's Changing Economy: Strategies for Private Firms

References & Further Readings

David Ahlstrom, Garry D. Bruton, Steven S.Y. Lui (2018), "Navigating China's Changing Economy: Strategies for Private Firms Harvard Business Review Case Study. Published by HBR Publications.