Sanlu's Melamine-Tainted Milk Crisis in China 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 Sanlu's Melamine-Tainted Milk Crisis in China case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Sanlu's Melamine-Tainted Milk Crisis in China case study is a Harvard Business School (HBR) case study written by Jiangyong Lu, Zhigang Tao, Claudia H. L. Woo. The Sanlu's Melamine-Tainted Milk Crisis in China (referred as “Sanlu Melamine” from here on) case study provides evaluation & decision scenario in field of Global Business. It also touches upon business topics such as - Value proposition, Ethics, Government, Marketing, Social enterprise, 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 Sanlu's Melamine-Tainted Milk Crisis in China Case Study

On 12 September 2008, Sanlu Group, the biggest producer of milk powder in China, rocked the country when it admitted that its infant formula had been contaminated with the toxic chemical melamine. China's national inspection agency extended its investigation to other dairy manufacturers across the nation. Shockingly, products of 21 other dairies, including some famous Chinese brands, also tested positive for melamine. Due to consumption of melamine-laced milk products, more than 56,000 infants and young children had become sick and four babies had died from kidney failure by the end of September. The melamine scare also resulted in many countries recalling and banning goods using milk products from China. When Sanlu became the key culprit in the milk crisis after its infant formula was revealed to contain as much as four times more melamine than other tainted brands, the company apologized to the public. Sanlu also explained that its unscrupulous raw-milk dealers had illegally added melamine to milk. However, it failed to explain its delay in alerting the public when it first received customer complaints in late 2007. Instead, Sanlu had tried to cover up the news until being prompted by its New Zealand partner, Fonterra, which later alerted the New Zealand government. As a result of the milk crisis, the local government of Shijiazhuang, where Sanlu was headquartered, was accused of holding back the news from the central government. Fonterra wrote off all its investment in Sanlu, and Sanlu finally declared bankruptcy on 24 December 2008. The Sanlu incident has spotlighted the inadequacy of China's entire dairy supply chain and has forced the government and the industry to make a collective effort to restore consumer confidence in Chinese dairy products.

Case Authors : Jiangyong Lu, Zhigang Tao, Claudia H. L. Woo

Topic : Global Business

Related Areas : Ethics, Government, Marketing, Social enterprise, Supply chain

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Calculating Net Present Value (NPV) at 6% for Sanlu's Melamine-Tainted Milk Crisis in China Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10021352)	-10021352	-	-
Year 1	3464178	-6557174	3464178	0.9434	3268092
Year 2	3974532	-2582642	7438710	0.89	3537319
Year 3	3938309	1355667	11377019	0.8396	3306680
Year 4	3222286	4577953	14599305	0.7921	2552352
TOTAL			14599305		12664444

The Net Present Value at 6% discount rate is 2643092

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. Profitability Index
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. Sanlu Melamine 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 Sanlu Melamine 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 Sanlu's Melamine-Tainted Milk Crisis in China

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 Sanlu Melamine 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 Sanlu Melamine 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	(10021352)	-10021352	-	-
Year 1	3464178	-6557174	3464178	0.8696	3012329
Year 2	3974532	-2582642	7438710	0.7561	3005317
Year 3	3938309	1355667	11377019	0.6575	2589502
Year 4	3222286	4577953	14599305	0.5718	1842352
TOTAL					10449500

The Net NPV after 4 years is 428148

(10449500 - 10021352 )

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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	(10021352)	-10021352	-	-
Year 1	3464178	-6557174	3464178	0.8333	2886815
Year 2	3974532	-2582642	7438710	0.6944	2760092
Year 3	3938309	1355667	11377019	0.5787	2279114
Year 4	3222286	4577953	14599305	0.4823	1553957
TOTAL					9479978

The Net NPV after 4 years is -541374

At 20% discount rate the NPV is negative (9479978 - 10021352 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Sanlu Melamine 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 Sanlu Melamine has a NPV value higher than Zero then finance managers at Sanlu Melamine 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 Sanlu Melamine, then the stock price of the Sanlu Melamine 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 Sanlu Melamine 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 can impact the cash flow of 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.

Understanding of risks involved in 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.

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Negotiation Strategy of Sanlu's Melamine-Tainted Milk Crisis in China

References & Further Readings

Jiangyong Lu, Zhigang Tao, Claudia H. L. Woo (2018), "Sanlu's Melamine-Tainted Milk Crisis in China Harvard Business Review Case Study. Published by HBR Publications.