"Cementos Lima: Laying the Foundations of Social Responsibility" 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 "Cementos Lima: Laying the Foundations of Social Responsibility" case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. "Cementos Lima: Laying the Foundations of Social Responsibility" case study is a Harvard Business School (HBR) case study written by Felipe Portocarrero, Cynthia Sanborn, Elsa Del Castillo, Martha Chavez. The "Cementos Lima: Laying the Foundations of Social Responsibility" (referred as “Cementos Lima” from here on) case study provides evaluation & decision scenario in field of Innovation & Entrepreneurship. It also touches upon business topics such as - Value proposition, Organizational structure, Social responsibility.

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 "Cementos Lima: Laying the Foundations of Social Responsibility" Case Study

Cementos Lima S.A, is a leading organization in the Peruvian cement sector, with 44% of the national market share and a growing presence in certain international markets. Parallel to the growth of the company, population centers have grown up in the areas adjacent to the cement plant. As time goes by, the neighboring communities have come to literally surround Cementos Lima S.A. and have developed a complex relationship with the company. On one hand, the residents in these areas are directly affected by the company's industrial operations, which produce negative effects on the environment. On the other hand, these same individuals benefit from the company's social initiatives over time. As the organization's social actions began to evolve, from disarticulated and basically philanthropic practices towards an attempt at more formal and effective projects in the community, a "breaking point" is produced in the company's management focus. This situation is generated by the company's plans for export growth, which implies physical expansion of their activities, and as a result a larger impact on the surrounding community due to the necessary increase in the transportation flow of primary materials and finished products. To meet its new transportation needs, the company has planned two major projects. Both projects require the approval of the neighboring community, as part of the authorization process established by municipal authorities. In the face of observed reluctance among the neighboring communities to approve these projects, company officials have begun to reexamine the way they have been managing community relations and the importance that these relationships have in achieving their strategic objectives.

Case Authors : Felipe Portocarrero, Cynthia Sanborn, Elsa Del Castillo, Martha Chavez

Topic : Innovation & Entrepreneurship

Related Areas : Organizational structure, Social responsibility

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Calculating Net Present Value (NPV) at 6% for "Cementos Lima: Laying the Foundations of Social Responsibility" Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10000679)	-10000679	-	-
Year 1	3469609	-6531070	3469609	0.9434	3273216
Year 2	3969489	-2561581	7439098	0.89	3532831
Year 3	3954352	1392771	11393450	0.8396	3320150
Year 4	3229306	4622077	14622756	0.7921	2557913
TOTAL			14622756		12684110

The Net Present Value at 6% discount rate is 2683431

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. Profitability Index
3. Internal Rate of Return
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. Timing of the expected cash flows – stockholders of Cementos Lima 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. Cementos Lima shareholders have preference for diversified projects investment rather than prospective high income from a single capital intensive project.

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Formula and Steps to Calculate Net Present Value (NPV) of "Cementos Lima: Laying the Foundations of Social Responsibility"

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 Innovation & Entrepreneurship 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 Cementos Lima 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 Cementos Lima 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	(10000679)	-10000679	-	-
Year 1	3469609	-6531070	3469609	0.8696	3017051
Year 2	3969489	-2561581	7439098	0.7561	3001504
Year 3	3954352	1392771	11393450	0.6575	2600051
Year 4	3229306	4622077	14622756	0.5718	1846366
TOTAL					10464972

The Net NPV after 4 years is 464293

(10464972 - 10000679 )

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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	(10000679)	-10000679	-	-
Year 1	3469609	-6531070	3469609	0.8333	2891341
Year 2	3969489	-2561581	7439098	0.6944	2756590
Year 3	3954352	1392771	11393450	0.5787	2288398
Year 4	3229306	4622077	14622756	0.4823	1557343
TOTAL					9493671

The Net NPV after 4 years is -507008

At 20% discount rate the NPV is negative (9493671 - 10000679 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Cementos Lima 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 Cementos Lima has a NPV value higher than Zero then finance managers at Cementos Lima 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 Cementos Lima, then the stock price of the Cementos Lima 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 Cementos Lima 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 key aspects of the projects that need to be monitored, refined, and retuned for continuous delivery of projected cash flows.

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 can impact the cash flow of the project.

Understanding of risks involved in the project.

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

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 "Cementos Lima: Laying the Foundations of Social Responsibility"

References & Further Readings

Felipe Portocarrero, Cynthia Sanborn, Elsa Del Castillo, Martha Chavez (2018), ""Cementos Lima: Laying the Foundations of Social Responsibility" Harvard Business Review Case Study. Published by HBR Publications.