Taino Construction Supplies: Managing Innovation Risks at an SME in a Small, Developing Nation 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 Taino Construction Supplies: Managing Innovation Risks at an SME in a Small, Developing Nation case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Taino Construction Supplies: Managing Innovation Risks at an SME in a Small, Developing Nation case study is a Harvard Business School (HBR) case study written by Carmen Rios Figueroa, Julia Sagebien. The Taino Construction Supplies: Managing Innovation Risks at an SME in a Small, Developing Nation (referred as “Taino Green” from here on) case study provides evaluation & decision scenario in field of Innovation & Entrepreneurship. It also touches upon business topics such as - Value proposition, Innovation, International business, Sustainability.

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 Taino Construction Supplies: Managing Innovation Risks at an SME in a Small, Developing Nation Case Study

The president of Taino Construction has to make several strategic decisions that can guide the firm during very difficult times for the construction industry - globally and locally. He is trying to find ways to capitalize on the company's innovations and international advantages. At the same time, he is trying to adapt the company to the needs of the local market, which requires smaller volumes and simpler products. In order to do this, management must assess the level of risk inherent in the company's portfolio of innovations by estimating the potential of the markets for these products, determining how to strategically position the products in the markets and making a sober assessment of the company's financial strength. The case can be used in a management of innovation course as well as in an international business or marketing strategy or integrative strategy course. It could also be used in a family business course. It lends itself to use in a green products/sustainability module. The objectives of the case are 1) to allow students an opportunity to analyze a company's innovation portfolio and, more specifically, the level of risk inherent in market opportunities 2) to explore how innovative international strategies can help a company survive adverse local market conditions, though it may add to the overall risk of the innovation portfolio of the company 3) to showcase a company committed to green products, allowing for a discussion on sustainability in the construction industry, as well as on how what is considered a "green product" by some stakeholders is not considered a green product by others 4) to showcase the complexity of the relationship between a company's clients/competitors/partners and the way in which government initiative can offer opportunities and challenges to a company 5) to offer an opportunity to conduct financial performance analysis.

Case Authors : Carmen Rios Figueroa, Julia Sagebien

Topic : Innovation & Entrepreneurship

Related Areas : Innovation, International business, Sustainability

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Calculating Net Present Value (NPV) at 6% for Taino Construction Supplies: Managing Innovation Risks at an SME in a Small, Developing Nation Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10020629)	-10020629	-	-
Year 1	3453134	-6567495	3453134	0.9434	3257674
Year 2	3959512	-2607983	7412646	0.89	3523952
Year 3	3954090	1346107	11366736	0.8396	3319930
Year 4	3232486	4578593	14599222	0.7921	2560432
TOTAL			14599222		12661987

The Net Present Value at 6% discount rate is 2641358

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. Profitability Index
2. Payback Period
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 Taino Green 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. Taino Green 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 Taino Construction Supplies: Managing Innovation Risks at an SME in a Small, Developing Nation

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 Taino Green 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 Taino Green 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	(10020629)	-10020629	-	-
Year 1	3453134	-6567495	3453134	0.8696	3002725
Year 2	3959512	-2607983	7412646	0.7561	2993960
Year 3	3954090	1346107	11366736	0.6575	2599878
Year 4	3232486	4578593	14599222	0.5718	1848184
TOTAL					10444748

The Net NPV after 4 years is 424119

(10444748 - 10020629 )

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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	(10020629)	-10020629	-	-
Year 1	3453134	-6567495	3453134	0.8333	2877612
Year 2	3959512	-2607983	7412646	0.6944	2749661
Year 3	3954090	1346107	11366736	0.5787	2288247
Year 4	3232486	4578593	14599222	0.4823	1558876
TOTAL					9474396

The Net NPV after 4 years is -546233

At 20% discount rate the NPV is negative (9474396 - 10020629 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Taino Green 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 Taino Green has a NPV value higher than Zero then finance managers at Taino Green 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 Taino Green, then the stock price of the Taino Green 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 Taino Green 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.

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.

What are the key aspects of the projects that need to be monitored, refined, and retuned for continuous delivery of projected cash flows.

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 Taino Construction Supplies: Managing Innovation Risks at an SME in a Small, Developing Nation

References & Further Readings

Carmen Rios Figueroa, Julia Sagebien (2018), "Taino Construction Supplies: Managing Innovation Risks at an SME in a Small, Developing Nation Harvard Business Review Case Study. Published by HBR Publications.