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Refresh Organics Board of Directors: Three Vignettes 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 Refresh Organics Board of Directors: Three Vignettes case study


At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Refresh Organics Board of Directors: Three Vignettes case study is a Harvard Business School (HBR) case study written by Arar Han, Mike Child, Jeff Chambers. The Refresh Organics Board of Directors: Three Vignettes (referred as “Hausman Refresh” from here on) case study provides evaluation & decision scenario in field of Innovation & Entrepreneurship. It also touches upon business topics such as - Value proposition, Entrepreneurial management.

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 Refresh Organics Board of Directors: Three Vignettes Case Study


George Hausman, co-founder and CEO of Pleasanton, California-based Refresh Organics (fictional), was proud of the business he had built over the past 15 years. Along with a minority partner, Hausman had started Refresh as a distributor of organic produce sourced throughout California. The business had grown steadily, if not explosively, and was now a distributor for organic farms throughout the United States. Refresh's distribution revenues were on track to hit $40 million this year. Refresh Organics also has a lucrative juice business. As the business grows, Hausman wonders if and how he ought to expand his ad hoc board of family and friends into a "real" board (vignette 1). He also wonders whom to add and whether the group of ten he has assembled is 'right' (vignette 2). Finally, Hausman has an opportunity to learn some best practices around how to deliver bad news to the board (vignette 3).


Case Authors : Arar Han, Mike Child, Jeff Chambers

Topic : Innovation & Entrepreneurship

Related Areas : Entrepreneurial management




Calculating Net Present Value (NPV) at 6% for Refresh Organics Board of Directors: Three Vignettes Case Study


Years              Cash Flow     Net Cash Flow     Cumulative    
Cash Flow
Discount Rate
@ 6 %
Discounted
Cash Flows
Year 0 (10008193) -10008193 - -
Year 1 3455660 -6552533 3455660 0.9434 3260057
Year 2 3967260 -2585273 7422920 0.89 3530847
Year 3 3936225 1350952 11359145 0.8396 3304930
Year 4 3239528 4590480 14598673 0.7921 2566010
TOTAL 14598673 12661844




The Net Present Value at 6% discount rate is 2653651

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. Net Present Value
2. Payback Period
3. Profitability Index
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 Hausman Refresh 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. Hausman Refresh 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 Refresh Organics Board of Directors: Three Vignettes

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 Hausman Refresh 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 Hausman Refresh 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 (10008193) -10008193 - -
Year 1 3455660 -6552533 3455660 0.8696 3004922
Year 2 3967260 -2585273 7422920 0.7561 2999819
Year 3 3936225 1350952 11359145 0.6575 2588132
Year 4 3239528 4590480 14598673 0.5718 1852211
TOTAL 10445083


The Net NPV after 4 years is 436890

(10445083 - 10008193 )








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 (10008193) -10008193 - -
Year 1 3455660 -6552533 3455660 0.8333 2879717
Year 2 3967260 -2585273 7422920 0.6944 2755042
Year 3 3936225 1350952 11359145 0.5787 2277908
Year 4 3239528 4590480 14598673 0.4823 1562272
TOTAL 9474939


The Net NPV after 4 years is -533254

At 20% discount rate the NPV is negative (9474939 - 10008193 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Hausman Refresh 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 Hausman Refresh has a NPV value higher than Zero then finance managers at Hausman Refresh 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 Hausman Refresh, then the stock price of the Hausman Refresh 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 Hausman Refresh 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.

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.

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 Refresh Organics Board of Directors: Three Vignettes

References & Further Readings

Arar Han, Mike Child, Jeff Chambers (2018), "Refresh Organics Board of Directors: Three Vignettes Harvard Business Review Case Study. Published by HBR Publications.


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