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Online Market Makers 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 Online Market Makers case study


At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Online Market Makers case study is a Harvard Business School (HBR) case study written by Thomas R. Eisenmann, Christopher J. Hackett. The Online Market Makers (referred as “Makers Online” from here on) case study provides evaluation & decision scenario in field of Innovation & Entrepreneurship. It also touches upon business topics such as - Value proposition, Entrepreneurship, Internet, Market research.

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 Online Market Makers Case Study


Describes the business model for online market makers, firms that use the Internet to organize a marketplace, providing participants with a virtual "place" to trade, rules to govern their exchanges, and infrastructure to support trading. First it proposes a definition of market making and presents different ways to categorize online market makers. Next it describes how online market makers create value for market participants. Then it examines the economics of market making, focusing on revenue and cost drivers, using both online and offline examples. Building on that analysis, the final section examines the risks and potential payoffs to online market makers from pursuing aggressive growth strategies. Explores the value proposition offered by these companies and the economic imperatives they face. Finally, seeks to provide a framework for evaluating whether the adoption of aggressive growth strategies is prudent for online market makers.


Case Authors : Thomas R. Eisenmann, Christopher J. Hackett

Topic : Innovation & Entrepreneurship

Related Areas : Entrepreneurship, Internet, Market research




Calculating Net Present Value (NPV) at 6% for Online Market Makers Case Study


Years              Cash Flow     Net Cash Flow     Cumulative    
Cash Flow
Discount Rate
@ 6 %
Discounted
Cash Flows
Year 0 (10026067) -10026067 - -
Year 1 3449748 -6576319 3449748 0.9434 3254479
Year 2 3953066 -2623253 7402814 0.89 3518215
Year 3 3938191 1314938 11341005 0.8396 3306581
Year 4 3244627 4559565 14585632 0.7921 2570048
TOTAL 14585632 12649324


The Net Present Value at 6% discount rate is 2623257

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. Profitability Index
2. Payback Period
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 Makers Online 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. Makers Online 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 Online Market Makers

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 Makers Online 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 Makers Online 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 (10026067) -10026067 - -
Year 1 3449748 -6576319 3449748 0.8696 2999781
Year 2 3953066 -2623253 7402814 0.7561 2989086
Year 3 3938191 1314938 11341005 0.6575 2589425
Year 4 3244627 4559565 14585632 0.5718 1855126
TOTAL 10433417


The Net NPV after 4 years is 407350

(10433417 - 10026067 )






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 (10026067) -10026067 - -
Year 1 3449748 -6576319 3449748 0.8333 2874790
Year 2 3953066 -2623253 7402814 0.6944 2745185
Year 3 3938191 1314938 11341005 0.5787 2279046
Year 4 3244627 4559565 14585632 0.4823 1564731
TOTAL 9463752


The Net NPV after 4 years is -562315

At 20% discount rate the NPV is negative (9463752 - 10026067 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Makers Online 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 Makers Online has a NPV value higher than Zero then finance managers at Makers Online 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 Makers Online, then the stock price of the Makers Online 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 Makers Online 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 can impact the cash flow of the project.

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 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.




References & Further Readings

Thomas R. Eisenmann, Christopher J. Hackett (2018), "Online Market Makers Harvard Business Review Case Study. Published by HBR Publications.