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Preview Travel (A) 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 Preview Travel (A) case study


At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Preview Travel (A) case study is a Harvard Business School (HBR) case study written by William A. Sahlman, Nicole Tempest. The Preview Travel (A) (referred as “Preview Travel” from here on) case study provides evaluation & decision scenario in field of Innovation & Entrepreneurship. It also touches upon business topics such as - Value proposition, Financial management, IPO.

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 Preview Travel (A) Case Study


Preview Travel was a leader in the online travel industry, having generated $80 million in bookings in 1997 and growing at a 34% compound annual growth rate per quarter. This case describes the evolution of Preview Travel's business plan and financing strategy and highlights a financial turning point that the company faced in August 1997. In August 1997, the company was in need of an additional cash infusion and had received strong indications of interest from a major U.S. media company. However, Preview Travel was disappointed with the offer the media company eventually made--$4.50 a share--since it was significantly less than the Series E round a year earlier ($9.00 a share). An investment bank advising Preview Travel believed that Preview Travel could garner a higher valuation in the public market and recommended that the company consider an IPO as an alternative means of raising capital. However, there were risks to this strategy. Closes with the question of whether Preview Travel should accept the "sure" but low offer from the media company or pursue an accelerated and potentially risky IPO.


Case Authors : William A. Sahlman, Nicole Tempest

Topic : Innovation & Entrepreneurship

Related Areas : Financial management, IPO




Calculating Net Present Value (NPV) at 6% for Preview Travel (A) Case Study


Years              Cash Flow     Net Cash Flow     Cumulative    
Cash Flow
Discount Rate
@ 6 %
Discounted
Cash Flows
Year 0 (10007278) -10007278 - -
Year 1 3456163 -6551115 3456163 0.9434 3260531
Year 2 3954222 -2596893 7410385 0.89 3519244
Year 3 3961227 1364334 11371612 0.8396 3325923
Year 4 3249757 4614091 14621369 0.7921 2574112
TOTAL 14621369 12679809


The Net Present Value at 6% discount rate is 2672531

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. 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. Magnitude of both incoming and outgoing cash flows – Projects can be capital intensive, time intensive, or both. Preview Travel 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 Preview Travel have higher preference for cash returns over 4-5 years rather than 10-15 years given the nature of the volatility in the industry.




Formula and Steps to Calculate Net Present Value (NPV) of Preview Travel (A)

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 Preview Travel 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 Preview Travel 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 (10007278) -10007278 - -
Year 1 3456163 -6551115 3456163 0.8696 3005359
Year 2 3954222 -2596893 7410385 0.7561 2989960
Year 3 3961227 1364334 11371612 0.6575 2604571
Year 4 3249757 4614091 14621369 0.5718 1858059
TOTAL 10457949


The Net NPV after 4 years is 450671

(10457949 - 10007278 )






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 (10007278) -10007278 - -
Year 1 3456163 -6551115 3456163 0.8333 2880136
Year 2 3954222 -2596893 7410385 0.6944 2745988
Year 3 3961227 1364334 11371612 0.5787 2292377
Year 4 3249757 4614091 14621369 0.4823 1567205
TOTAL 9485705


The Net NPV after 4 years is -521573

At 20% discount rate the NPV is negative (9485705 - 10007278 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Preview Travel 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 Preview Travel has a NPV value higher than Zero then finance managers at Preview Travel 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 Preview Travel, then the stock price of the Preview Travel 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 Preview Travel 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 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 are the key aspects of the projects that need to be monitored, refined, and retuned for continuous delivery of projected cash flows.

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 Preview Travel (A)

References & Further Readings

William A. Sahlman, Nicole Tempest (2018), "Preview Travel (A) Harvard Business Review Case Study. Published by HBR Publications.