Doug Rauch: Solving the American Food Paradox 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 Doug Rauch: Solving the American Food Paradox case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Doug Rauch: Solving the American Food Paradox case study is a Harvard Business School (HBR) case study written by Jose B. Alvarez, Ryan Johnson. The Doug Rauch: Solving the American Food Paradox (referred as “Rauch Food” 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, Marketing, Operations management, Organizational culture.

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 Doug Rauch: Solving the American Food Paradox Case Study

Doug Rauch, the former president of grocery store chain Trader Joe's, had long been troubled by the amount of food, especially fresh and healthy produce, which was wasted in the food system. Simultaneously, he was frustrated by the paradox he saw in the U.S. food system: rising food insecurity, broadly defined as a lack of access to enough food to fully meet basic needs at all times, concurrent with an obesity epidemic, suggesting that low-income communities lacked access not just to food in general, but to healthy foods in particular. Rauch believed he could build a non-profit grocery store model that took advantage of grocery stores' built-in waste and channeled that wasted food to be resold at a significant discount. Rauch faced significant challenges in the implementation and execution of his plan, notably legal hurdles related to selling products past their expiration date, marketing challenges, and convincing grocers to partner with him to combat waste. He had to carefully select a partner from a number of interested parties. Finally, he would need to change shopping, eating, and cooking behaviors of a community. In doing so, he hoped to leave a lasting positive health impact and a scalable model for change across the United States.

Case Authors : Jose B. Alvarez, Ryan Johnson

Topic : Innovation & Entrepreneurship

Related Areas : Entrepreneurship, Marketing, Operations management, Organizational culture

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Calculating Net Present Value (NPV) at 6% for Doug Rauch: Solving the American Food Paradox Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10016429)	-10016429	-	-
Year 1	3453457	-6562972	3453457	0.9434	3257978
Year 2	3954180	-2608792	7407637	0.89	3519206
Year 3	3960806	1352014	11368443	0.8396	3325569
Year 4	3244900	4596914	14613343	0.7921	2570265
TOTAL			14613343		12673018

The Net Present Value at 6% discount rate is 2656589

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. Net Present Value
2. Profitability Index
3. Payback Period
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 Rauch Food 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. Rauch Food 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 Doug Rauch: Solving the American Food Paradox

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 Rauch Food 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 Rauch Food 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	(10016429)	-10016429	-	-
Year 1	3453457	-6562972	3453457	0.8696	3003006
Year 2	3954180	-2608792	7407637	0.7561	2989928
Year 3	3960806	1352014	11368443	0.6575	2604294
Year 4	3244900	4596914	14613343	0.5718	1855282
TOTAL					10452511

The Net NPV after 4 years is 436082

(10452511 - 10016429 )

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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	(10016429)	-10016429	-	-
Year 1	3453457	-6562972	3453457	0.8333	2877881
Year 2	3954180	-2608792	7407637	0.6944	2745958
Year 3	3960806	1352014	11368443	0.5787	2292133
Year 4	3244900	4596914	14613343	0.4823	1564863
TOTAL					9480835

The Net NPV after 4 years is -535594

At 20% discount rate the NPV is negative (9480835 - 10016429 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Rauch Food 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 Rauch Food has a NPV value higher than Zero then finance managers at Rauch Food 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 Rauch Food, then the stock price of the Rauch Food 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 Rauch Food 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 can impact the cash flow of the project.

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.

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 Doug Rauch: Solving the American Food Paradox

References & Further Readings

Jose B. Alvarez, Ryan Johnson (2018), "Doug Rauch: Solving the American Food Paradox Harvard Business Review Case Study. Published by HBR Publications.