Valuation of Late-Stage Companies and Buyouts 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 Valuation of Late-Stage Companies and Buyouts case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Valuation of Late-Stage Companies and Buyouts case study is a Harvard Business School (HBR) case study written by Susan Chaplinsky, Shikha Khetrepal. The Valuation of Late-Stage Companies and Buyouts (referred as “Stage Lbos” 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 analysis, Financial management, Mergers & acquisitions.

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 Valuation of Late-Stage Companies and Buyouts Case Study

This note focuses on the valuation of late-stage companies with a particular emphasis on leveraged buyouts (LBOs). In addition to LBOs, late-stage investments can arise in situations involving growth equity, turnarounds, mezzanine investments, and distressed debt. In contrast to venture capital, where firms are typically at an early stage of development, late-stage investments involve more established businesses that have an ability to take on higher levels of leverage to augment investor returns. While in practice there are several approaches to valuation, the approach chosen often comes down to which provides the most accurate representation of the situation and perspectives of the parties involved. This note takes the perspective of a PE investor and assumes some basic familiarity with the structure of PE investing. It provides a basic overview of the primary sources of financing and the metrics used to gauge LBO capital structures and a step-by-step example of an LBO analysis.

Case Authors : Susan Chaplinsky, Shikha Khetrepal

Topic : Innovation & Entrepreneurship

Related Areas : Financial analysis, Financial management, Mergers & acquisitions

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Calculating Net Present Value (NPV) at 6% for Valuation of Late-Stage Companies and Buyouts Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10017817)	-10017817	-	-
Year 1	3445019	-6572798	3445019	0.9434	3250018
Year 2	3962932	-2609866	7407951	0.89	3526995
Year 3	3953131	1343265	11361082	0.8396	3319125
Year 4	3240884	4584149	14601966	0.7921	2567084
TOTAL			14601966		12663222

The Net Present Value at 6% discount rate is 2645405

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 Stage Lbos 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. Stage Lbos 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 Valuation of Late-Stage Companies and Buyouts

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 Stage Lbos 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 Stage Lbos 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	(10017817)	-10017817	-	-
Year 1	3445019	-6572798	3445019	0.8696	2995669
Year 2	3962932	-2609866	7407951	0.7561	2996546
Year 3	3953131	1343265	11361082	0.6575	2599248
Year 4	3240884	4584149	14601966	0.5718	1852986
TOTAL					10444448

The Net NPV after 4 years is 426631

(10444448 - 10017817 )

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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	(10017817)	-10017817	-	-
Year 1	3445019	-6572798	3445019	0.8333	2870849
Year 2	3962932	-2609866	7407951	0.6944	2752036
Year 3	3953131	1343265	11361082	0.5787	2287692
Year 4	3240884	4584149	14601966	0.4823	1562926
TOTAL					9473503

The Net NPV after 4 years is -544314

At 20% discount rate the NPV is negative (9473503 - 10017817 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Stage Lbos 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 Stage Lbos has a NPV value higher than Zero then finance managers at Stage Lbos 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 Stage Lbos, then the stock price of the Stage Lbos 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 Stage Lbos 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.

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.

Understanding of risks involved in 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.

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 Valuation of Late-Stage Companies and Buyouts

References & Further Readings

Susan Chaplinsky, Shikha Khetrepal (2018), "Valuation of Late-Stage Companies and Buyouts Harvard Business Review Case Study. Published by HBR Publications.