Shaping an Industry in Your Favor 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 Shaping an Industry in Your Favor case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Shaping an Industry in Your Favor case study is a Harvard Business School (HBR) case study written by Fabrizio Ferraro. The Shaping an Industry in Your Favor (referred as “Architectural Wasserman” from here on) case study provides evaluation & decision scenario in field of Innovation & Entrepreneurship. It also touches upon business topics such as - Value proposition, Change management, Manufacturing.

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 Shaping an Industry in Your Favor Case Study

In 1939, at the age of 26, Lew Wasserman arrived in Los Angeles with the talent agency MCA. Over the next three decades, he took MCA from a peripheral player to becoming the dominant studio in Hollywood. How did an outsider manage to change the competitive landscape of the entire moviemaking industry so completely? A study of this fascinating historical account reveals the process by which a firm can achieve "architectural advantage." Managers may be familiar with the idea that "shocks" brought on by technological and regulatory changes can trigger the emergence of novel industry structures. The Wasserman case shows there is more to it than that. An innovative business model, by itself, is not sufficient. Rather, the acquisition of mispriced resources by newcomers and the incumbents' (in)action are also critical for newcomers to enter the industry, redraw its boundaries and achieve architectural advantage. Are there opportunities for your company to position itself in segments that would put it in the dominant position? Wasserman's experience in the movie and television business, as well as other timely examples drawn from music and publishing, provide useful insights for managers operating in industries with unstable, contested architectures; entrepreneurial firms trying to develop architectural advantage in an emerging industry; and venture capitalists trying to identify investment opportunities.

Case Authors : Fabrizio Ferraro

Topic : Innovation & Entrepreneurship

Related Areas : Change management, Manufacturing

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Calculating Net Present Value (NPV) at 6% for Shaping an Industry in Your Favor Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10004105)	-10004105	-	-
Year 1	3472844	-6531261	3472844	0.9434	3276268
Year 2	3965279	-2565982	7438123	0.89	3529084
Year 3	3971969	1405987	11410092	0.8396	3334942
Year 4	3242027	4648014	14652119	0.7921	2567989
TOTAL			14652119		12708283

The Net Present Value at 6% discount rate is 2704178

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. Internal Rate of Return
2. Payback Period
3. Profitability Index
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 Architectural Wasserman 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. Architectural Wasserman 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 Shaping an Industry in Your Favor

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 Architectural Wasserman 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 Architectural Wasserman 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	(10004105)	-10004105	-	-
Year 1	3472844	-6531261	3472844	0.8696	3019864
Year 2	3965279	-2565982	7438123	0.7561	2998321
Year 3	3971969	1405987	11410092	0.6575	2611634
Year 4	3242027	4648014	14652119	0.5718	1853639
TOTAL					10483459

The Net NPV after 4 years is 479354

(10483459 - 10004105 )

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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	(10004105)	-10004105	-	-
Year 1	3472844	-6531261	3472844	0.8333	2894037
Year 2	3965279	-2565982	7438123	0.6944	2753666
Year 3	3971969	1405987	11410092	0.5787	2298593
Year 4	3242027	4648014	14652119	0.4823	1563478
TOTAL					9509773

The Net NPV after 4 years is -494332

At 20% discount rate the NPV is negative (9509773 - 10004105 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Architectural Wasserman 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 Architectural Wasserman has a NPV value higher than Zero then finance managers at Architectural Wasserman 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 Architectural Wasserman, then the stock price of the Architectural Wasserman 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 Architectural Wasserman 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 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.

What can impact the cash flow of the project.

What will be a multi year spillover effect of various taxation regulations.

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.

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Negotiation Strategy of Shaping an Industry in Your Favor

References & Further Readings

Fabrizio Ferraro (2018), "Shaping an Industry in Your Favor Harvard Business Review Case Study. Published by HBR Publications.