Gazi (B): Bringing the sum of the parts together with the whole 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 Gazi (B): Bringing the sum of the parts together with the whole case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Gazi (B): Bringing the sum of the parts together with the whole case study is a Harvard Business School (HBR) case study written by Derek F. Abell. The Gazi (B): Bringing the sum of the parts together with the whole (referred as “Gazi's Tourism” from here on) case study provides evaluation & decision scenario in field of Innovation & Entrepreneurship. It also touches upon business topics such as - Value proposition, Emerging markets, Entrepreneurship, Financial analysis, Leadership, Leadership development, Organizational structure, Risk management, Succession planning.

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 Gazi (B): Bringing the sum of the parts together with the whole Case Study

The Gazi B case focuses on two issues: First, it provides a bottom-up perspective on each of Gazi's main lines of business, namely, the Avis/Budget car rental and other vehicle and leasing businesses, in-bound tourism, outbound tourism and ticketing, conference and event business, and cruise ship landings. Detailed plans are presented for each of these business lines and can be contrasted with plans and figures presented in the A case which provided a top-down perspective. The two perspectives remain far apart. Gazi's top-down vision is to have overall company revenues of a??100 million within five years; bottom-up estimates range from a??50 million overall downwards. The case invites a debate of how to reconcile these two disparate perspectives. It allows students to understand that the real issue behind these disparate growth goals is to decide first and foremost on the overall corporate business definition and scope, and whether the previous pattern of continuous diversification is sustainable in the long run. Also worth debating is whether Gazi's focus on top line revenue growth, and on employee projections, should not be tempered by a parallel concern for the bottom line, for example profitability. The second in the B case is to decide on a possible brand name to replace Albanian Experience for the incoming tourism and conference business. This existing brand's credibility and utility has been overtaken by a substantial de-facto expansion of tourism destinations to include virtually all of the Balkan area, Greece to the south and parts of Italy to the north, as well as destinations in Central and Eastern Europe (CEE). Although the corporate scope and focus issue and the branding issue appear to be separate, they are of course related. A new brand name must be found which if possible reflects the overall business scope as well as the new tourist sources, destinations, and USPs.

Case Authors : Derek F. Abell

Topic : Innovation & Entrepreneurship

Related Areas : Emerging markets, Entrepreneurship, Financial analysis, Leadership, Leadership development, Organizational structure, Risk management, Succession planning

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Calculating Net Present Value (NPV) at 6% for Gazi (B): Bringing the sum of the parts together with the whole Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10012593)	-10012593	-	-
Year 1	3452176	-6560417	3452176	0.9434	3256770
Year 2	3960006	-2600411	7412182	0.89	3524391
Year 3	3970432	1370021	11382614	0.8396	3333651
Year 4	3229652	4599673	14612266	0.7921	2558187
TOTAL			14612266		12672999

The Net Present Value at 6% discount rate is 2660406

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. Internal Rate of Return
3. Payback Period
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. Magnitude of both incoming and outgoing cash flows – Projects can be capital intensive, time intensive, or both. Gazi's Tourism 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 Gazi's Tourism have higher preference for cash returns over 4-5 years rather than 10-15 years given the nature of the volatility in the industry.

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Formula and Steps to Calculate Net Present Value (NPV) of Gazi (B): Bringing the sum of the parts together with the whole

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 Gazi's Tourism 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 Gazi's Tourism 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	(10012593)	-10012593	-	-
Year 1	3452176	-6560417	3452176	0.8696	3001892
Year 2	3960006	-2600411	7412182	0.7561	2994333
Year 3	3970432	1370021	11382614	0.6575	2610623
Year 4	3229652	4599673	14612266	0.5718	1846564
TOTAL					10453413

The Net NPV after 4 years is 440820

(10453413 - 10012593 )

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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	(10012593)	-10012593	-	-
Year 1	3452176	-6560417	3452176	0.8333	2876813
Year 2	3960006	-2600411	7412182	0.6944	2750004
Year 3	3970432	1370021	11382614	0.5787	2297704
Year 4	3229652	4599673	14612266	0.4823	1557510
TOTAL					9482031

The Net NPV after 4 years is -530562

At 20% discount rate the NPV is negative (9482031 - 10012593 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Gazi's Tourism 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 Gazi's Tourism has a NPV value higher than Zero then finance managers at Gazi's Tourism 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 Gazi's Tourism, then the stock price of the Gazi's Tourism 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 Gazi's Tourism 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 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.

What are the key aspects of the projects that need to be monitored, refined, and retuned for continuous delivery of projected cash flows.

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 Gazi (B): Bringing the sum of the parts together with the whole

References & Further Readings

Derek F. Abell (2018), "Gazi (B): Bringing the sum of the parts together with the whole Harvard Business Review Case Study. Published by HBR Publications.