Introduction to Net Present Value (NPV) - What is Net Present Value (NPV) ? How it impacts financial decisions regarding project management?

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Crowdfunding: A Tale of Two Campaigns case study is a Harvard Business School (HBR) case study written by Andrew Zacharakis, Gabriel Quintana, Tommy Ripke. The Crowdfunding: A Tale of Two Campaigns (referred as “Kickstarter Hanson” from here on) case study provides evaluation & decision scenario in field of Innovation & Entrepreneurship. It also touches upon business topics such as - Value proposition, Marketing, Venture capital.

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.

Crowdfunding is considered an alternative to traditional angel and venture capital funding that has helped get many business ventures off the ground. The basic idea of crowdfunding centers on pitching a business idea to a large group of people and seeking financial support. Although crowdfunding has existed for hundreds of years, it has recently gone to online platforms. The most successful platforms to date have been Kickstarter and Indiegogo, which have helped many ventures raise initial funding. This case is concerned with two different startups, one started by a twin sister duo (Marla and Annie) and the other by a Babson College student (Hanson). Enerchi Bites is a startup featuring a new food product that was developed out of a passion for fitness and yoga. Identical twin sisters (Marla and Annie Feldman) started experimenting with different combinations of foods with a chia-seed base. Once they had developed three different flavors, they began distributing their products at various yoga conventions. They quickly built some buzz about their new products and were faced with the problem of scaling their new venture. They decided to try a Kickstarter campaign where they would attempt to raise $10,000. They figured this was the amount they needed to help scale up their operations. After the completion of the Kickstarter campaign, the sisters found the final results disappointing as they netted only about $5,000 after expenses from advertising and the rewards that were due to the campaign backers. Think Board is the creation of a Babson student, Hanson Grant. This business venture was born out of one of Hanson's earlier ideas. He had created white board t-shirts. He found that the t-shirt idea was not going to work and was thinking through how to use this to his advantage until his friends connected the dots for him. If he put pieces of the material together, he ended up with an oversized dry-erase board that could be printed to feature any pattern. With the interest from his friends, Hanson thought that he could use Kickstarter to gauge the market and the opportunity. He planned to raise $10,000, but his intent was more focused on marketing his new product. He successfully raised the money and more important than that, his focused marketing paid off as he was contacted by a news station to give an interview. The publicity made the campaign worthwhile for Hanson.

Years | Cash Flow | Net Cash Flow | Cumulative Cash Flow |
Discount Rate @ 6 % |
Discounted Cash Flows |
---|---|---|---|---|---|

Year 0 | (10023981) | -10023981 | - | - | |

Year 1 | 3455538 | -6568443 | 3455538 | 0.9434 | 3259942 |

Year 2 | 3957148 | -2611295 | 7412686 | 0.89 | 3521848 |

Year 3 | 3945603 | 1334308 | 11358289 | 0.8396 | 3312804 |

Year 4 | 3234737 | 4569045 | 14593026 | 0.7921 | 2562215 |

TOTAL | 14593026 | 12656808 |

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 -

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

There are four types of capital budgeting techniques that are widely used in the corporate world –

1. Payback Period

2. Internal Rate of Return

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 Kickstarter Hanson 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. Kickstarter Hanson shareholders have preference for diversified projects investment rather than prospective high income from a single capital intensive project.

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

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 Kickstarter Hanson 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 Kickstarter Hanson 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.

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 | (10023981) | -10023981 | - | - | |

Year 1 | 3455538 | -6568443 | 3455538 | 0.8696 | 3004816 |

Year 2 | 3957148 | -2611295 | 7412686 | 0.7561 | 2992172 |

Year 3 | 3945603 | 1334308 | 11358289 | 0.6575 | 2594298 |

Year 4 | 3234737 | 4569045 | 14593026 | 0.5718 | 1849471 |

TOTAL | 10440757 |

(10440757 - 10023981 )

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 | (10023981) | -10023981 | - | - | |

Year 1 | 3455538 | -6568443 | 3455538 | 0.8333 | 2879615 |

Year 2 | 3957148 | -2611295 | 7412686 | 0.6944 | 2748019 |

Year 3 | 3945603 | 1334308 | 11358289 | 0.5787 | 2283335 |

Year 4 | 3234737 | 4569045 | 14593026 | 0.4823 | 1559962 |

TOTAL | 9470931 |

At 20% discount rate the NPV is negative (9470931 - 10023981 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Kickstarter Hanson to discount cash flow at lower discount rates such as 15%.

Simplest Approach – If the investment project of Kickstarter Hanson has a NPV value higher than Zero then finance managers at Kickstarter Hanson 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 Kickstarter Hanson, then the stock price of the Kickstarter Hanson 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.

Project selection is often a far more complex decision than just choosing it based on the NPV number. Finance managers at Kickstarter Hanson 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.

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.

** Andrew Zacharakis, Gabriel Quintana, Tommy Ripke (2018)**, "Crowdfunding: A Tale of Two Campaigns Harvard Business Review Case Study. Published by HBR Publications.

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