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The Course Allocation Problem 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 The Course Allocation Problem case study


At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. The Course Allocation Problem case study is a Harvard Business School (HBR) case study written by Tarun Jain, Sarda Priyanka. The The Course Allocation Problem (referred as “Allocation Courses” from here on) case study provides evaluation & decision scenario in field of Leadership & Managing People. It also touches upon business topics such as - Value proposition, Economy.

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




Case Description of The Course Allocation Problem Case Study


Why is allocating courses to students in universities a challenging task? How difficult is it for institutions to strike a balance between the students' preferences over courses and what they can make available given the feasibility and other constraints? What are the plausible short-term and long-term effects of this demand-supply mismatch on students' university experiences and career aspirations? What are the relative pros and cons of allocation mechanisms such as course auctions, rank-order lists and random serial dictatorship used by academic administrators? Can universities design better systems that are simpler, fairer and cannot be gamed yet put students in courses they want? This case attempts to answer these questions by primarily examining the course allocation problem as a two-sided matching issue.


Case Authors : Tarun Jain, Sarda Priyanka

Topic : Leadership & Managing People

Related Areas : Economy




Calculating Net Present Value (NPV) at 6% for The Course Allocation Problem Case Study


Years              Cash Flow     Net Cash Flow     Cumulative    
Cash Flow
Discount Rate
@ 6 %
Discounted
Cash Flows
Year 0 (10026730) -10026730 - -
Year 1 3448749 -6577981 3448749 0.9434 3253537
Year 2 3957019 -2620962 7405768 0.89 3521733
Year 3 3961619 1340657 11367387 0.8396 3326252
Year 4 3234969 4575626 14602356 0.7921 2562398
TOTAL 14602356 12663920


The Net Present Value at 6% discount rate is 2637190

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.




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. Net Present Value
3. Profitability Index
4. Payback Period

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




Formula and Steps to Calculate Net Present Value (NPV) of The Course Allocation Problem

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 Leadership & Managing People 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 Allocation Courses 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 Allocation Courses 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 (10026730) -10026730 - -
Year 1 3448749 -6577981 3448749 0.8696 2998912
Year 2 3957019 -2620962 7405768 0.7561 2992075
Year 3 3961619 1340657 11367387 0.6575 2604829
Year 4 3234969 4575626 14602356 0.5718 1849604
TOTAL 10445420


The Net NPV after 4 years is 418690

(10445420 - 10026730 )






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 (10026730) -10026730 - -
Year 1 3448749 -6577981 3448749 0.8333 2873958
Year 2 3957019 -2620962 7405768 0.6944 2747930
Year 3 3961619 1340657 11367387 0.5787 2292604
Year 4 3234969 4575626 14602356 0.4823 1560074
TOTAL 9474565


The Net NPV after 4 years is -552165

At 20% discount rate the NPV is negative (9474565 - 10026730 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Allocation Courses 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 Allocation Courses has a NPV value higher than Zero then finance managers at Allocation Courses 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 Allocation Courses, then the stock price of the Allocation Courses 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 Allocation Courses 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 –

Understanding of risks involved in 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 will be a multi year spillover effect of various taxation regulations.

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.

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.




References & Further Readings

Tarun Jain, Sarda Priyanka (2018), "The Course Allocation Problem Harvard Business Review Case Study. Published by HBR Publications.