Larsen and Toubro: Spare Parts Forecasting 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 Larsen and Toubro: Spare Parts Forecasting case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Larsen and Toubro: Spare Parts Forecasting case study is a Harvard Business School (HBR) case study written by Suhruta Kulkarni, Prakash Hegde, Ruchi Jaiswal, Dinesh Kumar Unnikrishnan. The Larsen and Toubro: Spare Parts Forecasting (referred as “Spare Forecasting” 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, Operations management.

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 Larsen and Toubro: Spare Parts Forecasting Case Study

Larsen and Toubro (L&T) was India's largest technology, engineering, construction and manufacturing company. Construction and Mining Business (CMB) sold equipment such as Dozer Shovels, Dozers, Dumpers, Hydraulic Excavators, Motor Graders, Pipe Layers, Surface Miners, Tipper Trucks, Wheel Dozers and Wheel Loaders. CMB also provided the services of equipment installation and commissioning and other maintenance services. Supply of spare parts was critical, since the customer faced severe losses in case of equipment unavailability. Forecasting was done on an ad hoc basis based on the experience of the planning personnel. The value of each spare part ranged from INR 10 to INR 8 Million. It was critical to maintain a correct balance for the spare-parts inventories, since unavailability led to loss of revenues, decreased profitability, customer dissatisfaction and also gave rise to the fake products industry. Excess inventory led to high inventory carrying costs, working capital lock-in and also a possibility of spare parts becoming obsolete. Vijaya Kumar, Deputy General Manager of CMB, had to arrive at a forecasting methodology with an error of less than 10% for the 20,000 odd spare-parts. This warranted for 20,000 forecasting models, however this was not only very time consuming but also very expensive to develop and manage. Kumar wanted to build the forecasting model quickly so that he could roll out the forecasting strategy on a pan-India basis within a few weeks.

Case Authors : Suhruta Kulkarni, Prakash Hegde, Ruchi Jaiswal, Dinesh Kumar Unnikrishnan

Topic : Leadership & Managing People

Related Areas : Operations management

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Calculating Net Present Value (NPV) at 6% for Larsen and Toubro: Spare Parts Forecasting Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10010239)	-10010239	-	-
Year 1	3456243	-6553996	3456243	0.9434	3260607
Year 2	3971295	-2582701	7427538	0.89	3534438
Year 3	3955569	1372868	11383107	0.8396	3321172
Year 4	3242496	4615364	14625603	0.7921	2568361
TOTAL			14625603		12684578

The Net Present Value at 6% discount rate is 2674339

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. 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. Magnitude of both incoming and outgoing cash flows – Projects can be capital intensive, time intensive, or both. Spare Forecasting 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 Spare Forecasting 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 Larsen and Toubro: Spare Parts Forecasting

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 Spare Forecasting 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 Spare Forecasting 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	(10010239)	-10010239	-	-
Year 1	3456243	-6553996	3456243	0.8696	3005429
Year 2	3971295	-2582701	7427538	0.7561	3002870
Year 3	3955569	1372868	11383107	0.6575	2600851
Year 4	3242496	4615364	14625603	0.5718	1853908
TOTAL					10463057

The Net NPV after 4 years is 452818

(10463057 - 10010239 )

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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	(10010239)	-10010239	-	-
Year 1	3456243	-6553996	3456243	0.8333	2880203
Year 2	3971295	-2582701	7427538	0.6944	2757844
Year 3	3955569	1372868	11383107	0.5787	2289102
Year 4	3242496	4615364	14625603	0.4823	1563704
TOTAL					9490852

The Net NPV after 4 years is -519387

At 20% discount rate the NPV is negative (9490852 - 10010239 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Spare Forecasting 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 Spare Forecasting has a NPV value higher than Zero then finance managers at Spare Forecasting 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 Spare Forecasting, then the stock price of the Spare Forecasting 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 Spare Forecasting 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.

Understanding of risks involved in the project.

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

What can impact the cash flow of 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 Larsen and Toubro: Spare Parts Forecasting

References & Further Readings

Suhruta Kulkarni, Prakash Hegde, Ruchi Jaiswal, Dinesh Kumar Unnikrishnan (2018), "Larsen and Toubro: Spare Parts Forecasting Harvard Business Review Case Study. Published by HBR Publications.