Building Community at Terra Nova Consulting 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 Building Community at Terra Nova Consulting case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Building Community at Terra Nova Consulting case study is a Harvard Business School (HBR) case study written by Ken Ogata, Gary Spraakman. The Building Community at Terra Nova Consulting (referred as “Terra Nova” 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, Generational issues, Influence, Leadership transitions, Managing people, Organizational culture, Organizational structure, Work-life balance.

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 Building Community at Terra Nova Consulting Case Study

This case describes the challenges faced by the president of an engineering and environmental services consulting firm (Terra Nova Consulting) as it seeks to address deep internal cultural divisions. Terra Nova began as a small niche firm that has expanded through internal growth and mergers to become an elite, international professional services firm. It was founded upon certain values and principles, but has drifted away from these over time, such that younger members perceived a disconnect between its professed and actual culture. Survival as an elite firm will depend upon the ability to repair this divide and convince the next generation to continue the founders' vision or develop a new shared vision.

Case Authors : Ken Ogata, Gary Spraakman

Topic : Leadership & Managing People

Related Areas : Generational issues, Influence, Leadership transitions, Managing people, Organizational culture, Organizational structure, Work-life balance

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Calculating Net Present Value (NPV) at 6% for Building Community at Terra Nova Consulting Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10000165)	-10000165	-	-
Year 1	3460631	-6539534	3460631	0.9434	3264746
Year 2	3956104	-2583430	7416735	0.89	3520918
Year 3	3953154	1369724	11369889	0.8396	3319144
Year 4	3230530	4600254	14600419	0.7921	2558882
TOTAL			14600419		12663691

The Net Present Value at 6% discount rate is 2663526

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. Net Present Value
4. Profitability Index

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 Terra Nova 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. Terra Nova 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 Building Community at Terra Nova Consulting

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 Terra Nova 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 Terra Nova 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	(10000165)	-10000165	-	-
Year 1	3460631	-6539534	3460631	0.8696	3009244
Year 2	3956104	-2583430	7416735	0.7561	2991383
Year 3	3953154	1369724	11369889	0.6575	2599263
Year 4	3230530	4600254	14600419	0.5718	1847066
TOTAL					10446956

The Net NPV after 4 years is 446791

(10446956 - 10000165 )

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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	(10000165)	-10000165	-	-
Year 1	3460631	-6539534	3460631	0.8333	2883859
Year 2	3956104	-2583430	7416735	0.6944	2747294
Year 3	3953154	1369724	11369889	0.5787	2287705
Year 4	3230530	4600254	14600419	0.4823	1557933
TOTAL					9476792

The Net NPV after 4 years is -523373

At 20% discount rate the NPV is negative (9476792 - 10000165 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Terra Nova 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 Terra Nova has a NPV value higher than Zero then finance managers at Terra Nova 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 Terra Nova, then the stock price of the Terra Nova 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 Terra Nova 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.

Understanding of risks involved in the project.

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

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 Building Community at Terra Nova Consulting

References & Further Readings

Ken Ogata, Gary Spraakman (2018), "Building Community at Terra Nova Consulting Harvard Business Review Case Study. Published by HBR Publications.