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. Borjomi: Rebuilding a Brand Icon in Russia case study is a Harvard Business School (HBR) case study written by Dominique Turpin, Mope Ogunsulire. The Borjomi: Rebuilding a Brand Icon in Russia (referred as “Ggmw Fleury” 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, .
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.
Borjomi is one of Russia's oldest, best-known and well-loved mineral waters. After going through a steep decline at the end of the Soviet era, the brand was bought by Georgian Glass & Mineral Water (GGMW) in 1995. Two years later, GGMW hired Frenchman Jacques Fleury-he turned the company around, and in 2001 had restored Borjomi to its former glory. In 2002, GGMW was bought by venture capital firm, Salford. Together with Fleury, Salford partner, Vladimir Ashurov, led a further transformation of the company turning it from a local, almost family-run company into a professional corporate enterprise, and growing annual sales from $25 to $125 million, and from 54 to 366 million liters. Their achievement did not go unnoticed. In 2005, GGMW received two offers from two multinationals to either sell the business, or create a partnership. But Fleury and Ashurov believe there is still significant room for growth. Indeed, that they can grow revenues further to $320 million (without acquisitions) in 3-4 years, of which $155 million will come from Russia alone. The rest would come from Ukraine and other markets. This case focuses on Russia where GGMW has a three-product portfolio. Fleury and his team are now asking themselves whether, to achieve that growth, GGMW should use all three, or rationalize its portfolio and focus on Borjomi Classic, its flagship product?
| Years | Cash Flow | Net Cash Flow | Cumulative Cash Flow |
Discount Rate @ 6 % |
Discounted Cash Flows |
|---|---|---|---|---|---|
| Year 0 | (10012942) | -10012942 | - | - | |
| Year 1 | 3448302 | -6564640 | 3448302 | 0.9434 | 3253115 |
| Year 2 | 3964286 | -2600354 | 7412588 | 0.89 | 3528200 |
| Year 3 | 3944590 | 1344236 | 11357178 | 0.8396 | 3311954 |
| Year 4 | 3226002 | 4570238 | 14583180 | 0.7921 | 2555296 |
| TOTAL | 14583180 | 12648565 |
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 -
Capital Budgeting Approaches
There are four types of capital budgeting techniques that are widely used in the corporate world –
1. Profitability Index
2. Net Present Value
3. Payback Period
4. Internal Rate of Return
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. Ggmw Fleury 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 Ggmw Fleury have higher preference for cash returns over 4-5 years rather than 10-15 years given the nature of the volatility in the industry.
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 Ggmw Fleury 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 Ggmw Fleury 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 | (10012942) | -10012942 | - | - | |
| Year 1 | 3448302 | -6564640 | 3448302 | 0.8696 | 2998523 |
| Year 2 | 3964286 | -2600354 | 7412588 | 0.7561 | 2997570 |
| Year 3 | 3944590 | 1344236 | 11357178 | 0.6575 | 2593632 |
| Year 4 | 3226002 | 4570238 | 14583180 | 0.5718 | 1844477 |
| TOTAL | 10434202 |
(10434202 - 10012942 )
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 | (10012942) | -10012942 | - | - | |
| Year 1 | 3448302 | -6564640 | 3448302 | 0.8333 | 2873585 |
| Year 2 | 3964286 | -2600354 | 7412588 | 0.6944 | 2752976 |
| Year 3 | 3944590 | 1344236 | 11357178 | 0.5787 | 2282749 |
| Year 4 | 3226002 | 4570238 | 14583180 | 0.4823 | 1555749 |
| TOTAL | 9465060 |
At 20% discount rate the NPV is negative (9465060 - 10012942 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Ggmw Fleury to discount cash flow at lower discount rates such as 15%.
Simplest Approach – If the investment project of Ggmw Fleury has a NPV value higher than Zero then finance managers at Ggmw Fleury 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 Ggmw Fleury, then the stock price of the Ggmw Fleury 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 Ggmw Fleury 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 will be a multi year spillover effect of various taxation regulations.
Understanding of risks involved in the project.
What can impact the cash flow of 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.
Dominique Turpin, Mope Ogunsulire (2018), "Borjomi: Rebuilding a Brand Icon in Russia Harvard Business Review Case Study. Published by HBR Publications.
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