Business of Life 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 Business of Life case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Business of Life case study is a Harvard Business School (HBR) case study written by Cate Reavis, Debora L. Spar. The Business of Life (referred as “Rhetoric Eggs” 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, Government, Social responsibility, 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 Business of Life Case Study

Every day, around the world, babies and children are being sold. Frequently, these transactions appear to be above or beyond the market. Orphaned children are never "sold"--they are only "matched" with their "forever families." Eggs are "donated," and surrogate mothers offer their services to help the infertile. Certainly, the rhetoric that surrounds these transactions has little to do with markets or profits. Quite possibly, the people who undertake them want only to help. But neither the rhetoric nor the motive can change the underlying activity. When parents buy eggs or sperm, contract with surrogates, or choose a child to adopt or an embryo to implant, they are doing business. Examines the workings of the baby trade, exploring a realm where technology currently runs far faster than rules.

Case Authors : Cate Reavis, Debora L. Spar

Topic : Leadership & Managing People

Related Areas : Generational issues, Government, Social responsibility, Work-life balance

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Calculating Net Present Value (NPV) at 6% for Business of Life Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10017510)	-10017510	-	-
Year 1	3452108	-6565402	3452108	0.9434	3256706
Year 2	3967123	-2598279	7419231	0.89	3530725
Year 3	3941787	1343508	11361018	0.8396	3309600
Year 4	3236585	4580093	14597603	0.7921	2563678
TOTAL			14597603		12660710

The Net Present Value at 6% discount rate is 2643200

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. Profitability Index
3. Net Present Value
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. Timing of the expected cash flows – stockholders of Rhetoric Eggs 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. Rhetoric Eggs 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 Business of Life

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 Rhetoric Eggs 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 Rhetoric Eggs 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	(10017510)	-10017510	-	-
Year 1	3452108	-6565402	3452108	0.8696	3001833
Year 2	3967123	-2598279	7419231	0.7561	2999715
Year 3	3941787	1343508	11361018	0.6575	2591789
Year 4	3236585	4580093	14597603	0.5718	1850528
TOTAL					10443865

The Net NPV after 4 years is 426355

(10443865 - 10017510 )

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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	(10017510)	-10017510	-	-
Year 1	3452108	-6565402	3452108	0.8333	2876757
Year 2	3967123	-2598279	7419231	0.6944	2754947
Year 3	3941787	1343508	11361018	0.5787	2281127
Year 4	3236585	4580093	14597603	0.4823	1560853
TOTAL					9473683

The Net NPV after 4 years is -543827

At 20% discount rate the NPV is negative (9473683 - 10017510 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Rhetoric Eggs 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 Rhetoric Eggs has a NPV value higher than Zero then finance managers at Rhetoric Eggs 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 Rhetoric Eggs, then the stock price of the Rhetoric Eggs 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 Rhetoric Eggs 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 will be a multi year spillover effect of various taxation regulations.

What are the key aspects of the projects that need to be monitored, refined, and retuned for continuous delivery of projected cash flows.

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.

Understanding of risks involved in 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 Business of Life

References & Further Readings

Cate Reavis, Debora L. Spar (2018), "Business of Life Harvard Business Review Case Study. Published by HBR Publications.