Aaron's: Household Goods for the U.S. Base of the Pyramid 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 Aaron's: Household Goods for the U.S. Base of the Pyramid case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Aaron's: Household Goods for the U.S. Base of the Pyramid case study is a Harvard Business School (HBR) case study written by Michael Chu, Charles Smithgall. The Aaron's: Household Goods for the U.S. Base of the Pyramid (referred as “Aaron's Rent” 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, Ethics, Recession, Social enterprise, Social responsibility, Strategy execution.

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 Aaron's: Household Goods for the U.S. Base of the Pyramid Case Study

To maximize their effectiveness, color cases should be printed in color.With $2.5 billion system-wide revenues, Aaron's, a major rent-to-own supplier to the US base of the pyramid, continues to grow in the recession, but CEO R.C. Loudermilk, Jr. wonders how long the company can sustain the fast growth rate of its past. Founded in 1955, and publicly-listed since 1982, Aaron's success has paralleled the emergence of the rent-to-own industry as a major channel for the lower income US population to access durable household goods. In this space, Aaron has only one other large national rival, Rent-A-Center. As he faces Aaron's future growth, Loudermilk must consider continuing with the basic business model, follow his competitor into expanding the product line, or tap into underserved foreign markets. At the same time, the entire rent-to-own industry in the US is coming under attack by consumer advocates and politicians as the nation continues to battle a deep economic crisis.

Case Authors : Michael Chu, Charles Smithgall

Topic : Leadership & Managing People

Related Areas : Ethics, Recession, Social enterprise, Social responsibility, Strategy execution

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Calculating Net Present Value (NPV) at 6% for Aaron's: Household Goods for the U.S. Base of the Pyramid Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10004944)	-10004944	-	-
Year 1	3448872	-6556072	3448872	0.9434	3253653
Year 2	3971535	-2584537	7420407	0.89	3534652
Year 3	3942309	1357772	11362716	0.8396	3310039
Year 4	3239118	4596890	14601834	0.7921	2565685
TOTAL			14601834		12664028

The Net Present Value at 6% discount rate is 2659084

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. Profitability Index
2. Internal Rate of Return
3. Payback Period
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. Timing of the expected cash flows – stockholders of Aaron's Rent 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. Aaron's Rent 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 Aaron's: Household Goods for the U.S. Base of the Pyramid

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 Aaron's Rent 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 Aaron's Rent 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	(10004944)	-10004944	-	-
Year 1	3448872	-6556072	3448872	0.8696	2999019
Year 2	3971535	-2584537	7420407	0.7561	3003051
Year 3	3942309	1357772	11362716	0.6575	2592132
Year 4	3239118	4596890	14601834	0.5718	1851976
TOTAL					10446179

The Net NPV after 4 years is 441235

(10446179 - 10004944 )

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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	(10004944)	-10004944	-	-
Year 1	3448872	-6556072	3448872	0.8333	2874060
Year 2	3971535	-2584537	7420407	0.6944	2758010
Year 3	3942309	1357772	11362716	0.5787	2281429
Year 4	3239118	4596890	14601834	0.4823	1562075
TOTAL					9475574

The Net NPV after 4 years is -529370

At 20% discount rate the NPV is negative (9475574 - 10004944 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Aaron's Rent 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 Aaron's Rent has a NPV value higher than Zero then finance managers at Aaron's Rent 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 Aaron's Rent, then the stock price of the Aaron's Rent 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 Aaron's Rent 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.

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

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 Aaron's: Household Goods for the U.S. Base of the Pyramid

References & Further Readings

Michael Chu, Charles Smithgall (2018), "Aaron's: Household Goods for the U.S. Base of the Pyramid Harvard Business Review Case Study. Published by HBR Publications.