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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. Axel Springer in 2014: Strategic Leadership of the Digital Transformation case study is a Harvard Business School (HBR) case study written by Robert Burgelman, Robert Siegel, Jason Luther. The Axel Springer in 2014: Strategic Leadership of the Digital Transformation (referred as “Axel Springer” 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.

In 2013, Mathias Dopfner, CEO of the publishing house Axel Springer SE, a premier source of content in Germany, with its popular newspapers and magazines such as Bild and Die Welt, was evaluating the progress of his company's digital transformation. The advent of the digital revolution at the end of the twentieth century had caused an appreciable shift in the publishing industry. Traditional print media players were confronted with major technological advancements and changes in consumer tastes and how news was consumed. Thus, the challenge for Axel Springer was in finding fresh ways to disDopfner had directed Axel Springer to approach this task with a two-stage digital transformation strategy process. Beginning in 2006, the company focused on organic growth and late-stage digital acquisitions. This stage of the strategy process had centered around profitability and the infusion of digitization into the corporate culture. In 2013, the second stage of the strategy process was driven by Dopfner's formulation of the firm's corporate mission to become "The Leading Digital Publisher" and his defining the company's business as its branded content and not its distribution channels. With this new strategy, Axel Springer intended to espouse early-stage investments and entrepreneurship and grow revenue through three business models: paid content, marketing, and classified advertising. As of 2013, Dopfner's two-stage digital transformation strategy had been a stunning success. Axel Springer had more than 12,800 employees, total revenues of $3.9 billion, and EBITDA of $625 million. The company had exceeded the goals it had set for digital media contributions to revenue and EBITDA, achieved reach in 44 countries, and serviced 98 million unique digital visitors worldwide. Looking forward in April 2014, however, it was clear that the future still held many challenges. Dopfner knew that Axel Springer would need to continue to successfully balance digital and traditional media business strategies, further reestablish the firm's identity, and continue to pioneer the cultural transition within the organization. Most importantly, he realized the urgency of preparing his organization for the looming battle between digitally transforming old media content providers (like Axel Springer) and new giant digital technology experts (like Google) transforming themselves into media companies. He also pondered whether it would be possible, and if so how, to mobilize a sufficiently powerful coalition to help the digitally transforming old media content providers in that battle.

Years | Cash Flow | Net Cash Flow | Cumulative Cash Flow |
Discount Rate @ 6 % |
Discounted Cash Flows |
---|---|---|---|---|---|

Year 0 | (10027443) | -10027443 | - | - | |

Year 1 | 3464313 | -6563130 | 3464313 | 0.9434 | 3268220 |

Year 2 | 3971897 | -2591233 | 7436210 | 0.89 | 3534974 |

Year 3 | 3941174 | 1349941 | 11377384 | 0.8396 | 3309086 |

Year 4 | 3251353 | 4601294 | 14628737 | 0.7921 | 2575376 |

TOTAL | 14628737 | 12687656 |

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 -

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.

Capital Budgeting Approaches

There are four types of capital budgeting techniques that are widely used in the corporate world –

1. Net Present Value

2. Internal Rate of Return

3. Profitability Index

4. Payback Period

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 Axel Springer 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. Axel Springer shareholders have preference for diversified projects investment rather than prospective high income from a single capital intensive project.

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 Axel Springer 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 Axel Springer 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 | (10027443) | -10027443 | - | - | |

Year 1 | 3464313 | -6563130 | 3464313 | 0.8696 | 3012446 |

Year 2 | 3971897 | -2591233 | 7436210 | 0.7561 | 3003325 |

Year 3 | 3941174 | 1349941 | 11377384 | 0.6575 | 2591386 |

Year 4 | 3251353 | 4601294 | 14628737 | 0.5718 | 1858972 |

TOTAL | 10466128 |

(10466128 - 10027443 )

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 | (10027443) | -10027443 | - | - | |

Year 1 | 3464313 | -6563130 | 3464313 | 0.8333 | 2886928 |

Year 2 | 3971897 | -2591233 | 7436210 | 0.6944 | 2758262 |

Year 3 | 3941174 | 1349941 | 11377384 | 0.5787 | 2280772 |

Year 4 | 3251353 | 4601294 | 14628737 | 0.4823 | 1567975 |

TOTAL | 9493936 |

At 20% discount rate the NPV is negative (9493936 - 10027443 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Axel Springer to discount cash flow at lower discount rates such as 15%.

Simplest Approach – If the investment project of Axel Springer has a NPV value higher than Zero then finance managers at Axel Springer 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 Axel Springer, then the stock price of the Axel Springer 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 Axel Springer 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 –

Understanding of risks involved in the project.

What can impact the cash flow of the project.

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.

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.

** Robert Burgelman, Robert Siegel, Jason Luther (2018)**, "Axel Springer in 2014: Strategic Leadership of the Digital Transformation Harvard Business Review Case Study. Published by HBR Publications.

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