GEARBOX (China) Ltd.: Will the Company's ERP System Support Its Ambitious Growth Strategy? 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 GEARBOX (China) Ltd.: Will the Company's ERP System Support Its Ambitious Growth Strategy? case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. GEARBOX (China) Ltd.: Will the Company's ERP System Support Its Ambitious Growth Strategy? case study is a Harvard Business School (HBR) case study written by Kai Reimers. The GEARBOX (China) Ltd.: Will the Company's ERP System Support Its Ambitious Growth Strategy? (referred as “Erp Tianjin” 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, Manufacturing.

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

Case Description of GEARBOX (China) Ltd.: Will the Company's ERP System Support Its Ambitious Growth Strategy? Case Study

This case describes the experience of a wholly foreign-owned manufacturing company in Tianjin/China regarding the use of its ERP system in its main functional departments, purchasing, production planning, sales/distribution, and finance. The company is part of a group which is a global leader in the manufacturing and distribution of mechanical devices, called gearboxes, that are needed to drive a wide range of facilities such as escalators and baggage conveyor belts in airports. It has entered China in 1995 and the Tianjin manufacturing facility has soon become a hub for the Asian market. The main challenge confronting the management team is to support the breakneck growth rate of this young company. The company's ERP system plays a crucial role in this task. However, it seems that middle managers are frequently hitting an invisible wall when trying to expand the use of the ERP system in order to cope with ever-increasing workloads and coordination tasks. This case serves to illustrate cultural issues implicated in the use of an enterprise wide information system in a medium size company operating in an emerging market economy. In addition, issues of operations management, global management, and organizational behaviour are addressed.

Case Authors : Kai Reimers

Topic : Leadership & Managing People

Related Areas : Manufacturing

Calculating Net Present Value (NPV) at 6% for GEARBOX (China) Ltd.: Will the Company's ERP System Support Its Ambitious Growth Strategy? Case Study

Years              Cash Flow     Net Cash Flow     Cumulative    
Cash Flow
Discount Rate
@ 6 %
Cash Flows
Year 0 (10006800) -10006800 - -
Year 1 3456314 -6550486 3456314 0.9434 3260674
Year 2 3976088 -2574398 7432402 0.89 3538704
Year 3 3940024 1365626 11372426 0.8396 3308120
Year 4 3243247 4608873 14615673 0.7921 2568955
TOTAL 14615673 12676453

The Net Present Value at 6% discount rate is 2669653

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.

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. Internal Rate of Return
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 Erp Tianjin 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. Erp Tianjin shareholders have preference for diversified projects investment rather than prospective high income from a single capital intensive project.

Formula and Steps to Calculate Net Present Value (NPV) of GEARBOX (China) Ltd.: Will the Company's ERP System Support Its Ambitious Growth Strategy?

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 Erp Tianjin 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 Erp Tianjin 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 %
Cash Flows
Year 0 (10006800) -10006800 - -
Year 1 3456314 -6550486 3456314 0.8696 3005490
Year 2 3976088 -2574398 7432402 0.7561 3006494
Year 3 3940024 1365626 11372426 0.6575 2590630
Year 4 3243247 4608873 14615673 0.5718 1854337
TOTAL 10456951

The Net NPV after 4 years is 450151

(10456951 - 10006800 )

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 %
Cash Flows
Year 0 (10006800) -10006800 - -
Year 1 3456314 -6550486 3456314 0.8333 2880262
Year 2 3976088 -2574398 7432402 0.6944 2761172
Year 3 3940024 1365626 11372426 0.5787 2280106
Year 4 3243247 4608873 14615673 0.4823 1564066
TOTAL 9485606

The Net NPV after 4 years is -521194

At 20% discount rate the NPV is negative (9485606 - 10006800 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Erp Tianjin 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 Erp Tianjin has a NPV value higher than Zero then finance managers at Erp Tianjin 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 Erp Tianjin, then the stock price of the Erp Tianjin 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 Erp Tianjin 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 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.

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.

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.

References & Further Readings

Kai Reimers (2018), "GEARBOX (China) Ltd.: Will the Company's ERP System Support Its Ambitious Growth Strategy? Harvard Business Review Case Study. Published by HBR Publications.