Socially Responsible Pricing: Lessons from the Pricing of AIDS Drugs in Developing Countries 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 Socially Responsible Pricing: Lessons from the Pricing of AIDS Drugs in Developing Countries case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Socially Responsible Pricing: Lessons from the Pricing of AIDS Drugs in Developing Countries case study is a Harvard Business School (HBR) case study written by Sushil Vachani, N. Craig Smith. The Socially Responsible Pricing: Lessons from the Pricing of AIDS Drugs in Developing Countries (referred as “Pricing Socially” 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, Health, Pricing, Social responsibility.

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 Socially Responsible Pricing: Lessons from the Pricing of AIDS Drugs in Developing Countries Case Study

Corporate social responsibility has major implications for pricing decisions in some markets. An extreme case is the pricing of life-saving drugs in developing countries; industry critics have pointed to price as an obstacle to treatment and a factor in the deaths of millions of AIDS victims. Examines socially responsible pricing in the form of differential pricing across markets, taking into account ability to pay and social welfare. An analysis of AIDS drug pricing between 1999 and 2003 suggests that, in fact, the high prices of AIDS drugs in developing countries suboptimized contribution earnings in those markets. In the 1990s, multinationals could have earned greater contribution in developing countries by reducing prices, while also saving thousands of lives. However, that could have jeopardized earnings in developed countries, and this, together with other factors, created barriers to socially responsible pricing. Neither multinationals nor developing country governments can alone create conditions for socially responsible pricing to prevail. Identifies the role of different players in addressing barriers to socially responsible pricing, including multinationals, governments, nongovernmental organizations, and multilateral institutions such as the World Trade Organization and the World Health Organization. Also offers lessons for managers in industries with characteristics similar to the drug industry, where socially responsible pricing also may be needed, if not demanded.

Case Authors : Sushil Vachani, N. Craig Smith

Topic : Leadership & Managing People

Related Areas : Health, Pricing, Social responsibility

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Calculating Net Present Value (NPV) at 6% for Socially Responsible Pricing: Lessons from the Pricing of AIDS Drugs in Developing Countries Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10015640)	-10015640	-	-
Year 1	3449060	-6566580	3449060	0.9434	3253830
Year 2	3955766	-2610814	7404826	0.89	3520618
Year 3	3971497	1360683	11376323	0.8396	3334545
Year 4	3234595	4595278	14610918	0.7921	2562102
TOTAL			14610918		12671096

The Net Present Value at 6% discount rate is 2655456

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. 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. Pricing Socially 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 Pricing Socially have higher preference for cash returns over 4-5 years rather than 10-15 years given the nature of the volatility in the industry.

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Formula and Steps to Calculate Net Present Value (NPV) of Socially Responsible Pricing: Lessons from the Pricing of AIDS Drugs in Developing Countries

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 Pricing Socially 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 Pricing Socially 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	(10015640)	-10015640	-	-
Year 1	3449060	-6566580	3449060	0.8696	2999183
Year 2	3955766	-2610814	7404826	0.7561	2991127
Year 3	3971497	1360683	11376323	0.6575	2611324
Year 4	3234595	4595278	14610918	0.5718	1849390
TOTAL					10451024

The Net NPV after 4 years is 435384

(10451024 - 10015640 )

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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	(10015640)	-10015640	-	-
Year 1	3449060	-6566580	3449060	0.8333	2874217
Year 2	3955766	-2610814	7404826	0.6944	2747060
Year 3	3971497	1360683	11376323	0.5787	2298320
Year 4	3234595	4595278	14610918	0.4823	1559893
TOTAL					9479490

The Net NPV after 4 years is -536150

At 20% discount rate the NPV is negative (9479490 - 10015640 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Pricing Socially 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 Pricing Socially has a NPV value higher than Zero then finance managers at Pricing Socially 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 Pricing Socially, then the stock price of the Pricing Socially 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 Pricing Socially 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 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.

What can impact the cash flow of the project.

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 Socially Responsible Pricing: Lessons from the Pricing of AIDS Drugs in Developing Countries

References & Further Readings

Sushil Vachani, N. Craig Smith (2018), "Socially Responsible Pricing: Lessons from the Pricing of AIDS Drugs in Developing Countries Harvard Business Review Case Study. Published by HBR Publications.