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. Sms For Life (A): A Public-Private Collaboration To Prevent Stock-Outs Of Life Saving Marlaria Drugs In Africa case study is a Harvard Business School (HBR) case study written by Donald A. Marchand, Anna Moncef. The Sms For Life (A): A Public-Private Collaboration To Prevent Stock-Outs Of Life Saving Marlaria Drugs In Africa (referred as “Sms Malaria” 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, Innovation, Supply chain.
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.
Malaria is a mosquito-borne infectious disease and a public health problem in over 100 countries worldwide. It causes about one million deaths each year; most of them are children under the age of five in Sub-Saharan Africa. The tragedy is that most of the deaths are preventable.Drugs to cure the disease exist, however they don't reach the demand where it occurs and stock-outs of drugs to treat malaria cost lives. Jim Barrington, former chief information officer (CIO) at Novartis and current director of the SMS for Life project, had been trying to solve the problem since 2006, when he first heard about the "last mile" problem from Silvio Gabriel, executive vice president (EVP), Novartis Malaria Initiatives. The case talks about how he approached the supply-chain problem and established a public-private partnership to develop a simple solution suitable for the rugged African environment. The essential idea was to create an in-county forecasting system based on the use of SMS messaging between the health posts that dispense the drugs and the district and regional warehouses that distribute the drug. A data management system with a reporting interface using charts provided stock level information from all facilities to facilitate stock movement and supply, as well as improving stock forecasting and planning. The case describes the process of developing and implementing the solution through a pilot in three districts in Tanzania. The pilot was successful and the case ends with the question how to approach a country-wide and even a pan-African roll-out. Learning objectives: There are three learning objectives, and ways to teach the case: 1) To discuss a new, collaborative way, involving private and public companies (and contrast it other available approaches), to solve world-wide problems, which demand solutions beyond the capabilities and responsibilities of single players. 2) How simple technology, e.g. based on available mobile phone networks, can solve supply chain problems in most difficult environments. 3) How external collaborations can bring innovation into well established multinational players, and have a potential impact on their business model.
| Years | Cash Flow | Net Cash Flow | Cumulative Cash Flow |
Discount Rate @ 6 % |
Discounted Cash Flows |
|---|---|---|---|---|---|
| Year 0 | (10004146) | -10004146 | - | - | |
| Year 1 | 3458347 | -6545799 | 3458347 | 0.9434 | 3262592 |
| Year 2 | 3976082 | -2569717 | 7434429 | 0.89 | 3538699 |
| Year 3 | 3951837 | 1382120 | 11386266 | 0.8396 | 3318039 |
| Year 4 | 3237641 | 4619761 | 14623907 | 0.7921 | 2564515 |
| TOTAL | 14623907 | 12683844 |
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 -
Capital Budgeting Approaches
There are four types of capital budgeting techniques that are widely used in the corporate world –
1. Profitability Index
2. Net Present Value
3. Internal Rate of Return
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. Magnitude of both incoming and outgoing cash flows – Projects can be capital intensive, time intensive, or both. Sms Malaria 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 Sms Malaria have higher preference for cash returns over 4-5 years rather than 10-15 years given the nature of the volatility in the industry.
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 Sms Malaria 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 Sms Malaria 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 | (10004146) | -10004146 | - | - | |
| Year 1 | 3458347 | -6545799 | 3458347 | 0.8696 | 3007258 |
| Year 2 | 3976082 | -2569717 | 7434429 | 0.7561 | 3006489 |
| Year 3 | 3951837 | 1382120 | 11386266 | 0.6575 | 2598397 |
| Year 4 | 3237641 | 4619761 | 14623907 | 0.5718 | 1851132 |
| TOTAL | 10463276 |
(10463276 - 10004146 )
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 | (10004146) | -10004146 | - | - | |
| Year 1 | 3458347 | -6545799 | 3458347 | 0.8333 | 2881956 |
| Year 2 | 3976082 | -2569717 | 7434429 | 0.6944 | 2761168 |
| Year 3 | 3951837 | 1382120 | 11386266 | 0.5787 | 2286943 |
| Year 4 | 3237641 | 4619761 | 14623907 | 0.4823 | 1561362 |
| TOTAL | 9491429 |
At 20% discount rate the NPV is negative (9491429 - 10004146 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Sms Malaria to discount cash flow at lower discount rates such as 15%.
Simplest Approach – If the investment project of Sms Malaria has a NPV value higher than Zero then finance managers at Sms Malaria 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 Sms Malaria, then the stock price of the Sms Malaria 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 Sms Malaria 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 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.
What will be a multi year spillover effect of various taxation regulations.
What can impact the cash flow of the project.
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.
Donald A. Marchand, Anna Moncef (2018), "Sms For Life (A): A Public-Private Collaboration To Prevent Stock-Outs Of Life Saving Marlaria Drugs In Africa Harvard Business Review Case Study. Published by HBR Publications.
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