THE MERCKS OF DARMSTADT: WHAT FAMILY CAN DO (A) 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 THE MERCKS OF DARMSTADT: WHAT FAMILY CAN DO (A) case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. THE MERCKS OF DARMSTADT: WHAT FAMILY CAN DO (A) case study is a Harvard Business School (HBR) case study written by Benoit Leleux, Anne Catrin Glemser. The THE MERCKS OF DARMSTADT: WHAT FAMILY CAN DO (A) (referred as “Family Merck” 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, Growth strategy, Mergers & acquisitions, Work-life balance.

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 THE MERCKS OF DARMSTADT: WHAT FAMILY CAN DO (A) Case Study

DARMSTADT, SEPTEMBER 2006. The Serono deal was long in the making; it had eluded the Merck Group, a 338-year-old German global pharmaceutical and chemical enterprise, for months. So much so that last March, the Merck Group and its family owners had hopped onto the Schering AG acquisition train to ensure the growth it needed to remain competitive in the cutthroat pharmaceutical business. When the a??14.6 billion hostile offer they made for Schering was rejected in favor of a friendly offer from Bayer, it was difficult not to feel despondent.For months, Jon Baumhauer, the Chairman of the Family Board and influential member of the Executive Board of E. Merck OHG, had sustained the commitment of the family owners to a transformational merger that would define the future of Merck. Maintaining such secrecy among the 120-plus family partners representing the 10th to the 12th generations of Merck family owners was no small feat, but the absence of a deal was starting to create tensions on all levels. The offer from Ernesto Bertarelli, the largest shareholder of Serono, a Swiss-listed, family-controlled biotechnology firm, was hardly a surprise. Ernesto, through the company's investment bankers, had peddled the firm for months to all major pharma companies in the world, but had found few takers. The surprise was the newfound willingness of Serono to consider a negotiated deal. Merck's Executive Board, the family and Merck's advisers had kept an eye on Serono throughout the year. The company was attractive for its family culture, strong R&D capabilities, significant US presence, a rich product pipeline and of course world-class biotechnology manufac-turing competencies. Its size would give Merck much needed critical mass, but the deal was not cheap. It required extensive leverage and new equity injections from the family, its risk profile was higher than Merck's and cultural differences ran deep. Now the deal was within reach. Was this the transformational opportunity the Merck family sought? It was time to put the "courage and pioneering spirit" of the family firm to the ultimate test. Learning objectives: Managing a family business for sustainability; sophisticated family and business governance structures; managing growth; technology innovation; maintaining the entrepreneurial spirit; multi-generation family business; critical size and growth issues in the pharma business; managing incentive systems for executives.

Case Authors : Benoit Leleux, Anne Catrin Glemser

Topic : Leadership & Managing People

Related Areas : Growth strategy, Mergers & acquisitions, Work-life balance

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Calculating Net Present Value (NPV) at 6% for THE MERCKS OF DARMSTADT: WHAT FAMILY CAN DO (A) Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10016227)	-10016227	-	-
Year 1	3450997	-6565230	3450997	0.9434	3255658
Year 2	3977349	-2587881	7428346	0.89	3539826
Year 3	3957980	1370099	11386326	0.8396	3323196
Year 4	3231627	4601726	14617953	0.7921	2559751
TOTAL			14617953		12678432

The Net Present Value at 6% discount rate is 2662205

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. Internal Rate of Return
2. Profitability Index
3. Net Present Value
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. Family Merck 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 Family Merck 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 THE MERCKS OF DARMSTADT: WHAT FAMILY CAN DO (A)

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 Family Merck 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 Family Merck 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	(10016227)	-10016227	-	-
Year 1	3450997	-6565230	3450997	0.8696	3000867
Year 2	3977349	-2587881	7428346	0.7561	3007447
Year 3	3957980	1370099	11386326	0.6575	2602436
Year 4	3231627	4601726	14617953	0.5718	1847693
TOTAL					10458444

The Net NPV after 4 years is 442217

(10458444 - 10016227 )

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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	(10016227)	-10016227	-	-
Year 1	3450997	-6565230	3450997	0.8333	2875831
Year 2	3977349	-2587881	7428346	0.6944	2762048
Year 3	3957980	1370099	11386326	0.5787	2290498
Year 4	3231627	4601726	14617953	0.4823	1558462
TOTAL					9486839

The Net NPV after 4 years is -529388

At 20% discount rate the NPV is negative (9486839 - 10016227 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Family Merck 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 Family Merck has a NPV value higher than Zero then finance managers at Family Merck 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 Family Merck, then the stock price of the Family Merck 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 Family Merck 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.

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.

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 THE MERCKS OF DARMSTADT: WHAT FAMILY CAN DO (A)

References & Further Readings

Benoit Leleux, Anne Catrin Glemser (2018), "THE MERCKS OF DARMSTADT: WHAT FAMILY CAN DO (A) Harvard Business Review Case Study. Published by HBR Publications.