Lake Pleasant Bodies Case (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 Lake Pleasant Bodies Case (A) case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Lake Pleasant Bodies Case (A) case study is a Harvard Business School (HBR) case study written by Joseph L. Badaracco Jr., Ellen West. The Lake Pleasant Bodies Case (A) (referred as “Obligations Attorney” 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, Decision making, Ethics, Psychology.

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 Lake Pleasant Bodies Case (A) Case Study

Presents a classic dilemma in legal ethics--the conflict between an attorney's obligations as an attorney, in this case to protect a client's confidentiality, and his or her own moral obligations as a person. An attorney must decide how to respond to the father of a missing young woman who has asked for information about her whereabouts. The attorney knows from conversations with his client that the young woman is dead and where her body is. Shows students what role-related obligations are, why they have strong moral claims, and the difficult dilemmas role obligations can create.

Case Authors : Joseph L. Badaracco Jr., Ellen West

Topic : Leadership & Managing People

Related Areas : Decision making, Ethics, Psychology

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Calculating Net Present Value (NPV) at 6% for Lake Pleasant Bodies Case (A) Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10026227)	-10026227	-	-
Year 1	3465776	-6560451	3465776	0.9434	3269600
Year 2	3965687	-2594764	7431463	0.89	3529447
Year 3	3964907	1370143	11396370	0.8396	3329012
Year 4	3225425	4595568	14621795	0.7921	2554839
TOTAL			14621795		12682898

The Net Present Value at 6% discount rate is 2656671

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. Payback Period
2. Profitability Index
3. Net Present Value
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. Timing of the expected cash flows – stockholders of Obligations Attorney 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. Obligations Attorney shareholders have preference for diversified projects investment rather than prospective high income from a single capital intensive project.

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Formula and Steps to Calculate Net Present Value (NPV) of Lake Pleasant Bodies Case (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 Obligations Attorney 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 Obligations Attorney 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	(10026227)	-10026227	-	-
Year 1	3465776	-6560451	3465776	0.8696	3013718
Year 2	3965687	-2594764	7431463	0.7561	2998629
Year 3	3964907	1370143	11396370	0.6575	2606991
Year 4	3225425	4595568	14621795	0.5718	1844147
TOTAL					10463485

The Net NPV after 4 years is 437258

(10463485 - 10026227 )

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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	(10026227)	-10026227	-	-
Year 1	3465776	-6560451	3465776	0.8333	2888147
Year 2	3965687	-2594764	7431463	0.6944	2753949
Year 3	3964907	1370143	11396370	0.5787	2294506
Year 4	3225425	4595568	14621795	0.4823	1555471
TOTAL					9492073

The Net NPV after 4 years is -534154

At 20% discount rate the NPV is negative (9492073 - 10026227 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Obligations Attorney 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 Obligations Attorney has a NPV value higher than Zero then finance managers at Obligations Attorney 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 Obligations Attorney, then the stock price of the Obligations Attorney 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 Obligations Attorney 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 can impact the cash flow of the project.

What will be a multi year spillover effect of various taxation regulations.

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 Lake Pleasant Bodies Case (A)

References & Further Readings

Joseph L. Badaracco Jr., Ellen West (2018), "Lake Pleasant Bodies Case (A) Harvard Business Review Case Study. Published by HBR Publications.