Redefining Value Creation in Value Chains: The Social Side of Sustainability 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 Redefining Value Creation in Value Chains: The Social Side of Sustainability case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Redefining Value Creation in Value Chains: The Social Side of Sustainability case study is a Harvard Business School (HBR) case study written by Francisco Szekely, Zahir Dossa. The Redefining Value Creation in Value Chains: The Social Side of Sustainability (referred as “Argan Oil” 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, Supply chain, Sustainability.

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 Redefining Value Creation in Value Chains: The Social Side of Sustainability Case Study

Although most cases on the sustainability of supply chains focus on environmental impacts, this case assesses the role of producers and the social impact of value chains by focusing on the argan oil sector. As scientific processes proved the significant health and beauty benefits of argan oil in the 1990s, demand stirred in European and North American Markets. Dr. Zoubida Charrouf founded the first argan oil cooperative in 1996 to provide jobs to the under-privileged female producers in rural Moroccan areas. While cooperatives paid three-times more than their private competitors, women still earned a fractional share of the final retail value of the oil they worked tirelessly to produce. The question addressed in this case is: how can producers gain a greater percentage of value in the argan oil sector? Is ethical labeling, such as Fair Trade, the solution? Alternatively, could the value chain be transformed more significantly by increasing the role of certain actors (such as producers) while eliminating some actors altogether? By investigating the current value chain of argan oil cooperatives, readers are called upon to contrast the value provided by actors with their economic costs to determine a more sustainable value chain.

Case Authors : Francisco Szekely, Zahir Dossa

Topic : Leadership & Managing People

Related Areas : Supply chain, Sustainability

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Calculating Net Present Value (NPV) at 6% for Redefining Value Creation in Value Chains: The Social Side of Sustainability Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10012548)	-10012548	-	-
Year 1	3463152	-6549396	3463152	0.9434	3267125
Year 2	3963951	-2585445	7427103	0.89	3527902
Year 3	3965400	1379955	11392503	0.8396	3329426
Year 4	3227381	4607336	14619884	0.7921	2556388
TOTAL			14619884		12680841

The Net Present Value at 6% discount rate is 2668293

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. 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. Magnitude of both incoming and outgoing cash flows – Projects can be capital intensive, time intensive, or both. Argan Oil 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 Argan Oil 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 Redefining Value Creation in Value Chains: The Social Side of Sustainability

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 Argan Oil 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 Argan Oil 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	(10012548)	-10012548	-	-
Year 1	3463152	-6549396	3463152	0.8696	3011437
Year 2	3963951	-2585445	7427103	0.7561	2997316
Year 3	3965400	1379955	11392503	0.6575	2607315
Year 4	3227381	4607336	14619884	0.5718	1845266
TOTAL					10461333

The Net NPV after 4 years is 448785

(10461333 - 10012548 )

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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	(10012548)	-10012548	-	-
Year 1	3463152	-6549396	3463152	0.8333	2885960
Year 2	3963951	-2585445	7427103	0.6944	2752744
Year 3	3965400	1379955	11392503	0.5787	2294792
Year 4	3227381	4607336	14619884	0.4823	1556414
TOTAL					9489910

The Net NPV after 4 years is -522638

At 20% discount rate the NPV is negative (9489910 - 10012548 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Argan Oil 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 Argan Oil has a NPV value higher than Zero then finance managers at Argan Oil 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 Argan Oil, then the stock price of the Argan Oil 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 Argan Oil 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.

What can impact the cash flow of the project.

Understanding of risks involved in 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 Redefining Value Creation in Value Chains: The Social Side of Sustainability

References & Further Readings

Francisco Szekely, Zahir Dossa (2018), "Redefining Value Creation in Value Chains: The Social Side of Sustainability Harvard Business Review Case Study. Published by HBR Publications.