IBM China Development Lab Shanghai: Capability by Design 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 IBM China Development Lab Shanghai: Capability by Design case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. IBM China Development Lab Shanghai: Capability by Design case study is a Harvard Business School (HBR) case study written by Willy Shih, Kamen Bliznashki, Fan Zhao. The IBM China Development Lab Shanghai: Capability by Design (referred as “Cdl Shanghai” 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, IT, Knowledge management, Organizational structure.

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 IBM China Development Lab Shanghai: Capability by Design Case Study

To maximize their effectiveness, color cases should be printed in color.When IBM shifted from a traditional territory-based multinational organization to what it called a globally integrated enterprise, it established its headquarters for "Growth Markets" in Shanghai and "Established Markets" in New York. This positioned its China Development Labs (CDL) in Shanghai as a key platform for serving growth markets including the BRIC countries and other rapidly developing regions. Though quite young, CDL Shanghai had grown to become one of IBM's largest labs. The case examines IBM's early-mover establishment of its corporate research lab and CDL, and through the examination of three product development vignettes looks at the systematic approach taken to the development of lab personnel and capabilities.

Case Authors : Willy Shih, Kamen Bliznashki, Fan Zhao

Topic : Leadership & Managing People

Related Areas : IT, Knowledge management, Organizational structure

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Calculating Net Present Value (NPV) at 6% for IBM China Development Lab Shanghai: Capability by Design Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10004973)	-10004973	-	-
Year 1	3448458	-6556515	3448458	0.9434	3253262
Year 2	3969156	-2587359	7417614	0.89	3532535
Year 3	3970534	1383175	11388148	0.8396	3333737
Year 4	3229001	4612176	14617149	0.7921	2557671
TOTAL			14617149		12677205

The Net Present Value at 6% discount rate is 2672232

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. Internal Rate of Return
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. Cdl Shanghai 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 Cdl Shanghai 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 IBM China Development Lab Shanghai: Capability by Design

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 Cdl Shanghai 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 Cdl Shanghai 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	(10004973)	-10004973	-	-
Year 1	3448458	-6556515	3448458	0.8696	2998659
Year 2	3969156	-2587359	7417614	0.7561	3001252
Year 3	3970534	1383175	11388148	0.6575	2610691
Year 4	3229001	4612176	14617149	0.5718	1846192
TOTAL					10456794

The Net NPV after 4 years is 451821

(10456794 - 10004973 )

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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	(10004973)	-10004973	-	-
Year 1	3448458	-6556515	3448458	0.8333	2873715
Year 2	3969156	-2587359	7417614	0.6944	2756358
Year 3	3970534	1383175	11388148	0.5787	2297763
Year 4	3229001	4612176	14617149	0.4823	1557196
TOTAL					9485032

The Net NPV after 4 years is -519941

At 20% discount rate the NPV is negative (9485032 - 10004973 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Cdl Shanghai 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 Cdl Shanghai has a NPV value higher than Zero then finance managers at Cdl Shanghai 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 Cdl Shanghai, then the stock price of the Cdl Shanghai 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 Cdl Shanghai 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 –

Understanding of risks involved in the project.

What can impact the cash flow of the project.

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 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.

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 IBM China Development Lab Shanghai: Capability by Design

References & Further Readings

Willy Shih, Kamen Bliznashki, Fan Zhao (2018), "IBM China Development Lab Shanghai: Capability by Design Harvard Business Review Case Study. Published by HBR Publications.