Milk and Money 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 Milk and Money case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Milk and Money case study is a Harvard Business School (HBR) case study written by Karl Schmedders, Patrick Johnston, Charlotte Snyder. The Milk and Money (referred as “Milk Price” from here on) case study provides evaluation & decision scenario in field of Finance & Accounting. It also touches upon business topics such as - Value proposition, Financial markets.

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 Milk and Money Case Study

The financial success of dairy farms depends critically on the price of their main output, milk. Large volatility in the price of milk poses a considerable business risk to dairy farms. This is particularly true for family-run dairy farms. The question then arises: how can a farm owner hedge the milk price risk? The standard approach to establish a price floor for a commodity such as milk is to purchase put options on commodity futures. At the Chicago Mercantile Exchange, farmers can buy put options on the price of a variety of milk products. However, the price a farm receives for its milk depends on many factors and is unique to the farm. Thus, a farmer cannot directly buy put options on the price he receives for the milk his farm produces. Instead the farmer needs to determine which of the options available for trade at the Chicago Mercantile Exchange offer the best hedge for his own milk price. The assignment in this case is to examine historical data on several prices of milk products and the milk price received by a family-run dairy farm in California. Students need to find the price that is most closely correlated to the farm's milk price and to then choose options with the appropriate strike price that serve as the best hedge for the farm's price risk.

Case Authors : Karl Schmedders, Patrick Johnston, Charlotte Snyder

Topic : Finance & Accounting

Related Areas : Financial markets

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Calculating Net Present Value (NPV) at 6% for Milk and Money Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10028506)	-10028506	-	-
Year 1	3454399	-6574107	3454399	0.9434	3258867
Year 2	3980286	-2593821	7434685	0.89	3542440
Year 3	3961587	1367766	11396272	0.8396	3326225
Year 4	3228615	4596381	14624887	0.7921	2557365
TOTAL			14624887		12684898

The Net Present Value at 6% discount rate is 2656392

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. Timing of the expected cash flows – stockholders of Milk Price 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. Milk Price 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 Milk and Money

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 Finance & Accounting 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 Milk Price 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 Milk Price 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	(10028506)	-10028506	-	-
Year 1	3454399	-6574107	3454399	0.8696	3003825
Year 2	3980286	-2593821	7434685	0.7561	3009668
Year 3	3961587	1367766	11396272	0.6575	2604808
Year 4	3228615	4596381	14624887	0.5718	1845971
TOTAL					10464272

The Net NPV after 4 years is 435766

(10464272 - 10028506 )

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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	(10028506)	-10028506	-	-
Year 1	3454399	-6574107	3454399	0.8333	2878666
Year 2	3980286	-2593821	7434685	0.6944	2764088
Year 3	3961587	1367766	11396272	0.5787	2292585
Year 4	3228615	4596381	14624887	0.4823	1557010
TOTAL					9492348

The Net NPV after 4 years is -536158

At 20% discount rate the NPV is negative (9492348 - 10028506 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Milk Price 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 Milk Price has a NPV value higher than Zero then finance managers at Milk Price 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 Milk Price, then the stock price of the Milk Price 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 Milk Price 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.

Understanding of risks involved in the project.

What are the key aspects of the projects that need to be monitored, refined, and retuned for continuous delivery of projected cash flows.

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 Milk and Money

References & Further Readings

Karl Schmedders, Patrick Johnston, Charlotte Snyder (2018), "Milk and Money Harvard Business Review Case Study. Published by HBR Publications.