Double, Double, Toil and Trouble: One Compounding Pharmacy's Recipe for Steroids 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 Double, Double, Toil and Trouble: One Compounding Pharmacy's Recipe for Steroids case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Double, Double, Toil and Trouble: One Compounding Pharmacy's Recipe for Steroids case study is a Harvard Business School (HBR) case study written by Cheryl Kirschner. The Double, Double, Toil and Trouble: One Compounding Pharmacy's Recipe for Steroids (referred as “Necc Medication” 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, Ethics, Negotiations, Public relations, Risk management.

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 Double, Double, Toil and Trouble: One Compounding Pharmacy's Recipe for Steroids Case Study

This case is based on highly publicized events surrounding lethal medication manufactured and sold by a small pharmaceutical company outside Boston, Massachusetts called New England Compounding Center (NECC). Formed in 1998, NECC was owned and operated by husband and wife Barry Cadden and Lisa Conigliaro Cadden, along with other family members. In conjunction with its sister company, Ameridose, the businesses focused on preparing prefilled syringes and large vats of medication into smaller intravenous bags, ready for individual use. It also compounded medication for individual patients' specific needs. But as the business grew aggressively, taking larger and larger orders, fast production was prioritized over safety and sanitation. A fungal meningitis outbreak in the fall of 2012 was linked to steroids fabricated by NECC. Despite an immediate recall, the allegedly contaminated product had been distributed to more than 14,000 patients in 23 states. In total, the Centers for Disease Control and Prevention reported 751 cases of fungal infection that could be linked to tainted steroid injections compounded by NECC. Of these, 64 were fatal. How should the legal system respond?

Case Authors : Cheryl Kirschner

Topic : Leadership & Managing People

Related Areas : Ethics, Negotiations, Public relations, Risk management

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Calculating Net Present Value (NPV) at 6% for Double, Double, Toil and Trouble: One Compounding Pharmacy's Recipe for Steroids Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10012778)	-10012778	-	-
Year 1	3460127	-6552651	3460127	0.9434	3264271
Year 2	3977998	-2574653	7438125	0.89	3540404
Year 3	3974698	1400045	11412823	0.8396	3337233
Year 4	3243396	4643441	14656219	0.7921	2569073
TOTAL			14656219		12710981

The Net Present Value at 6% discount rate is 2698203

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. Necc Medication 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 Necc Medication 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 Double, Double, Toil and Trouble: One Compounding Pharmacy's Recipe for Steroids

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 Necc Medication 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 Necc Medication 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	(10012778)	-10012778	-	-
Year 1	3460127	-6552651	3460127	0.8696	3008806
Year 2	3977998	-2574653	7438125	0.7561	3007938
Year 3	3974698	1400045	11412823	0.6575	2613428
Year 4	3243396	4643441	14656219	0.5718	1854422
TOTAL					10484595

The Net NPV after 4 years is 471817

(10484595 - 10012778 )

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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	(10012778)	-10012778	-	-
Year 1	3460127	-6552651	3460127	0.8333	2883439
Year 2	3977998	-2574653	7438125	0.6944	2762499
Year 3	3974698	1400045	11412823	0.5787	2300172
Year 4	3243396	4643441	14656219	0.4823	1564138
TOTAL					9510248

The Net NPV after 4 years is -502530

At 20% discount rate the NPV is negative (9510248 - 10012778 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Necc Medication 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 Necc Medication has a NPV value higher than Zero then finance managers at Necc Medication 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 Necc Medication, then the stock price of the Necc Medication 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 Necc Medication 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 can impact the cash flow of 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.

Understanding of risks involved in 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 Double, Double, Toil and Trouble: One Compounding Pharmacy's Recipe for Steroids

References & Further Readings

Cheryl Kirschner (2018), "Double, Double, Toil and Trouble: One Compounding Pharmacy's Recipe for Steroids Harvard Business Review Case Study. Published by HBR Publications.