eRecon Software Development at Hospital Corporation of America 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 eRecon Software Development at Hospital Corporation of America case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. eRecon Software Development at Hospital Corporation of America case study is a Harvard Business School (HBR) case study written by Kenneth J. Klassen, Leanne Rayo. The eRecon Software Development at Hospital Corporation of America (referred as “Erecon Completion” 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, Internet, IT, Operations management, Product development, Project management, Security & privacy.

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 eRecon Software Development at Hospital Corporation of America Case Study

On July 28, 2014, the eRecon technical team at Physician Services Group in Hospital Corporation of America, gathered in the main conference room just as it did every Monday morning. The goal of the meeting was to review the project plan and update task completion for the team's two-year undertaking - a six-phase, in-house development of a custom, web-based accounting software called eRecon. As the team members worked through each task and updated the percentage that they had completed to date, they grew increasingly concerned about obtaining the critical source data that they required from the human resources department. They were approaching their deadline, and it was unclear what the consequences would be if they did not obtain the data on time, and what impact the delay would have on the completion deadline of December 8, 2014, for the next phase. With 125 end users patiently waiting on eRecon's completion, could the technical team ensure the success of the project? Kenneth J. Klassen is affiliated with Brock University.

Case Authors : Kenneth J. Klassen, Leanne Rayo

Topic : Leadership & Managing People

Related Areas : Internet, IT, Operations management, Product development, Project management, Security & privacy

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Calculating Net Present Value (NPV) at 6% for eRecon Software Development at Hospital Corporation of America Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10014157)	-10014157	-	-
Year 1	3450883	-6563274	3450883	0.9434	3255550
Year 2	3973478	-2589796	7424361	0.89	3536381
Year 3	3948327	1358531	11372688	0.8396	3315091
Year 4	3243846	4602377	14616534	0.7921	2569430
TOTAL			14616534		12676453

The Net Present Value at 6% discount rate is 2662296

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. Payback Period
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 Erecon Completion 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. Erecon Completion 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 eRecon Software Development at Hospital Corporation of America

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 Erecon Completion 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 Erecon Completion 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	(10014157)	-10014157	-	-
Year 1	3450883	-6563274	3450883	0.8696	3000768
Year 2	3973478	-2589796	7424361	0.7561	3004520
Year 3	3948327	1358531	11372688	0.6575	2596089
Year 4	3243846	4602377	14616534	0.5718	1854679
TOTAL					10456057

The Net NPV after 4 years is 441900

(10456057 - 10014157 )

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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	(10014157)	-10014157	-	-
Year 1	3450883	-6563274	3450883	0.8333	2875736
Year 2	3973478	-2589796	7424361	0.6944	2759360
Year 3	3948327	1358531	11372688	0.5787	2284911
Year 4	3243846	4602377	14616534	0.4823	1564355
TOTAL					9484362

The Net NPV after 4 years is -529795

At 20% discount rate the NPV is negative (9484362 - 10014157 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Erecon Completion 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 Erecon Completion has a NPV value higher than Zero then finance managers at Erecon Completion 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 Erecon Completion, then the stock price of the Erecon Completion 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 Erecon Completion 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 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.

Understanding of risks involved in the project.

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 eRecon Software Development at Hospital Corporation of America

References & Further Readings

Kenneth J. Klassen, Leanne Rayo (2018), "eRecon Software Development at Hospital Corporation of America Harvard Business Review Case Study. Published by HBR Publications.