Introduction to Net Present Value (NPV) - What is Net Present Value (NPV) ? How it impacts financial decisions regarding project management?
At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Amagi: Creating Value in the TV Broadcasting Industry case study is a Harvard Business School (HBR) case study written by Anshuman Tripathy, Leela Krishna Annam, Mayur Agrawal. The Amagi: Creating Value in the TV Broadcasting Industry (referred as “Amagi Broadcasting” 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, Technology.
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.
This case traces the growth of Amagi and the various challenges faced by it as it has grown to develop its own niche in the TV broadcasting industry in India, and is now slowly growing in markets outside India. Amagi, founded by three entrepreneurs, has come a long way from its initial days of trying to sell its standalone broadcast signal splitting technology to television (TV) broadcasting channels. From what was supposed to be a technology company, it has metamorphosed into a full-fledged media company managing advertising airtime for some of India's biggest broadcasting channels and advertisers. Outside of India, Amagi has positioned itself as a broadcast playout management company helping channels provide customized content to multiple countries using a single stream. Although, the underlying technology of Amagi has not changed radically over the years, the innovations in Amagi's offerings to the market have helped it become the success that it is today. The case outlines all the steps taken by Amagi to address each of the challenges that it has faced in its journey to success, clearly highlighting the various capabilities that it had to develop or acquire over the various time-periods. The case shows how while a firm may believe that it is providing a suitable value proposition, the customers may not see value in this value proposition. The case shows how the firm has to interject at various points of the value chain to establish its presence, and as a consequence of having established its presence and having developed various capabilities, what could be its growth strategy, and how its activities and capabilities will influence the same.
| Years | Cash Flow | Net Cash Flow | Cumulative Cash Flow |
Discount Rate @ 6 % |
Discounted Cash Flows |
|---|---|---|---|---|---|
| Year 0 | (10008106) | -10008106 | - | - | |
| Year 1 | 3463666 | -6544440 | 3463666 | 0.9434 | 3267609 |
| Year 2 | 3968061 | -2576379 | 7431727 | 0.89 | 3531560 |
| Year 3 | 3959787 | 1383408 | 11391514 | 0.8396 | 3324714 |
| Year 4 | 3249299 | 4632707 | 14640813 | 0.7921 | 2573749 |
| TOTAL | 14640813 | 12697632 |
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 -
Capital Budgeting Approaches
There are four types of capital budgeting techniques that are widely used in the corporate world –
1. Net Present Value
2. Payback Period
3. Profitability Index
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. Magnitude of both incoming and outgoing cash flows – Projects can be capital intensive, time intensive, or both. Amagi Broadcasting 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 Amagi Broadcasting have higher preference for cash returns over 4-5 years rather than 10-15 years given the nature of the volatility in the industry.
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
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 Amagi Broadcasting 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 Amagi Broadcasting 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.
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 | (10008106) | -10008106 | - | - | |
| Year 1 | 3463666 | -6544440 | 3463666 | 0.8696 | 3011883 |
| Year 2 | 3968061 | -2576379 | 7431727 | 0.7561 | 3000424 |
| Year 3 | 3959787 | 1383408 | 11391514 | 0.6575 | 2603624 |
| Year 4 | 3249299 | 4632707 | 14640813 | 0.5718 | 1857797 |
| TOTAL | 10473729 |
(10473729 - 10008106 )
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 | (10008106) | -10008106 | - | - | |
| Year 1 | 3463666 | -6544440 | 3463666 | 0.8333 | 2886388 |
| Year 2 | 3968061 | -2576379 | 7431727 | 0.6944 | 2755598 |
| Year 3 | 3959787 | 1383408 | 11391514 | 0.5787 | 2291543 |
| Year 4 | 3249299 | 4632707 | 14640813 | 0.4823 | 1566984 |
| TOTAL | 9500514 |
At 20% discount rate the NPV is negative (9500514 - 10008106 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Amagi Broadcasting to discount cash flow at lower discount rates such as 15%.
Simplest Approach – If the investment project of Amagi Broadcasting has a NPV value higher than Zero then finance managers at Amagi Broadcasting 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 Amagi Broadcasting, then the stock price of the Amagi Broadcasting 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.
Project selection is often a far more complex decision than just choosing it based on the NPV number. Finance managers at Amagi Broadcasting 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 are the key aspects of the projects that need to be monitored, refined, and retuned for continuous delivery of projected cash flows.
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 can impact the cash flow of the project.
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.
Anshuman Tripathy, Leela Krishna Annam, Mayur Agrawal (2018), "Amagi: Creating Value in the TV Broadcasting Industry Harvard Business Review Case Study. Published by HBR Publications.
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