BMR Advisors - Competing on Quality 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 BMR Advisors - Competing on Quality case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. BMR Advisors - Competing on Quality case study is a Harvard Business School (HBR) case study written by Suhruta Kulkarni, Dinesh Kumar Unnikrishnan. The BMR Advisors - Competing on Quality (referred as “Bmr Ratio” 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, Mergers & acquisitions, 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 BMR Advisors - Competing on Quality Case Study

Arthur Andersen collapsed in May 2002 and a significant part of Arthur Andersen India merged with Ernst & Young. Bobby Parikh, Mukesh Butani, Rajiv Dimri, Sanjay Mehta and Ajay Mehra, all of whom were senior leaders at Arthur Anderson, had joined Ernst & Young after the merger in various roles; however, they left one by one to establish a firm in their chosen practice areas, which would be differentiated by quality of thinking and enable clients to experience a different way of engagement execution. Thus, BMR Advisors was started to provide high quality professional services; wherein it wanted to differentiate itself and compete solely on quality. BMR started with services in three areas - Tax, Mergers and Acquisitions (M&A) and Risk Advisory - a unique combination which could solve any business problem. Audit services and management consulting were deliberately not offered. BMR focused on maintaining a low leverage ratio, that is, the number of team members per partner, to ensure higher amount of partner time on each assignment. BMR Advisors thus far had achieved success with its low leverage ratio, that is, partner to team members' ratio, which in turn had ensured higher quality of strategic inputs to complex client engagements and higher amount of partner face time with clients. With increased growth in recent times, maintaining a lower leverage ratio was becoming a challenge, since growth entailed more engagements and needed additional team members, which in turn diluted the leverage ratio. New partners had joined from other organization and ensuring a seamless integration of culture was another challenge. Developing the next set of leaders to take over the mantle from the founding partners was one more challenge to be dealt with. Besides these unique challenges, BMR advisors also faced regular challenges such as talent war, technology, undercutting by competition, etc.

Case Authors : Suhruta Kulkarni, Dinesh Kumar Unnikrishnan

Topic : Leadership & Managing People

Related Areas : Mergers & acquisitions, Risk management

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Calculating Net Present Value (NPV) at 6% for BMR Advisors - Competing on Quality Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10015640)	-10015640	-	-
Year 1	3458970	-6556670	3458970	0.9434	3263179
Year 2	3970034	-2586636	7429004	0.89	3533316
Year 3	3958184	1371548	11387188	0.8396	3323368
Year 4	3229397	4600945	14616585	0.7921	2557985
TOTAL			14616585		12677848

The Net Present Value at 6% discount rate is 2662208

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. 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. Timing of the expected cash flows – stockholders of Bmr Ratio 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. Bmr Ratio 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 BMR Advisors - Competing on Quality

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 Bmr Ratio 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 Bmr Ratio 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	(10015640)	-10015640	-	-
Year 1	3458970	-6556670	3458970	0.8696	3007800
Year 2	3970034	-2586636	7429004	0.7561	3001916
Year 3	3958184	1371548	11387188	0.6575	2602570
Year 4	3229397	4600945	14616585	0.5718	1846418
TOTAL					10458705

The Net NPV after 4 years is 443065

(10458705 - 10015640 )

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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	(10015640)	-10015640	-	-
Year 1	3458970	-6556670	3458970	0.8333	2882475
Year 2	3970034	-2586636	7429004	0.6944	2756968
Year 3	3958184	1371548	11387188	0.5787	2290616
Year 4	3229397	4600945	14616585	0.4823	1557387
TOTAL					9487445

The Net NPV after 4 years is -528195

At 20% discount rate the NPV is negative (9487445 - 10015640 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Bmr Ratio 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 Bmr Ratio has a NPV value higher than Zero then finance managers at Bmr Ratio 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 Bmr Ratio, then the stock price of the Bmr Ratio 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 Bmr Ratio 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 will be a multi year spillover effect of various taxation regulations.

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.

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 BMR Advisors - Competing on Quality

References & Further Readings

Suhruta Kulkarni, Dinesh Kumar Unnikrishnan (2018), "BMR Advisors - Competing on Quality Harvard Business Review Case Study. Published by HBR Publications.