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Stevenson Industries (A) 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 Stevenson Industries (A) case study


At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Stevenson Industries (A) case study is a Harvard Business School (HBR) case study written by John A. Davis, Kacie Lachapelle. The Stevenson Industries (A) (referred as “Carlson Steel” 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, Conflict, Leadership, Succession planning.

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




Case Description of Stevenson Industries (A) Case Study


Simon Carlson, chairman of the board of his family's fourth-generation industrial company, must decide how to deal with his conflict with the company's nonfamily CEO. Hired by the board just 15 months earlier to pursue growth more aggressively, CEO Paul Steel has upset Carlson and several managers with his management approach with the very strained relationship between the chairman and CEO. The board must decide how it will deal with Steel and Carlson.


Case Authors : John A. Davis, Kacie Lachapelle

Topic : Leadership & Managing People

Related Areas : Conflict, Leadership, Succession planning




Calculating Net Present Value (NPV) at 6% for Stevenson Industries (A) Case Study


Years              Cash Flow     Net Cash Flow     Cumulative    
Cash Flow
Discount Rate
@ 6 %
Discounted
Cash Flows
Year 0 (10019668) -10019668 - -
Year 1 3459220 -6560448 3459220 0.9434 3263415
Year 2 3961839 -2598609 7421059 0.89 3526023
Year 3 3959443 1360834 11380502 0.8396 3324425
Year 4 3226643 4587477 14607145 0.7921 2555803
TOTAL 14607145 12669666


The Net Present Value at 6% discount rate is 2649998

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.




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. 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 Carlson Steel 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. Carlson Steel shareholders have preference for diversified projects investment rather than prospective high income from a single capital intensive project.




Formula and Steps to Calculate Net Present Value (NPV) of Stevenson Industries (A)

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 Carlson Steel 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 Carlson Steel 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 (10019668) -10019668 - -
Year 1 3459220 -6560448 3459220 0.8696 3008017
Year 2 3961839 -2598609 7421059 0.7561 2995719
Year 3 3959443 1360834 11380502 0.6575 2603398
Year 4 3226643 4587477 14607145 0.5718 1844844
TOTAL 10451979


The Net NPV after 4 years is 432311

(10451979 - 10019668 )






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 (10019668) -10019668 - -
Year 1 3459220 -6560448 3459220 0.8333 2882683
Year 2 3961839 -2598609 7421059 0.6944 2751277
Year 3 3959443 1360834 11380502 0.5787 2291344
Year 4 3226643 4587477 14607145 0.4823 1556059
TOTAL 9481363


The Net NPV after 4 years is -538305

At 20% discount rate the NPV is negative (9481363 - 10019668 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Carlson Steel 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 Carlson Steel has a NPV value higher than Zero then finance managers at Carlson Steel 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 Carlson Steel, then the stock price of the Carlson Steel 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 Carlson Steel 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 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.

What will be a multi year spillover effect of various taxation regulations.

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.




References & Further Readings

John A. Davis, Kacie Lachapelle (2018), "Stevenson Industries (A) Harvard Business Review Case Study. Published by HBR Publications.