Perlegen Sciences 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 Perlegen Sciences case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Perlegen Sciences case study is a Harvard Business School (HBR) case study written by Linda A. Hill, Nicole Tempest. The Perlegen Sciences (referred as “Perlegen Margus” 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, Creativity, Entrepreneurship, Leadership, Leading teams, Organizational structure, Professional transitions, Talent 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

Case Description of Perlegen Sciences Case Study

As a biotech start-up company involved in studying human genomes, Perlegen needed to develop an organization that fostered innovation and teamwork among a group of highly trained professionals from both the science and technology fields. Perlegen's CEO, Brad Margus, had joined Perlegen from the shrimp processing business after learning that two of his three sons had been diagnosed with a rare genetic disease. A Harvard MBA and self-trained geneticist, Margus looked forward to the opportunity to dedicate himself to Perlegen's scientific mission. During his first nine months on the job, Margus had hired a number of junior-level and mid-level employees; now it was time to fill out the senior management team. Margus's first senior management hire was Greg Brandeau, the former vice president of computer operations at Pixar Animation Studios, who signed on to be Perlegen's CEO. Brandeau faced a number of challenges as he integrated into the Perlegen organization, including the fact that he lacked a science background, his two direct reports had already been hired, and he would be the third leg of a tight-knit, two-person senior management team already in place.

Case Authors : Linda A. Hill, Nicole Tempest

Topic : Leadership & Managing People

Related Areas : Creativity, Entrepreneurship, Leadership, Leading teams, Organizational structure, Professional transitions, Talent management

Calculating Net Present Value (NPV) at 6% for Perlegen Sciences Case Study

Years              Cash Flow     Net Cash Flow     Cumulative    
Cash Flow
Discount Rate
@ 6 %
Cash Flows
Year 0 (10000501) -10000501 - -
Year 1 3448571 -6551930 3448571 0.9434 3253369
Year 2 3965672 -2586258 7414243 0.89 3529434
Year 3 3946395 1360137 11360638 0.8396 3313469
Year 4 3229334 4589471 14589972 0.7921 2557935
TOTAL 14589972 12654207

The Net Present Value at 6% discount rate is 2653706

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. Magnitude of both incoming and outgoing cash flows – Projects can be capital intensive, time intensive, or both. Perlegen Margus 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 Perlegen Margus have higher preference for cash returns over 4-5 years rather than 10-15 years given the nature of the volatility in the industry.

Formula and Steps to Calculate Net Present Value (NPV) of Perlegen Sciences

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 Perlegen Margus 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 Perlegen Margus 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 %
Cash Flows
Year 0 (10000501) -10000501 - -
Year 1 3448571 -6551930 3448571 0.8696 2998757
Year 2 3965672 -2586258 7414243 0.7561 2998618
Year 3 3946395 1360137 11360638 0.6575 2594819
Year 4 3229334 4589471 14589972 0.5718 1846382
TOTAL 10438576

The Net NPV after 4 years is 438075

(10438576 - 10000501 )

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 %
Cash Flows
Year 0 (10000501) -10000501 - -
Year 1 3448571 -6551930 3448571 0.8333 2873809
Year 2 3965672 -2586258 7414243 0.6944 2753939
Year 3 3946395 1360137 11360638 0.5787 2283793
Year 4 3229334 4589471 14589972 0.4823 1557356
TOTAL 9468898

The Net NPV after 4 years is -531603

At 20% discount rate the NPV is negative (9468898 - 10000501 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Perlegen Margus 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 Perlegen Margus has a NPV value higher than Zero then finance managers at Perlegen Margus 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 Perlegen Margus, then the stock price of the Perlegen Margus 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 Perlegen Margus 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.

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 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

Linda A. Hill, Nicole Tempest (2018), "Perlegen Sciences Harvard Business Review Case Study. Published by HBR Publications.