Aurum Furniture and In-Law Management 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 Aurum Furniture and In-Law Management case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Aurum Furniture and In-Law Management case study is a Harvard Business School (HBR) case study written by Daniel T Holt, Jess H Chua, James J Chrisman, Shanan R Litchfield. The Aurum Furniture and In-Law Management (referred as “Family Laws” 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, 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

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Case Description of Aurum Furniture and In-Law Management Case Study

One of the most complex challenges for a family business is when an in-law joins the firm. In-laws are part of the family through marriage; but they form a group of unique stakeholders in the family firm as marriage can be severed but blood cannot be changed. Consequently, in-laws are not always viewed as full-fledged family members. While the firm's founder and family members face challenges as they consider integrating in-laws into the family firm, the in-laws face many challenges in joining a family firm as well. This case illustrates these tensions by tracing John Malone's involvement working as an in-law for Aurum Furniture, a small family business located in a large Midwestern city in the U.S. Issues that would have been straightforward in a non-family firm were anything but that in the non-professionalized family firm. The case provides considerable flexibility with instructors having opportunity to discuss the dynamics among members of a small family business. While we emphasize the challenges faced by in-laws, the case is particularly well-suited to facilitate a more general discussion on the challenges that an individual encounters as he or she joins a non-professionalized family firm. As such, it can be used with family business owners as they reflect on their concept of family and the roles of individual members-especially, in-laws-and the firm's decisions to professionalize. The case can be used with graduate and undergraduate students and workshops in family business or small business management.

Case Authors : Daniel T Holt, Jess H Chua, James J Chrisman, Shanan R Litchfield

Topic : Leadership & Managing People

Related Areas : Succession planning

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Calculating Net Present Value (NPV) at 6% for Aurum Furniture and In-Law Management Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10028127)	-10028127	-	-
Year 1	3466797	-6561330	3466797	0.9434	3270563
Year 2	3978436	-2582894	7445233	0.89	3540794
Year 3	3951666	1368772	11396899	0.8396	3317895
Year 4	3243415	4612187	14640314	0.7921	2569088
TOTAL			14640314		12698341

The Net Present Value at 6% discount rate is 2670214

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. Internal Rate of Return
2. Profitability Index
3. Net Present Value
4. Payback Period

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 Family Laws 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. Family Laws 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 Aurum Furniture and In-Law Management

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 Family Laws 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 Family Laws 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	(10028127)	-10028127	-	-
Year 1	3466797	-6561330	3466797	0.8696	3014606
Year 2	3978436	-2582894	7445233	0.7561	3008269
Year 3	3951666	1368772	11396899	0.6575	2598285
Year 4	3243415	4612187	14640314	0.5718	1854433
TOTAL					10475593

The Net NPV after 4 years is 447466

(10475593 - 10028127 )

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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	(10028127)	-10028127	-	-
Year 1	3466797	-6561330	3466797	0.8333	2888998
Year 2	3978436	-2582894	7445233	0.6944	2762803
Year 3	3951666	1368772	11396899	0.5787	2286844
Year 4	3243415	4612187	14640314	0.4823	1564147
TOTAL					9502791

The Net NPV after 4 years is -525336

At 20% discount rate the NPV is negative (9502791 - 10028127 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Family Laws 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 Family Laws has a NPV value higher than Zero then finance managers at Family Laws 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 Family Laws, then the stock price of the Family Laws 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 Family Laws 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 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.

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.

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 Aurum Furniture and In-Law Management

References & Further Readings

Daniel T Holt, Jess H Chua, James J Chrisman, Shanan R Litchfield (2018), "Aurum Furniture and In-Law Management Harvard Business Review Case Study. Published by HBR Publications.