Using Advertising and Price to Mitigate Losses in a Product-harm Crisis 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 Using Advertising and Price to Mitigate Losses in a Product-harm Crisis case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Using Advertising and Price to Mitigate Losses in a Product-harm Crisis case study is a Harvard Business School (HBR) case study written by Kathleen Cleeren. The Using Advertising and Price to Mitigate Losses in a Product-harm Crisis (referred as “Harm Crisis” from here on) case study provides evaluation & decision scenario in field of Communication. It also touches upon business topics such as - Value proposition, Customer service, Marketing, Pricing.

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 Using Advertising and Price to Mitigate Losses in a Product-harm Crisis Case Study

Product-harm crises are common in today's marketplace and are expected to occur with escalating frequency as products become increasingly complex, product-safety legislation evolves, and always-demanding customers continue to press for more. A product-harm crisis may cause major revenue losses, lead to costly recalls, and destroy carefully nurtured brand equity. Moreover, the crisis may not only be devastating for the affected brand, but also influence the entire category when other brands are perceived as guilty by association. Despite these enormous stakes, marketing managers are often unprepared to react appropriately to product-harm crises. Managers frequently increase advertising support or decrease price in the wake of a product-harm crisis in an attempt to regain lost consumers. Competitors in the same category may also boost advertising expenditures or lower their prices to benefit from the misfortune of the affected brand(s). This article provides insights regarding the effectiveness of these strategies in the wake of a product-harm crisis. The extant literature has shown that the effectiveness of these strategies depends largely on the role of the brand in the crisis--affected or not--and the characteristics of the crisis.

Case Authors : Kathleen Cleeren

Topic : Communication

Related Areas : Customer service, Marketing, Pricing

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Calculating Net Present Value (NPV) at 6% for Using Advertising and Price to Mitigate Losses in a Product-harm Crisis Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10019255)	-10019255	-	-
Year 1	3456521	-6562734	3456521	0.9434	3260869
Year 2	3973954	-2588780	7430475	0.89	3536805
Year 3	3950073	1361293	11380548	0.8396	3316557
Year 4	3226999	4588292	14607547	0.7921	2556085
TOTAL			14607547		12670317

The Net Present Value at 6% discount rate is 2651062

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. Payback Period
4. Net Present Value

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 Harm Crisis 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. Harm Crisis 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 Using Advertising and Price to Mitigate Losses in a Product-harm Crisis

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 Communication 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 Harm Crisis 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 Harm Crisis 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	(10019255)	-10019255	-	-
Year 1	3456521	-6562734	3456521	0.8696	3005670
Year 2	3973954	-2588780	7430475	0.7561	3004880
Year 3	3950073	1361293	11380548	0.6575	2597237
Year 4	3226999	4588292	14607547	0.5718	1845047
TOTAL					10452835

The Net NPV after 4 years is 433580

(10452835 - 10019255 )

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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	(10019255)	-10019255	-	-
Year 1	3456521	-6562734	3456521	0.8333	2880434
Year 2	3973954	-2588780	7430475	0.6944	2759690
Year 3	3950073	1361293	11380548	0.5787	2285922
Year 4	3226999	4588292	14607547	0.4823	1556230
TOTAL					9482277

The Net NPV after 4 years is -536978

At 20% discount rate the NPV is negative (9482277 - 10019255 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Harm Crisis 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 Harm Crisis has a NPV value higher than Zero then finance managers at Harm Crisis 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 Harm Crisis, then the stock price of the Harm Crisis 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 Harm Crisis 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 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 will be a multi year spillover effect of various taxation regulations.

Understanding of risks involved in the project.

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.

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 Using Advertising and Price to Mitigate Losses in a Product-harm Crisis

References & Further Readings

Kathleen Cleeren (2018), "Using Advertising and Price to Mitigate Losses in a Product-harm Crisis Harvard Business Review Case Study. Published by HBR Publications.