Introduction to Net Present Value (NPV) - What is Net Present Value (NPV) ? How it impacts financial decisions regarding project management?
At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Achieving Meritocracy in the Workplace case study is a Harvard Business School (HBR) case study written by Emilio J. Castilla. The Achieving Meritocracy in the Workplace (referred as “Merit Biases” 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, Gender, Motivating people.
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.
This is an MIT Sloan Management Review article. For their companies to remain competitive and successful, many executives strongly believe that they need to recruit and retain top talent. And to do so, they must foster meritocracies -hiring, rewarding, and promoting the best people, based on their merit. The most progressive companies have thus created formal systems for ensuring that job applicants and employees are judged solely by their efforts, skills, abilities, and performance, regardless of their gender, race, class, national origin, or sexual orientation.When managers believe their company is a meritocracy because formal evaluative and distributive mechanisms are in place, they are actually more likely to exhibit the very biases that those systems may seek to prevent. The very belief that an organization is meritocratic may open the door to biased, non-merit-based behavior when managers make key individual-level career decisions. The good news, the author reports, is that establishing a more meritocratic workplace doesn't require an inordinate amount of time or resources. It is a matter of establishing clear processes and criteria for hiring and evaluating employees. It is also a matter of monitoring and evaluating the outcomes of such company processes and bestowing an individual or group within the organization with the responsibility, ability, and authority to ensure that those formal processes are fair. The collection and analysis of data on people-related processes and outcomes -often referred to as "people analytics"-can enable companies to identify and correct workplace biases. The author conducted a longitudinal investigation of the translation of employee performance evaluations into compensation decisions at a large service organization in North America. He found that, over the long run, women and minorities received lower salary increases than white men with the same performance evaluation scores, even after controlling for job, work unit, and supervisor effects. The company's solution was to adopt a set of organizational procedures that incorporated both accountability and transparency into its performance reward system. The intervention consisted of introducing three key changes. First, a performance reward committee was appointed to monitor the fairness of pay decisions. Second, all senior managers had to follow a formalized process for assigning rewards based on employee evaluations. This process required the senior managers to briefly justify how much was awarded to each employee in their work unit. Third, the performance reward committee was granted the authority to modify pay decisions made by senior managers. After the new system was implemented, the author found significant reductions in the gender, race, and foreign nationality gaps for merit-based pay rewards. In fact, any remaining differences from such biases were negligible. Follow-up interviews with executives and managers at the company suggested that both the accountability and transparency mechanisms had been effective in reducing those pay gaps.
| Years | Cash Flow | Net Cash Flow | Cumulative Cash Flow |
Discount Rate @ 6 % |
Discounted Cash Flows |
|---|---|---|---|---|---|
| Year 0 | (10003025) | -10003025 | - | - | |
| Year 1 | 3457391 | -6545634 | 3457391 | 0.9434 | 3261690 |
| Year 2 | 3967704 | -2577930 | 7425095 | 0.89 | 3531242 |
| Year 3 | 3967121 | 1389191 | 11392216 | 0.8396 | 3330871 |
| Year 4 | 3222377 | 4611568 | 14614593 | 0.7921 | 2552424 |
| TOTAL | 14614593 | 12676228 |
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 -
Capital Budgeting Approaches
There are four types of capital budgeting techniques that are widely used in the corporate world –
1. Net Present Value
2. Internal Rate of Return
3. Payback Period
4. Profitability Index
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 Merit Biases 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. Merit Biases shareholders have preference for diversified projects investment rather than prospective high income from a single capital intensive project.
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
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 Merit Biases 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 Merit Biases 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.
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 | (10003025) | -10003025 | - | - | |
| Year 1 | 3457391 | -6545634 | 3457391 | 0.8696 | 3006427 |
| Year 2 | 3967704 | -2577930 | 7425095 | 0.7561 | 3000154 |
| Year 3 | 3967121 | 1389191 | 11392216 | 0.6575 | 2608446 |
| Year 4 | 3222377 | 4611568 | 14614593 | 0.5718 | 1842405 |
| TOTAL | 10457432 |
(10457432 - 10003025 )
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 | (10003025) | -10003025 | - | - | |
| Year 1 | 3457391 | -6545634 | 3457391 | 0.8333 | 2881159 |
| Year 2 | 3967704 | -2577930 | 7425095 | 0.6944 | 2755350 |
| Year 3 | 3967121 | 1389191 | 11392216 | 0.5787 | 2295788 |
| Year 4 | 3222377 | 4611568 | 14614593 | 0.4823 | 1554001 |
| TOTAL | 9486298 |
At 20% discount rate the NPV is negative (9486298 - 10003025 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Merit Biases to discount cash flow at lower discount rates such as 15%.
Simplest Approach – If the investment project of Merit Biases has a NPV value higher than Zero then finance managers at Merit Biases 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 Merit Biases, then the stock price of the Merit Biases 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.
Project selection is often a far more complex decision than just choosing it based on the NPV number. Finance managers at Merit Biases 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 are the key aspects of the projects that need to be monitored, refined, and retuned for continuous delivery of projected cash flows.
What can impact the cash flow of the project.
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.
Emilio J. Castilla (2018), "Achieving Meritocracy in the Workplace Harvard Business Review Case Study. Published by HBR Publications.
Feel free to connect with us if you need business research.
You can download Excel Template of Case Study Solution & Analysis of Achieving Meritocracy in the Workplace
Basic Materials , Gold & Silver
Services , Real Estate Operations
Basic Materials , Iron & Steel
Services , Advertising
Technology , Computer Services
Basic Materials , Misc. Fabricated Products
Transportation , Water Transportation
Technology , Semiconductors
Services , Real Estate Operations
Technology , Software & Programming
Basic Materials , Misc. Fabricated Products
