Preparing for Disruptions Through Early Detection 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 Preparing for Disruptions Through Early Detection case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Preparing for Disruptions Through Early Detection case study is a Harvard Business School (HBR) case study written by Yossi Sheffi. The Preparing for Disruptions Through Early Detection (referred as “Disruptions Detection” 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, .

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 Preparing for Disruptions Through Early Detection Case Study

This is an MIT Sloan Management Review article. Detecting the potential for disruptions to business operations -ideally before the disruptions occur -can help companies reduce their negative impact. Different disruptions have different degrees of impact, which affects how companies prioritize risk management efforts, and different disruptions occur with different frequencies or likelihoods. Author Yossi Sheffi notes that many risk management experts categorize potential disruptions by two dimensions: likelihood of occurrence and magnitude of impact.However, he writes, there is an important third dimension: the detection lead time. This is the amount of warning time during which a company can prepare for the disruption and mitigate its effects. As the author explains, some disruptions involve long-term trends that are widely discussed in the media (for example, aging populations in the Western world, China, and Japan) or are prescheduled events (such as new regulations or labor union contract deadlines; some (for instance, hurricanes) occur after a short warning of a few days; while others such as fires, earthquakes, or power outages occur without warning. Still other disruptions (such as product contaminations or design defects) may not be discovered until well after they've occurred or may never be recognized (for example, industrial espionage or cyberattacks). Drawing on examples from companies including Dow Chemical, Ikea, BNSF Railway, Walgreen's, Cisco Systems, UPS, and FedEx, the article presents nine data sources that leading companies use to improve their ability to detect potential disruptions early: monitoring the weather; tracking the news; using data from sensors; monitoring the supply base; visiting suppliers; being on the alert for deception; developing traceability capabilities; monitoring social media; and tracking regulatory developments. The article then discusses four ways companies can improve their abilities to both detect and respond to disruptions: (1) mapping the supply chain to determine the locations of their suppliers to assess supplier risks, (2) assessing global events to identify potential disruptions that could affect production or revenues, (3) creating supply chain control towers with technology, people, and processes that capture and use supply chain data to enable better short- and long-term decision making, and (4) improving response time through data and analysis. "Detection means vigilance on both specific near-term events and potential future events that might disrupt the company," the author writes. "It depends on creating visibility into the supply chain and understanding how the global moving parts connect to each other and impact each other." He adds: "At its heart, detection is the conversion of the relevant unknowns into salient knowns in a timely fashion."

Case Authors : Yossi Sheffi

Topic : Leadership & Managing People

Related Areas :

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Calculating Net Present Value (NPV) at 6% for Preparing for Disruptions Through Early Detection Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10016778)	-10016778	-	-
Year 1	3458033	-6558745	3458033	0.9434	3262295
Year 2	3966490	-2592255	7424523	0.89	3530162
Year 3	3954688	1362433	11379211	0.8396	3320432
Year 4	3239462	4601895	14618673	0.7921	2565957
TOTAL			14618673		12678847

The Net Present Value at 6% discount rate is 2662069

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

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Formula and Steps to Calculate Net Present Value (NPV) of Preparing for Disruptions Through Early Detection

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 Disruptions Detection 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 Disruptions Detection 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	(10016778)	-10016778	-	-
Year 1	3458033	-6558745	3458033	0.8696	3006985
Year 2	3966490	-2592255	7424523	0.7561	2999236
Year 3	3954688	1362433	11379211	0.6575	2600272
Year 4	3239462	4601895	14618673	0.5718	1852173
TOTAL					10458666

The Net NPV after 4 years is 441888

(10458666 - 10016778 )

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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	(10016778)	-10016778	-	-
Year 1	3458033	-6558745	3458033	0.8333	2881694
Year 2	3966490	-2592255	7424523	0.6944	2754507
Year 3	3954688	1362433	11379211	0.5787	2288593
Year 4	3239462	4601895	14618673	0.4823	1562241
TOTAL					9487034

The Net NPV after 4 years is -529744

At 20% discount rate the NPV is negative (9487034 - 10016778 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Disruptions Detection 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 Disruptions Detection has a NPV value higher than Zero then finance managers at Disruptions Detection 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 Disruptions Detection, then the stock price of the Disruptions Detection 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 Disruptions Detection 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 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.

What can impact the cash flow of the project.

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 Preparing for Disruptions Through Early Detection

References & Further Readings

Yossi Sheffi (2018), "Preparing for Disruptions Through Early Detection Harvard Business Review Case Study. Published by HBR Publications.