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How Boards Can Be Better -- a Manifesto 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 How Boards Can Be Better -- a Manifesto case study


At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. How Boards Can Be Better -- a Manifesto case study is a Harvard Business School (HBR) case study written by Robert J. Thomas, Michael Schrage, Joshua Bellin, George Marcotte. The How Boards Can Be Better -- a Manifesto (referred as “Directors Boards” 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, Leadership, Organizational structure.

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 How Boards Can Be Better -- a Manifesto Case Study


This is an MIT Sloan Management Review article. Managers and directors alike face tough choices as they decide on the quality and quantity of information that the board receives and uses in its governance and fiduciary roles. As the fallout from recent crises such as the subprime mortgage debacle illustrates, both sides must address the problem of "information asymmetry" -- the gap between the information available to management and to the board. The authors' research suggests that tomorrow's boardroom will be reshaped by three related forces: First, they face a thorough rethinking, brought on by concerned stakeholders, of directors' information needs. In responding to these pressures, boards and management must overcome several impediments: caution about altering the dynamics of the present manager-director relationship; directors' lack of needed skills for interpreting the new information; and the inertia of cultural norms. Second, they face dramatic improvements in the performance assessment approaches used to guide boards' decision making. The core of a healthy information relationship between managers and directors is their agreement on the most useful performance metrics to track and assess. This selection enables the building of trust and an eased and more pertinent workload for the board (having been freed from the need to decode reams of data while also gaining some independence from management's sometimes self-serving evaluations). Finally, boards and managers face the adoption of technologies that support critical board functions. Once access to such information is granted, new technologies can help directors obtain and use it. Board members may apply tools that, for example, enable improved visualizations and helpful alerts. And directors may engage in electronic "what-if" analyses, using company data as well as outside information -- related, say, to competing firms -- which is becoming increasingly available online.


Case Authors : Robert J. Thomas, Michael Schrage, Joshua Bellin, George Marcotte

Topic : Leadership & Managing People

Related Areas : Leadership, Organizational structure




Calculating Net Present Value (NPV) at 6% for How Boards Can Be Better -- a Manifesto Case Study


Years              Cash Flow     Net Cash Flow     Cumulative    
Cash Flow
Discount Rate
@ 6 %
Discounted
Cash Flows
Year 0 (10015585) -10015585 - -
Year 1 3454293 -6561292 3454293 0.9434 3258767
Year 2 3963936 -2597356 7418229 0.89 3527889
Year 3 3951944 1354588 11370173 0.8396 3318128
Year 4 3224051 4578639 14594224 0.7921 2553750
TOTAL 14594224 12658535




The Net Present Value at 6% discount rate is 2642950

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. Internal Rate of Return
2. Net Present Value
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. Magnitude of both incoming and outgoing cash flows – Projects can be capital intensive, time intensive, or both. Directors Boards 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 Directors Boards 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 How Boards Can Be Better -- a Manifesto

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 Directors Boards 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 Directors Boards 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 (10015585) -10015585 - -
Year 1 3454293 -6561292 3454293 0.8696 3003733
Year 2 3963936 -2597356 7418229 0.7561 2997305
Year 3 3951944 1354588 11370173 0.6575 2598467
Year 4 3224051 4578639 14594224 0.5718 1843362
TOTAL 10442867


The Net NPV after 4 years is 427282

(10442867 - 10015585 )








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 (10015585) -10015585 - -
Year 1 3454293 -6561292 3454293 0.8333 2878578
Year 2 3963936 -2597356 7418229 0.6944 2752733
Year 3 3951944 1354588 11370173 0.5787 2287005
Year 4 3224051 4578639 14594224 0.4823 1554809
TOTAL 9473124


The Net NPV after 4 years is -542461

At 20% discount rate the NPV is negative (9473124 - 10015585 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Directors Boards 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 Directors Boards has a NPV value higher than Zero then finance managers at Directors Boards 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 Directors Boards, then the stock price of the Directors Boards 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 Directors Boards 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 –

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 can impact the cash flow of the project.

What will be a multi year spillover effect of various taxation regulations.

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.






Negotiation Strategy of How Boards Can Be Better -- a Manifesto

References & Further Readings

Robert J. Thomas, Michael Schrage, Joshua Bellin, George Marcotte (2018), "How Boards Can Be Better -- a Manifesto Harvard Business Review Case Study. Published by HBR Publications.


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