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. Saving Costs Using Smart Call Routing:Aligning Business and IT through Finance case study is a Harvard Business School (HBR) case study written by Gustavo Vinueza. The Saving Costs Using Smart Call Routing:Aligning Business and IT through Finance (referred as “Call Telecommunication” 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, Manufacturing.
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 case describes the effective information technology (IT) business alignment considerations that led to the successful implementation of a telecommunication platform designed to efficiently route cell phone calls in a financial institution in Chile. The company had several branches throughout the country, including its headquarters in Santiago. This initiative was part of a Technology Cost Savings strategy generated in response to the 2008 crisis. The idea behind it was to align internal business leaders with the IT team in order to optimize these costs, realizing a more efficient telecommunication platform, and to work together, as several cost-reducing initiatives were being executed at the same time. Achievements were thoroughly reviewed by the board of directors, and thus pressure to clean up the house was high. At that time, when users called a cellular phone from a landline, the call was charged using a fee much higher than a mobile company rate. The goal of the project was naturally to optimize these charges. An automatic call routing was designed, discussed and executed with the participation of the business leaders, based on each branch's demand and projected growth. The case relates the project lifecycle: the mistakes made at the beginning, the initial platform tests and bottlenecks, the rejection and frustration of the business, and a posterior crisis control and recovery phase. IT alignment and sponsorship from the directors were crucial, as there was no way back. All these factors, plus the additional IT activities competing for business attention, made this project both a challenging and learning experience.
| Years | Cash Flow | Net Cash Flow | Cumulative Cash Flow |
Discount Rate @ 6 % |
Discounted Cash Flows |
|---|---|---|---|---|---|
| Year 0 | (10007787) | -10007787 | - | - | |
| Year 1 | 3472474 | -6535313 | 3472474 | 0.9434 | 3275919 |
| Year 2 | 3958451 | -2576862 | 7430925 | 0.89 | 3523007 |
| Year 3 | 3970500 | 1393638 | 11401425 | 0.8396 | 3333708 |
| Year 4 | 3247790 | 4641428 | 14649215 | 0.7921 | 2572554 |
| TOTAL | 14649215 | 12705188 |
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. 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 Call Telecommunication 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. Call Telecommunication 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 Call Telecommunication 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 Call Telecommunication 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 | (10007787) | -10007787 | - | - | |
| Year 1 | 3472474 | -6535313 | 3472474 | 0.8696 | 3019543 |
| Year 2 | 3958451 | -2576862 | 7430925 | 0.7561 | 2993158 |
| Year 3 | 3970500 | 1393638 | 11401425 | 0.6575 | 2610668 |
| Year 4 | 3247790 | 4641428 | 14649215 | 0.5718 | 1856934 |
| TOTAL | 10480303 |
(10480303 - 10007787 )
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 | (10007787) | -10007787 | - | - | |
| Year 1 | 3472474 | -6535313 | 3472474 | 0.8333 | 2893728 |
| Year 2 | 3958451 | -2576862 | 7430925 | 0.6944 | 2748924 |
| Year 3 | 3970500 | 1393638 | 11401425 | 0.5787 | 2297743 |
| Year 4 | 3247790 | 4641428 | 14649215 | 0.4823 | 1566257 |
| TOTAL | 9506652 |
At 20% discount rate the NPV is negative (9506652 - 10007787 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Call Telecommunication to discount cash flow at lower discount rates such as 15%.
Simplest Approach – If the investment project of Call Telecommunication has a NPV value higher than Zero then finance managers at Call Telecommunication 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 Call Telecommunication, then the stock price of the Call Telecommunication 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 Call Telecommunication 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 can impact the cash flow of 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.
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.
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.
Gustavo Vinueza (2018), "Saving Costs Using Smart Call Routing:Aligning Business and IT through Finance Harvard Business Review Case Study. Published by HBR Publications.
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