Acquisition of Hummer: M&A Challenges Faced by Chinese Companies Overseas 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 Acquisition of Hummer: M&A Challenges Faced by Chinese Companies Overseas case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Acquisition of Hummer: M&A Challenges Faced by Chinese Companies Overseas case study is a Harvard Business School (HBR) case study written by Dean Xu, Penelope Chan. The Acquisition of Hummer: M&A Challenges Faced by Chinese Companies Overseas (referred as “Tengzhong Hummer” 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, Motivating people, Supply chain.

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 Acquisition of Hummer: M&A Challenges Faced by Chinese Companies Overseas Case Study

In June 2009, Sichuan Tengzhong Heavy Industrial Machinery Company Limited ("Tengzhong"), a little-known manufacturer of construction machinery and special-use vehicles in south-western China, took the global auto industry by surprise when it announced its plan to acquire the money-losing Hummer division of General Motors Corp. Hummer's premium sport-utility vehicles and sport-utility trucks had relatively low fuel efficiency of 9a??16 miles per gallon. Since 2006, Hummer's sales volume had declined sharply due to escalating oil prices, its negative image as a "gas-guzzler" and a shift in customer preferences towards smaller sedans. Tengzhong had no prior experience in the light vehicle industry or in managing a major auto brand. Because this was Tengzhong's first attempt at foreign direct investment, it was imperative for its management to figure out the major obstacles in managing its new Hummer subsidiary in the US. They also had to formulate a sound business plan to get the Chinese government's approval for this acquisition, and to make the investment a big success. (Note: This acquisition was called off in February 2010 because Tengzhong was not able to get the Chinese government's approval. The details are included in Appendix 1 of the teaching note for reference.)

Case Authors : Dean Xu, Penelope Chan

Topic : Leadership & Managing People

Related Areas : Motivating people, Supply chain

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Calculating Net Present Value (NPV) at 6% for Acquisition of Hummer: M&A Challenges Faced by Chinese Companies Overseas Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10021165)	-10021165	-	-
Year 1	3465182	-6555983	3465182	0.9434	3269040
Year 2	3958724	-2597259	7423906	0.89	3523250
Year 3	3958994	1361735	11382900	0.8396	3324048
Year 4	3231414	4593149	14614314	0.7921	2559583
TOTAL			14614314		12675920

The Net Present Value at 6% discount rate is 2654755

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. Profitability Index
2. Net Present Value
3. Payback Period
4. Internal Rate of Return

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 Tengzhong Hummer 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. Tengzhong Hummer 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 Acquisition of Hummer: M&A Challenges Faced by Chinese Companies Overseas

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 Tengzhong Hummer 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 Tengzhong Hummer 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	(10021165)	-10021165	-	-
Year 1	3465182	-6555983	3465182	0.8696	3013202
Year 2	3958724	-2597259	7423906	0.7561	2993364
Year 3	3958994	1361735	11382900	0.6575	2603103
Year 4	3231414	4593149	14614314	0.5718	1847571
TOTAL					10457240

The Net NPV after 4 years is 436075

(10457240 - 10021165 )

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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	(10021165)	-10021165	-	-
Year 1	3465182	-6555983	3465182	0.8333	2887652
Year 2	3958724	-2597259	7423906	0.6944	2749114
Year 3	3958994	1361735	11382900	0.5787	2291084
Year 4	3231414	4593149	14614314	0.4823	1558359
TOTAL					9486209

The Net NPV after 4 years is -534956

At 20% discount rate the NPV is negative (9486209 - 10021165 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Tengzhong Hummer 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 Tengzhong Hummer has a NPV value higher than Zero then finance managers at Tengzhong Hummer 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 Tengzhong Hummer, then the stock price of the Tengzhong Hummer 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 Tengzhong Hummer 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 will be a multi year spillover effect of various taxation regulations.

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 are the key aspects of the projects that need to be monitored, refined, and retuned for continuous delivery of projected cash flows.

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 Acquisition of Hummer: M&A Challenges Faced by Chinese Companies Overseas

References & Further Readings

Dean Xu, Penelope Chan (2018), "Acquisition of Hummer: M&A Challenges Faced by Chinese Companies Overseas Harvard Business Review Case Study. Published by HBR Publications.