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Gorenje D.D.: Evolution or Revolution 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 Gorenje D.D.: Evolution or Revolution case study


At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Gorenje D.D.: Evolution or Revolution case study is a Harvard Business School (HBR) case study written by Lynn Isabella, Hatem Hatem, Nenad Filopovic, Gerry Yemen. The Gorenje D.D.: Evolution or Revolution (referred as “Gorenje Stani” 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, International business, Leadership, Strategic planning.

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 Gorenje D.D.: Evolution or Revolution Case Study


Following a popular leader such as JoA?e Stani, president of Gorenje d.d., Slovenia's largest household appliances manufacturer, is always a challenge. This legendary figure led Gorenje from the brink of bankruptcy in 1991 to its current position as eighth-largest household appliance producer in Europe. Stani's successor, Franjo Bobinac, a young executive who had been Stani's second in command for five years, had to lead the company through the country's accession into the European Union. This meant a changing competitive landscape-and the need for an internal organization willing to change to meet that competitive challenge. Students must put themselves in Bobinac's position as he works toward a clear vision and strategy for the future. How big is his window of opportunity? Would he be able to implement his strategy before the window closed on him? Could the company sustain major change without losing employees or being acquired? What would it take for company employees to follow his leadership as they did with Stani? Was a survival mentality enough to climb to their goal of holding the fifth position in Europe by 2006? Could the organization evolve or would change require nothing less than a revolution?


Case Authors : Lynn Isabella, Hatem Hatem, Nenad Filopovic, Gerry Yemen

Topic : Leadership & Managing People

Related Areas : International business, Leadership, Strategic planning




Calculating Net Present Value (NPV) at 6% for Gorenje D.D.: Evolution or Revolution Case Study


Years              Cash Flow     Net Cash Flow     Cumulative    
Cash Flow
Discount Rate
@ 6 %
Discounted
Cash Flows
Year 0 (10023220) -10023220 - -
Year 1 3452557 -6570663 3452557 0.9434 3257129
Year 2 3982134 -2588529 7434691 0.89 3544085
Year 3 3938967 1350438 11373658 0.8396 3307233
Year 4 3227523 4577961 14601181 0.7921 2556501
TOTAL 14601181 12664947




The Net Present Value at 6% discount rate is 2641727

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. Payback Period
2. Internal Rate of Return
3. Profitability Index
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 Gorenje Stani 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. Gorenje Stani shareholders have preference for diversified projects investment rather than prospective high income from a single capital intensive project.






Formula and Steps to Calculate Net Present Value (NPV) of Gorenje D.D.: Evolution or Revolution

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 Gorenje Stani 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 Gorenje Stani 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 (10023220) -10023220 - -
Year 1 3452557 -6570663 3452557 0.8696 3002223
Year 2 3982134 -2588529 7434691 0.7561 3011065
Year 3 3938967 1350438 11373658 0.6575 2589935
Year 4 3227523 4577961 14601181 0.5718 1845347
TOTAL 10448570


The Net NPV after 4 years is 425350

(10448570 - 10023220 )








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 (10023220) -10023220 - -
Year 1 3452557 -6570663 3452557 0.8333 2877131
Year 2 3982134 -2588529 7434691 0.6944 2765371
Year 3 3938967 1350438 11373658 0.5787 2279495
Year 4 3227523 4577961 14601181 0.4823 1556483
TOTAL 9478479


The Net NPV after 4 years is -544741

At 20% discount rate the NPV is negative (9478479 - 10023220 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Gorenje Stani 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 Gorenje Stani has a NPV value higher than Zero then finance managers at Gorenje Stani 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 Gorenje Stani, then the stock price of the Gorenje Stani 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 Gorenje Stani 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 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.

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 Gorenje D.D.: Evolution or Revolution

References & Further Readings

Lynn Isabella, Hatem Hatem, Nenad Filopovic, Gerry Yemen (2018), "Gorenje D.D.: Evolution or Revolution Harvard Business Review Case Study. Published by HBR Publications.


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