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How to Respond to a New Management Responsibility? 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 to Respond to a New Management Responsibility? case study


At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. How to Respond to a New Management Responsibility? case study is a Harvard Business School (HBR) case study written by Guido Stein Martinez. The How to Respond to a New Management Responsibility? (referred as “Reality Prejudices” 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, Influence, Leadership, Leading teams.

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 to Respond to a New Management Responsibility? Case Study


When starting a new position, there will inevitably be a contrast between what we believed or assumed it was going to be like, what we were certain about and what we have to deal with in reality. While that change may be very beneficial, that clash or disconnect between expectations and objectivity must be addressed so that our arrival does not cause a shock or any worse consequences. When taking on a new role, it is common for us to ask ourselves things like: What do I do now? What are my options for advancing in the right direction? As we illustrate in this paper, there are several different factors to consider when charting the path to follow and deciding how to move forward. These include: developing a plan for learning the key things we did not know before and discarding the beliefs we held that proved to be false. It all boils down to challenging what we believe to be evident by comparing it with contradictory information. When coming from outside the organization, it is important to subject our prejudices to the reality of things; if coming from the inside, we need to look at whether what we bring with us is what will guide us going forward, or if we should renew and round out our repertoire of resources for action.


Case Authors : Guido Stein Martinez

Topic : Leadership & Managing People

Related Areas : Influence, Leadership, Leading teams




Calculating Net Present Value (NPV) at 6% for How to Respond to a New Management Responsibility? Case Study


Years              Cash Flow     Net Cash Flow     Cumulative    
Cash Flow
Discount Rate
@ 6 %
Discounted
Cash Flows
Year 0 (10009152) -10009152 - -
Year 1 3451911 -6557241 3451911 0.9434 3256520
Year 2 3975814 -2581427 7427725 0.89 3538460
Year 3 3961645 1380218 11389370 0.8396 3326274
Year 4 3243970 4624188 14633340 0.7921 2569528
TOTAL 14633340 12690782


The Net Present Value at 6% discount rate is 2681630

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. Payback Period
3. Net Present Value
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. Timing of the expected cash flows – stockholders of Reality Prejudices 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. Reality Prejudices 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 How to Respond to a New Management Responsibility?

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 Reality Prejudices 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 Reality Prejudices 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 (10009152) -10009152 - -
Year 1 3451911 -6557241 3451911 0.8696 3001662
Year 2 3975814 -2581427 7427725 0.7561 3006287
Year 3 3961645 1380218 11389370 0.6575 2604846
Year 4 3243970 4624188 14633340 0.5718 1854750
TOTAL 10467545


The Net NPV after 4 years is 458393

(10467545 - 10009152 )






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 (10009152) -10009152 - -
Year 1 3451911 -6557241 3451911 0.8333 2876593
Year 2 3975814 -2581427 7427725 0.6944 2760982
Year 3 3961645 1380218 11389370 0.5787 2292619
Year 4 3243970 4624188 14633340 0.4823 1564415
TOTAL 9494608


The Net NPV after 4 years is -514544

At 20% discount rate the NPV is negative (9494608 - 10009152 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Reality Prejudices 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 Reality Prejudices has a NPV value higher than Zero then finance managers at Reality Prejudices 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 Reality Prejudices, then the stock price of the Reality Prejudices 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 Reality Prejudices 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.

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.




References & Further Readings

Guido Stein Martinez (2018), "How to Respond to a New Management Responsibility? Harvard Business Review Case Study. Published by HBR Publications.