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. Leading in the Age of Super-Transparency case study is a Harvard Business School (HBR) case study written by Robert Austin, David M. Upton. The Leading in the Age of Super-Transparency (referred as “Transparency Information” 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, .

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 is an MIT Sloan Management Review article. When Martha Payne, a 9-year-old student in Argyll, Scotland, started a blog in April 2012 to photograph and rate her school lunches, she had no idea of the stir she would cause. The blog logged 2 million hits in its first six weeks. When the local area council asked her to stop, an online firestorm ensued and the council reversed its decision. It's a familiar story -every day, images or events with the potential to incite passions get captured digitally, posted to the Web, and "go viral."With social media, people share their experiences with friends or followers, who share with more people. Seemingly insignificant occurrences can strike a nerve with a nascent virtual community, and unsuspecting parties must respond to a dicey new problem. The capacity to generate causes and controversies almost instantly may be the most salient aspect of what authors Robert D. Austin and David M. Upton call the "super-transparent society." Historically, the authors explain, people in a particular community were the only ones who paid attention to the local goings-on. When information moved outside of that environment, it was due to deliberate action: some identifiable person or organization moving it. If you wanted to guard information, you built a barrier. Many things have changed, particularly the volume of information. The article suggests several steps that can help managers meet the new expectations for transparency, including the following: Examine your assumptions about how you can keep information contained. Review your strategy for dealing with vulnerability to unintended transparency. Review operations for issues that might be problematic if revealed. Assume that others will put out information about your organization for their own reasons and that you won't be able to prevent it. Recognize that new information flows change what people consider to be fair.

Years | Cash Flow | Net Cash Flow | Cumulative Cash Flow |
Discount Rate @ 6 % |
Discounted Cash Flows |
---|---|---|---|---|---|

Year 0 | (10024333) | -10024333 | - | - | |

Year 1 | 3472696 | -6551637 | 3472696 | 0.9434 | 3276128 |

Year 2 | 3964307 | -2587330 | 7437003 | 0.89 | 3528219 |

Year 3 | 3964643 | 1377313 | 11401646 | 0.8396 | 3328791 |

Year 4 | 3247167 | 4624480 | 14648813 | 0.7921 | 2572060 |

TOTAL | 14648813 | 12705199 |

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 -

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

There are four types of capital budgeting techniques that are widely used in the corporate world –

1. Net Present Value

2. Internal Rate of Return

3. Profitability Index

4. Payback Period

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. Transparency Information 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 Transparency Information have higher preference for cash returns over 4-5 years rather than 10-15 years given the nature of the volatility in the industry.

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 Transparency Information 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 Transparency Information 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 | (10024333) | -10024333 | - | - | |

Year 1 | 3472696 | -6551637 | 3472696 | 0.8696 | 3019736 |

Year 2 | 3964307 | -2587330 | 7437003 | 0.7561 | 2997586 |

Year 3 | 3964643 | 1377313 | 11401646 | 0.6575 | 2606817 |

Year 4 | 3247167 | 4624480 | 14648813 | 0.5718 | 1856578 |

TOTAL | 10480717 |

(10480717 - 10024333 )

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 | (10024333) | -10024333 | - | - | |

Year 1 | 3472696 | -6551637 | 3472696 | 0.8333 | 2893913 |

Year 2 | 3964307 | -2587330 | 7437003 | 0.6944 | 2752991 |

Year 3 | 3964643 | 1377313 | 11401646 | 0.5787 | 2294354 |

Year 4 | 3247167 | 4624480 | 14648813 | 0.4823 | 1565956 |

TOTAL | 9507214 |

At 20% discount rate the NPV is negative (9507214 - 10024333 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Transparency Information to discount cash flow at lower discount rates such as 15%.

Simplest Approach – If the investment project of Transparency Information has a NPV value higher than Zero then finance managers at Transparency Information 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 Transparency Information, then the stock price of the Transparency Information 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 Transparency Information 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 will be a multi year spillover effect of various taxation regulations.

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 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.

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.

** Robert Austin, David M. Upton (2018)**, "Leading in the Age of Super-Transparency Harvard Business Review Case Study. Published by HBR Publications.

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