Should You Punish or Reward Current Customers? 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 Should You Punish or Reward Current Customers? case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Should You Punish or Reward Current Customers? case study is a Harvard Business School (HBR) case study written by Jiwoong Shin, K. Sudhir. The Should You Punish or Reward Current Customers? (referred as “Customers Authors” 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.

NPV = Present Value of Future Cash Flows LESS Project’s Initial Investment

---

Case Description of Should You Punish or Reward Current Customers? Case Study

This is an MIT Sloan Management Review article. Is it better to reward existing customers for loyalty -or spend your marketing dollars on attracting new ones? Many companies face that management dilemma, and expert opinions on the subject conflict. The authors argue that the answer to that question depends on how fluid customer preferences are in a market and to what degree some of a company's customers are much more valuable than others. In markets where consumer preferences are highly fluid and where the highest-value customers are much more valuable than others, companies should focus on rewarding their best existing customers. Examples of industries in which this is the case include airlines and car rentals. However, if either or both of those two characteristics -customer shopping flexibility and concentrations in customer value -is not in place, then companies should focus on offering their best prices to new customers. When identifying high-value customers, it's important to remember that revenues and profits may not necessarily be correlated. The authors note that it is not only possible that high-volume customers are not as valuable as they seem, but, in some settings, they may be downright unprofitable. For example, at one bank with which one of the authors worked, about 50% of customers contributed negatively to profits. The authors suggest several approaches to addressing the problem of unprofitable customers, including customer education and selectively increasing prices to those customers.

Case Authors : Jiwoong Shin, K. Sudhir

Topic : Leadership & Managing People

Related Areas :

---

Calculating Net Present Value (NPV) at 6% for Should You Punish or Reward Current Customers? Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10006576)	-10006576	-	-
Year 1	3465226	-6541350	3465226	0.9434	3269081
Year 2	3953592	-2587758	7418818	0.89	3518683
Year 3	3949970	1362212	11368788	0.8396	3316471
Year 4	3244737	4606949	14613525	0.7921	2570136
TOTAL			14613525		12674371

The Net Present Value at 6% discount rate is 2667795

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. 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 Customers Authors 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. Customers Authors 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 Should You Punish or Reward Current Customers?

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 Customers Authors 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 Customers Authors 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	(10006576)	-10006576	-	-
Year 1	3465226	-6541350	3465226	0.8696	3013240
Year 2	3953592	-2587758	7418818	0.7561	2989484
Year 3	3949970	1362212	11368788	0.6575	2597169
Year 4	3244737	4606949	14613525	0.5718	1855189
TOTAL					10455082

The Net NPV after 4 years is 448506

(10455082 - 10006576 )

---

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	(10006576)	-10006576	-	-
Year 1	3465226	-6541350	3465226	0.8333	2887688
Year 2	3953592	-2587758	7418818	0.6944	2745550
Year 3	3949970	1362212	11368788	0.5787	2285862
Year 4	3244737	4606949	14613525	0.4823	1564784
TOTAL					9483885

The Net NPV after 4 years is -522691

At 20% discount rate the NPV is negative (9483885 - 10006576 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Customers Authors 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 Customers Authors has a NPV value higher than Zero then finance managers at Customers Authors 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 Customers Authors, then the stock price of the Customers Authors 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 Customers Authors 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 can impact the cash flow of 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 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.

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 Should You Punish or Reward Current Customers?

References & Further Readings

Jiwoong Shin, K. Sudhir (2018), "Should You Punish or Reward Current Customers? Harvard Business Review Case Study. Published by HBR Publications.