Margaret Jefferson: Performance Issue at a Performing Arts Company A 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 Margaret Jefferson: Performance Issue at a Performing Arts Company A case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Margaret Jefferson: Performance Issue at a Performing Arts Company A case study is a Harvard Business School (HBR) case study written by Lyn Purdy, James O Brien. The Margaret Jefferson: Performance Issue at a Performing Arts Company A (referred as “Arts Manager's” 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, Organizational culture, Strategy.

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 Margaret Jefferson: Performance Issue at a Performing Arts Company A Case Study

This case series describes a general manager's decision of whether to fire an employee at a performing arts company. The scope of the case includes the organization of the company, the decision to hire the employee, his performance, and the decision to end the employment relationship. The general manager's selection practices are described, and two role-playing exercises are included.

Case Authors : Lyn Purdy, James O Brien

Topic : Leadership & Managing People

Related Areas : Organizational culture, Strategy

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Calculating Net Present Value (NPV) at 6% for Margaret Jefferson: Performance Issue at a Performing Arts Company A Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10000472)	-10000472	-	-
Year 1	3450207	-6550265	3450207	0.9434	3254912
Year 2	3964318	-2585947	7414525	0.89	3528229
Year 3	3961443	1375496	11375968	0.8396	3326104
Year 4	3222437	4597933	14598405	0.7921	2552472
TOTAL			14598405		12661717

The Net Present Value at 6% discount rate is 2661245

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. Payback Period
2. Profitability Index
3. Net Present Value
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. Magnitude of both incoming and outgoing cash flows – Projects can be capital intensive, time intensive, or both. Arts Manager's 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 Arts Manager's have higher preference for cash returns over 4-5 years rather than 10-15 years given the nature of the volatility in the industry.

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Formula and Steps to Calculate Net Present Value (NPV) of Margaret Jefferson: Performance Issue at a Performing Arts Company A

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 Arts Manager's 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 Arts Manager's 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	(10000472)	-10000472	-	-
Year 1	3450207	-6550265	3450207	0.8696	3000180
Year 2	3964318	-2585947	7414525	0.7561	2997594
Year 3	3961443	1375496	11375968	0.6575	2604713
Year 4	3222437	4597933	14598405	0.5718	1842439
TOTAL					10444926

The Net NPV after 4 years is 444454

(10444926 - 10000472 )

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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	(10000472)	-10000472	-	-
Year 1	3450207	-6550265	3450207	0.8333	2875173
Year 2	3964318	-2585947	7414525	0.6944	2752999
Year 3	3961443	1375496	11375968	0.5787	2292502
Year 4	3222437	4597933	14598405	0.4823	1554030
TOTAL					9474703

The Net NPV after 4 years is -525769

At 20% discount rate the NPV is negative (9474703 - 10000472 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Arts Manager's 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 Arts Manager's has a NPV value higher than Zero then finance managers at Arts Manager's 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 Arts Manager's, then the stock price of the Arts Manager's 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 Arts Manager's 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 key aspects of the projects that need to be monitored, refined, and retuned for continuous delivery of projected cash flows.

Understanding of risks involved in the project.

What will be a multi year spillover effect of various taxation regulations.

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 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.

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Negotiation Strategy of Margaret Jefferson: Performance Issue at a Performing Arts Company A

References & Further Readings

Lyn Purdy, James O Brien (2018), "Margaret Jefferson: Performance Issue at a Performing Arts Company A Harvard Business Review Case Study. Published by HBR Publications.