Which Way Should You Downsize in a Crisis? 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 Which Way Should You Downsize in a Crisis? case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Which Way Should You Downsize in a Crisis? case study is a Harvard Business School (HBR) case study written by Christopher Zatzick, Mitchell Lee Marks, Roderick Iverson. The Which Way Should You Downsize in a Crisis? (referred as “Downsizing Quadrants” 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, Leadership, Operations management.

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 Which Way Should You Downsize in a Crisis? Case Study

This is an MIT Sloan Management Review article. The recent economic downturn has left many organizations in a quandary. Just several years ago, the major issue was winning the so-called "war for talent": how to attract, motivate and retain the best and the brightest. But then the current recession turned that thinking upside down. Now, many organizations are scrambling to figure out how best to restructure and cut costs without jeopardizing the valuable human capital that they built during the prior period of growth. To help such companies, the authors have developed a framework that integrates the seemingly paradoxical practices of talent management and downsizing. The framework looks at two important dimensions. The first is the type of downsizing, either reactive or proactive. The second dimension of the framework is the approach to managing employees, either control-oriented or commitment-oriented. Those two dimensions -type of downsizing and approach to talent management -can be combined to form a two-by-two matrix consisting of four quadrants. Each quadrant represents a different strategy, with a distinct philosophy, focus and key HR and downsizing best practices. The authors contend that there is no "one size fits all" approach to downsizing and that managers need to devise the approach that makes the best sense for their particular company, depending on its position in the matrix's quadrants.

Case Authors : Christopher Zatzick, Mitchell Lee Marks, Roderick Iverson

Topic : Leadership & Managing People

Related Areas : Leadership, Operations management

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Calculating Net Present Value (NPV) at 6% for Which Way Should You Downsize in a Crisis? Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10007803)	-10007803	-	-
Year 1	3454961	-6552842	3454961	0.9434	3259397
Year 2	3977849	-2574993	7432810	0.89	3540271
Year 3	3974167	1399174	11406977	0.8396	3336787
Year 4	3247852	4647026	14654829	0.7921	2572603
TOTAL			14654829		12709059

The Net Present Value at 6% discount rate is 2701256

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

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Formula and Steps to Calculate Net Present Value (NPV) of Which Way Should You Downsize in a Crisis?

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 Downsizing Quadrants 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 Downsizing Quadrants 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	(10007803)	-10007803	-	-
Year 1	3454961	-6552842	3454961	0.8696	3004314
Year 2	3977849	-2574993	7432810	0.7561	3007825
Year 3	3974167	1399174	11406977	0.6575	2613079
Year 4	3247852	4647026	14654829	0.5718	1856970
TOTAL					10482188

The Net NPV after 4 years is 474385

(10482188 - 10007803 )

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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	(10007803)	-10007803	-	-
Year 1	3454961	-6552842	3454961	0.8333	2879134
Year 2	3977849	-2574993	7432810	0.6944	2762395
Year 3	3974167	1399174	11406977	0.5787	2299865
Year 4	3247852	4647026	14654829	0.4823	1566287
TOTAL					9507681

The Net NPV after 4 years is -500122

At 20% discount rate the NPV is negative (9507681 - 10007803 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Downsizing Quadrants 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 Downsizing Quadrants has a NPV value higher than Zero then finance managers at Downsizing Quadrants 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 Downsizing Quadrants, then the stock price of the Downsizing Quadrants 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 Downsizing Quadrants 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 can impact the cash flow of the project.

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.

Understanding of risks involved in 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.

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 Which Way Should You Downsize in a Crisis?

References & Further Readings

Christopher Zatzick, Mitchell Lee Marks, Roderick Iverson (2018), "Which Way Should You Downsize in a Crisis? Harvard Business Review Case Study. Published by HBR Publications.