A Manager's Guide to Human Irrationalities 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 A Manager's Guide to Human Irrationalities case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. A Manager's Guide to Human Irrationalities case study is a Harvard Business School (HBR) case study written by Alden M. Hayashi. The A Manager's Guide to Human Irrationalities (referred as “Ariely Decisions” 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, Product development, Supply chain.

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 A Manager's Guide to Human Irrationalities Case Study

This is an MIT Sloan Management Review article. Dan Ariely is one of the world's foremost experts in behavioral economics, the study of how people behave when making business and financial decisions. Ariely's insights should make executives think twice about the wisdom of the decisions they regularly make -- as well as the inner processes they rely on to make those decisions. Why, for example, will managers veto a 10% cost increase for a $1 million project while thinking nothing of a 1% overrun on a $10 million budget -- even though the actual amount is the same? Why will they often agonize trying to choose between two close alternatives when they're frequently better off just flipping a coin? In this wide-ranging interview, Ariely talks about how Apple Inc.'s initial decision to price the iPhone at $600 only to drop it to $400 soon after might not have been a mistake but instead a very shrewd marketing maneuver. He also explains why a product monopoly might not necessarily be desirable because it can lead to consumer confusion, resulting in slow sales. With regards to hiring practices, Ariely strongly questions the interviewing processes routinely used and asserts that some companies might be better off hiring graduates from reputable colleges at random. Toward the end of the interview, he describes his research that has investigated ways in which teams might be better able to make group decisions. Lastly, Ariely explains one of his most valuable managerial insights -- that adding even just a little meaning to employees' work will often increase their motivation enormously.

Case Authors : Alden M. Hayashi

Topic : Leadership & Managing People

Related Areas : Product development, Supply chain

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Calculating Net Present Value (NPV) at 6% for A Manager's Guide to Human Irrationalities Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10026744)	-10026744	-	-
Year 1	3465542	-6561202	3465542	0.9434	3269379
Year 2	3974506	-2586696	7440048	0.89	3537296
Year 3	3974505	1387809	11414553	0.8396	3337071
Year 4	3240375	4628184	14654928	0.7921	2566681
TOTAL			14654928		12710427

The Net Present Value at 6% discount rate is 2683683

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. Net Present Value
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. Ariely Decisions 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 Ariely Decisions 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 A Manager's Guide to Human Irrationalities

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 Ariely Decisions 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 Ariely Decisions 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	(10026744)	-10026744	-	-
Year 1	3465542	-6561202	3465542	0.8696	3013515
Year 2	3974506	-2586696	7440048	0.7561	3005298
Year 3	3974505	1387809	11414553	0.6575	2613302
Year 4	3240375	4628184	14654928	0.5718	1852695
TOTAL					10484809

The Net NPV after 4 years is 458065

(10484809 - 10026744 )

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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	(10026744)	-10026744	-	-
Year 1	3465542	-6561202	3465542	0.8333	2887952
Year 2	3974506	-2586696	7440048	0.6944	2760074
Year 3	3974505	1387809	11414553	0.5787	2300061
Year 4	3240375	4628184	14654928	0.4823	1562681
TOTAL					9510767

The Net NPV after 4 years is -515977

At 20% discount rate the NPV is negative (9510767 - 10026744 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Ariely Decisions 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 Ariely Decisions has a NPV value higher than Zero then finance managers at Ariely Decisions 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 Ariely Decisions, then the stock price of the Ariely Decisions 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 Ariely Decisions 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.

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.

Understanding of risks involved in the project.

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 A Manager's Guide to Human Irrationalities

References & Further Readings

Alden M. Hayashi (2018), "A Manager's Guide to Human Irrationalities Harvard Business Review Case Study. Published by HBR Publications.