Jia Wu Goes West 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 Jia Wu Goes West case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Jia Wu Goes West case study is a Harvard Business School (HBR) case study written by Ines Alegre Tort-Martorell, Miguel Angel Canela Campos, Burcin Guclu. The Jia Wu Goes West (referred as “Jia Seasonals” 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, Sales.

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 Jia Wu Goes West Case Study

The objective of this case is to illustrate forecasting with monthly sales data. It is based on historical data for household goods sales in the United Kingdom from January 1997 to December 2011. Students are challenged to develop a model for this data and to calculate a forecast for 2012 sales based on that model. There is a companion IESE focus case, ADFC-003 "The Jia Wu Expansion," which describes Jia Wu's earlier expansion to Australia. The purpose and the content of the two cases are the same, although the methods used in the present case are more complex. While in the first case, the forecasts were based on a linear trend plus a set of multiplicative seasonals, here we discuss two alternatives: (a) a quadratic trend plus a set of additive seasonals and (b) an additive Holt-Winters model. This case can be used in many ways: (a) in one session, skipping one of the two models discussed in this note; (b) in two sessions, including both models; or (c) combined with the companion case, using one case for the quadratic trend and the other for the Holt-Winters method. Basic knowledge of Excel or an analogous spreadsheet application is required. The calculations are assumed to be performed using standard spreadsheet functions.

Case Authors : Ines Alegre Tort-Martorell, Miguel Angel Canela Campos, Burcin Guclu

Topic : Leadership & Managing People

Related Areas : Sales

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Calculating Net Present Value (NPV) at 6% for Jia Wu Goes West Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10016054)	-10016054	-	-
Year 1	3464264	-6551790	3464264	0.9434	3268174
Year 2	3959304	-2592486	7423568	0.89	3523766
Year 3	3960158	1367672	11383726	0.8396	3325025
Year 4	3243848	4611520	14627574	0.7921	2569431
TOTAL			14627574		12686397

The Net Present Value at 6% discount rate is 2670343

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. Net Present Value
2. Internal Rate of Return
3. Payback Period
4. Profitability Index

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. Jia Seasonals 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 Jia Seasonals 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 Jia Wu Goes West

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 Jia Seasonals 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 Jia Seasonals 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	(10016054)	-10016054	-	-
Year 1	3464264	-6551790	3464264	0.8696	3012403
Year 2	3959304	-2592486	7423568	0.7561	2993803
Year 3	3960158	1367672	11383726	0.6575	2603868
Year 4	3243848	4611520	14627574	0.5718	1854681
TOTAL					10464755

The Net NPV after 4 years is 448701

(10464755 - 10016054 )

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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	(10016054)	-10016054	-	-
Year 1	3464264	-6551790	3464264	0.8333	2886887
Year 2	3959304	-2592486	7423568	0.6944	2749517
Year 3	3960158	1367672	11383726	0.5787	2291758
Year 4	3243848	4611520	14627574	0.4823	1564356
TOTAL					9492517

The Net NPV after 4 years is -523537

At 20% discount rate the NPV is negative (9492517 - 10016054 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Jia Seasonals 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 Jia Seasonals has a NPV value higher than Zero then finance managers at Jia Seasonals 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 Jia Seasonals, then the stock price of the Jia Seasonals 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 Jia Seasonals 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 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 are the key aspects of the projects that need to be monitored, refined, and retuned for continuous delivery of projected cash flows.

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 Jia Wu Goes West

References & Further Readings

Ines Alegre Tort-Martorell, Miguel Angel Canela Campos, Burcin Guclu (2018), "Jia Wu Goes West Harvard Business Review Case Study. Published by HBR Publications.