Introduction to Net Present Value (NPV) - What is Net Present Value (NPV) ? How it impacts financial decisions regarding project management?
At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. REPUTATION: A BRIDGE TO THE ADVERTISING FUTURE case study is a Harvard Business School (HBR) case study written by Benoit Leleux, Barbara Scheel Agersnap. The REPUTATION: A BRIDGE TO THE ADVERTISING FUTURE (referred as “Bergsa Carsten” 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, Public relations, 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.
Seven years earlier, in early 2001, Alexander had started REPUTATION with his two partners, Carsten and Mikkel. Prior to launching the company, the three founders had worked together as a team at a Danish mid-sized advertising agency called BergsA?e. Their work had primarily involved international medical companies. Thanks to Carsten and Mikkel's award-winning creative minds, their customers were in for the long term. BergsA?e's healthcare department had quickly grown to 12 employees. But as the employee count mounted, so did the frustration of the three friends. They had found a uniquely successful formula, but personal satisfaction had been running low. They wanted more out of their jobs: better processes, better results for their clients, and better rewards for themselves. Somehow, they believed they knew exactly how to accomplish just that. What was needed was the ability to offer a one-stop, full-solution agency which would take care of every building block of a corporate reputation, centered on the concept of Corporate Identity. The three had been playing around with the idea of going independent in that new niche market for some time. After a couple of months of research and analysis, they were convinced they could make a robust case for that new concept, REPUTATION. Running an advertising agency in Denmark proved a challenge; balancing the leadership of creative souls and the pragmatism of account directors was a permanent juggling act, all that in a market that was small and treacherously competitive. Learning objectives: Managing and growing a service business, entrepreneurship in a creative services industry, service positioning, segmentation.
| Years | Cash Flow | Net Cash Flow | Cumulative Cash Flow |
Discount Rate @ 6 % |
Discounted Cash Flows |
|---|---|---|---|---|---|
| Year 0 | (10020572) | -10020572 | - | - | |
| Year 1 | 3463957 | -6556615 | 3463957 | 0.9434 | 3267884 |
| Year 2 | 3971664 | -2584951 | 7435621 | 0.89 | 3534767 |
| Year 3 | 3938691 | 1353740 | 11374312 | 0.8396 | 3307001 |
| Year 4 | 3228766 | 4582506 | 14603078 | 0.7921 | 2557485 |
| TOTAL | 14603078 | 12667137 |
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 -
Capital Budgeting Approaches
There are four types of capital budgeting techniques that are widely used in the corporate world –
1. Internal Rate of Return
2. Net Present Value
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. Timing of the expected cash flows – stockholders of Bergsa Carsten 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. Bergsa Carsten shareholders have preference for diversified projects investment rather than prospective high income from a single capital intensive project.
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
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 Bergsa Carsten 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 Bergsa Carsten 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.
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 | (10020572) | -10020572 | - | - | |
| Year 1 | 3463957 | -6556615 | 3463957 | 0.8696 | 3012137 |
| Year 2 | 3971664 | -2584951 | 7435621 | 0.7561 | 3003149 |
| Year 3 | 3938691 | 1353740 | 11374312 | 0.6575 | 2589753 |
| Year 4 | 3228766 | 4582506 | 14603078 | 0.5718 | 1846057 |
| TOTAL | 10451096 |
(10451096 - 10020572 )
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 | (10020572) | -10020572 | - | - | |
| Year 1 | 3463957 | -6556615 | 3463957 | 0.8333 | 2886631 |
| Year 2 | 3971664 | -2584951 | 7435621 | 0.6944 | 2758100 |
| Year 3 | 3938691 | 1353740 | 11374312 | 0.5787 | 2279335 |
| Year 4 | 3228766 | 4582506 | 14603078 | 0.4823 | 1557082 |
| TOTAL | 9481148 |
At 20% discount rate the NPV is negative (9481148 - 10020572 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Bergsa Carsten to discount cash flow at lower discount rates such as 15%.
Simplest Approach – If the investment project of Bergsa Carsten has a NPV value higher than Zero then finance managers at Bergsa Carsten 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 Bergsa Carsten, then the stock price of the Bergsa Carsten 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.
Project selection is often a far more complex decision than just choosing it based on the NPV number. Finance managers at Bergsa Carsten 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 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.
What can impact the cash flow of the project.
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.
Benoit Leleux, Barbara Scheel Agersnap (2018), "REPUTATION: A BRIDGE TO THE ADVERTISING FUTURE Harvard Business Review Case Study. Published by HBR Publications.
Feel free to connect with us if you need business research.
You can download Excel Template of Case Study Solution & Analysis of REPUTATION: A BRIDGE TO THE ADVERTISING FUTURE
Healthcare , Major Drugs
Services , Real Estate Operations
Financial , Insurance (Accident & Health)
Capital Goods , Construction Services
Capital Goods , Misc. Capital Goods
Consumer Cyclical , Furniture & Fixtures
Financial , Misc. Financial Services
Services , Communications Services
Capital Goods , Construction Services
Basic Materials , Misc. Fabricated Products
Technology , Electronic Instr. & Controls