Introduction to Net Present Value (NPV) - What is Net Present Value (NPV) ?

How it
impacts financial decisions regarding project management?

NPV solution for Black River Farms case study

At Oak Spring University, we provide corporate level professional Net Present Value
(NPV) case study solution. Black River Farms case study is a Harvard Business School
(HBR) case study written by David Currie, Kyle S. Meyer. The Black River Farms
(referred as “Cow Calf” from here on) case study provides evaluation & decision
scenario in field of Innovation & Entrepreneurship. It also touches upon business
topics such as - Value proposition, .

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

Case Description of Black River Farms Case Study

In 2016, the owner of a cow-calf operation must decide what the appropriate weight
for cows in their herd is. For decades, the national trend has been for cow weights to
increase because they produce larger calves, but evidence indicates that cow weights
may have reached the point where the cost of maintaining a larger cow has become
greater than the return from producing a larger calf. Analyzing this issue introduces
marginal principles from economics. Formerly "Old Mule Farms," product no.
9B10B004. The authors David M. Currie and Kyle S. Meyer are affiliated with Rollins
College.
Calculating Net Present Value (NPV) at 6% for Black
River Farms Case Study

Discount
Cumulative     Rate Discounted
Years Cash Flow     Net Cash Flow Cash Flow @6% Cash Flows
Year 0 (10027495) -10027495 - -
Year 1 3472131 -6555364 3472131 0.9434 3275595
Year 2 3959131 -2596233 7431262 0.89 3523612
Year 3 3938306 1342073 11369568 0.8396 3306678
Year 4 3238222 4580295 14607790 0.7921 2564975
TOTAL 14607790 1267086
The Net Present Value at 6% discount rate is 2643366

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.

Formula and Steps to Calculate Net Present Value (NPV)

of Black River Farms
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 Innovation & Entrepreneurship 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 Cow Calf 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 Cow Calf 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.

Cumulative     Discount Rate Discounted

Years Cash Flow     Net Cash Flow Cash Flow @ 15 % Cash Flows
Year 0 (10027495) -10027495 - -
Year 1 3472131 -6555364 3472131 0.8696 3019244
Year 2 3959131 -2596233 7431262 0.7561 2993672
Year 3 3938306 1342073 11369568 0.6575 2589500
Year 4 3238222 4580295 14607790 0.5718 1851464
TOTAL 10453880

The Net NPV after 4 years is 426385

(10453880 - 10027495 )

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%.

Cumulative     Discount Rate Discounted

Years Cash Flow Net Cash Flow Cash Flow @ 20 % Cash Flows
Year 0 (10027495) -10027495 - -
Year 1 3472131 -6555364 3472131 0.8333 2893443
Year 2 3959131 -2596233 7431262 0.6944 2749397
Year 3 3938306 1342073 11369568 0.5787 2279112
Year 4 3238222 4580295 14607790 0.4823 1561643
TOTAL 9483594

The Net NPV after 4 years is -543901

At 20% discount rate the NPV is negative (9483594 - 10027495 ) so ideally we can't
select the project if macro and micro factors don't allow financial managers of Cow
Calf 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 Cow Calf has a NPV value higher
than Zero then finance managers at Cow Calf 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 Cow Calf, then the stock price of the Cow Calf 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 Cow Calf 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.

References & Further Readings

David Currie, Kyle S. Meyer (2018), "Black River Farms Harvard Business Review
Case Study. Published by HBR Publications.

Case Study Solution & Analysis

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