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Introduction to Net Present Value (NPV) - What is Net Present Value (NPV) ? How it impacts financial decisions regarding project management?

NPV solution for Sumeru Software Solutions: Creating a Culture of Serene Dynamism case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Sumeru Software Solutions: Creating a Culture of Serene Dynamism case study is a Harvard Business School (HBR) case study written by Amit Gupta, Kshitij Saxena. The Sumeru Software Solutions: Creating a Culture of Serene Dynamism (referred as “Sumeru Aol” 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, Firing, International business, Leadership, Motivating people, Organizational culture, Social responsibility, Strategy, Work-life balance.
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 Sumeru Software Solutions: Creating a Culture of Serene Dynamism Case Study

Sumeru Software Solutions was a software-development-consultancy organization headquartered in Bangalore, India, with offices in Washington D.C., Dubai and London. It began operations in July 2001 as a single project with two employees, and grew to an organization with approximately 200 employees over a period of 10 years. The founding objective of Sumeru Software Solutions was to support Art of Living's (AOL) social development initiatives through profits earned from delivering high quality services. The Art of Living (AOL) was founded in 1981 by Sri Sri Ravi Shankarji as a not-for-profit, educational and humanitarian non-governmental organization engaged in stress-management and service initiatives. Art of Living offered stress-elimination programs, which included breathing techniques, meditation and yoga that were intended to help individuals get rid of stress and experience inner peace. Sumeru had developed a unique culture that combined corporate culture with the Art of Living principles of Seva, Satsang, Sadhana and smiling even in the face of adversity. The organizational culture was based on the AOL values of a stress free mind. In line with the AOL principles, the four pillars of Sumeru culture were ethics, caring, sharing and trust. It purported to follow a peaceful yet aggressive way of doing business called 'Serene Dynamism.' Sumeru tried to balance happiness, productivity and profitability. Harish Ramachandran, CEO of Sumeru Software Solutions, had created an enterprise that was different from other IT organizations. He was wondering how he would sustain the culture of the organization and make Sumeru a high performance company over the next 10 years as it expanded its business and hired new employees.

Case Authors : Amit Gupta, Kshitij Saxena

Topic : Leadership & Managing People

Related Areas : Firing, International business, Leadership, Motivating people, Organizational culture, Social responsibility, Strategy, Work-life balance

Calculating Net Present Value (NPV) at 6% for Sumeru Software Solutions: Creating a Culture of Serene Dynamism Case Study

Years	Cash Flow	Net Cash Flow	Cumulative Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10021935)	-10021935	-	-
Year 1	3451777	-6570158	3451777	0.9434	3256393
Year 2	3968134	-2602024	7419911	0.89	3531625
Year 3	3936880	1334856	11356791	0.8396	3305480
Year 4	3237336	4572192	14594127	0.7921	2564273
TOTAL	14594127	12657772

The Net Present Value at 6% discount rate is 2635837

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,

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How it is calculated,
How to use NPV number for project evaluation, and
Scenario Planning given risks and management priorities.

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. Payback Period
3. Internal Rate of Return
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. Magnitude of both incoming and outgoing cash flows – Projects can be capital intensive, time intensive, or both. Sumeru Aol 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 Sumeru Aol have higher preference for cash returns over 4-5 years rather than 10-15 years given the nature of the volatility in the industry.

Formula and Steps to Calculate Net Present Value (NPV) of Sumeru Software Solutions: Creating a Culture of Serene Dynamism

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 Sumeru Aol 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 Sumeru Aol 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	(10021935)	-10021935	-	-
Year 1	3451777	-6570158	3451777	0.8696	3001545
Year 2	3968134	-2602024	7419911	0.7561	3000479
Year 3	3936880	1334856	11356791	0.6575	2588563
Year 4	3237336	4572192	14594127	0.5718	1850957
TOTAL	10441544

The Net NPV after 4 years is 419609

(10441544 - 10021935 )

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%.

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Years	Cash Flow	Net Cash Flow	Cumulative Cash Flow	Discount Rate @ 20 %	Discounted Cash Flows
Year 0	(10021935)	-10021935	-	-
Year 1	3451777	-6570158	3451777	0.8333	2876481
Year 2	3968134	-2602024	7419911	0.6944	2755649
Year 3	3936880	1334856	11356791	0.5787	2278287
Year 4	3237336	4572192	14594127	0.4823	1561215
TOTAL	9471632

The Net NPV after 4 years is -550303

At 20% discount rate the NPV is negative (9471632 - 10021935 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Sumeru Aol 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 Sumeru Aol has a NPV value higher than Zero then finance managers at Sumeru Aol 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 Sumeru Aol, then the stock price of the Sumeru Aol 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 Sumeru Aol 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 –

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Understanding of risks involved in the project.

What will be a multi year spillover effect of various taxation regulations.

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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.

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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References & Further Readings

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Amit Gupta, Kshitij Saxena (2018), 'Sumeru Software Solutions: Creating a Culture of Serene Dynamism Harvard Business Review Case Study. Published by HBR Publications.