Decision-making by NPV: a deconstruction of the Flextronics case

Click the image above, or this link, to watch the 2:25 minute video | Courtesy of Stanford School of Business

The Flextronics case is a common scenario about how a financial decision today can impact your cash flows into the future. Michael Marks is in a pickle. He has a pretty big client ($1B or $1000 mil of annual revenue) that wants to skip on a $100 mil payment at t = 0. If he allows them to not pay the $100 mil, his company eats the full cost and he preserves the business relationship. If he enforces the contractual obligation they have, he collects the $100 mil but potentially loses all future business with this customer. What does he do?

Economic losses

Most of you will face a similar situation: accept payment from a patient-customer today and lose them *forever* or write-off the payment and salvage the entrepreneur-customer relationship for future business. 

It is probably obvious to you that Michael Marks will lose money over a long horizon if he accepts the $100 mil today (t = 0). Losing a $1B (or $1000 mil) a year is so consequential that one ought to forgo the $100 mil in t = 0. The bigger question is how much will Marks lose (in terms of economic value) if he sticks to his guns and enforces the contract.

Known knowns and known unknowns

To understand what happens if Marks enforces the contract, we have to calculate the cash flows at each point in the horizon. Here's what we know about the cash flows if Marks enforces the contract:

1. he collects the $100 mil at t = 0

2. he forgoes $1B ($1000 mil) each year thereafter

Here's what we don't know:

1. how many years in the horizon will he lose $1B each year

2. what is the opportunity cost or rate of return in the marketplace

Since we have 2 unknown variables, we know that our calculations will result in a sensitivity analysis.

The cash flows

There are two cash flows happening at each point in time: one positive and one negative.

Positive cash flow: the return on a $100 mil investment.

When Marks enforces the contract, he comes into a +$100 mil cash flow at t = 0. He doesn't tell us what he will do with that cash; let's assume he invests all of it in the market place. Therefore, he will collect a return for the time within the horizon. His return and the horizon are the two unknowns, so we will perform a sensitivity analysis using those two variables.

Negative cash flow: the loss of $1B ($1000 mil) each year

Unlike the positive cash flow above, this cash flow has 2 key features:

• it is negative each year for the horizon period, and

• it is an economic loss, not an accounting loss.

You won't see the loss of $1B each year on the income statement of Flextronics. The loss isn't an accounting loss but rather an economic loss - the opportunity cost of enforcing the contract. Each year's loss of $1B must be discounted back to t = 0 (because $1B lost at t = 1 ≠ $1B lost at t = 0), for which we need the rate of return. We also need to know the number of years in the horizon for which the client will forgo any further business with Flextronics. Once again, both unknowns are the same for the negative and positive cash flows.

∑ (discounted positive + negative cash flows) = net present value (NPV)

The sum of the cash flows coming in (from the $100 mil investment) and lost (opportunity cost of losing $1000 mil each year) is summed in the chart and displayed in the graph below. As predicted earlier, enforcing the contract results in an accounting gain of $100 mil at t = 0, and then huge opportunity losses each year no matter what the rate of return is. I extended the horizon to 4 years:  the trend will remain linear at returns close to 5% and parabolic as the returns increase.

The net present value gives us a quantitative assessment of the cost of decisions that we make. Some of those costs will show on an income statement; others will be hidden. Knowing what your costs will be can help you determine what action to take and how to mitigate losses as a result of that decision.