Delusion and Deception in Large Infrastructure Projects: Two Models for Explaining and Preventing Executive Disaster 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 Delusion and Deception in Large Infrastructure Projects: Two Models for Explaining and Preventing Executive Disaster case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Delusion and Deception in Large Infrastructure Projects: Two Models for Explaining and Preventing Executive Disaster case study is a Harvard Business School (HBR) case study written by Bent Flyvbjerg, Massimo Garbuio, Dan Lovallo. The Delusion and Deception in Large Infrastructure Projects: Two Models for Explaining and Preventing Executive Disaster (referred as “Delusion Deception” from here on) case study provides evaluation & decision scenario in field of Organizational Development. It also touches upon business topics such as - Value proposition, International business, Strategic planning.

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 Delusion and Deception in Large Infrastructure Projects: Two Models for Explaining and Preventing Executive Disaster Case Study

"Over budget, over time, over and over again" appears to be an appropriate slogan for large, complex infrastructure projects. This article explains why cost, benefits, and time forecasts for such projects are systematically over-optimistic in the planning phase. The underlying reasons for forecasting errors are grouped into three categories: delusions or honest mistakes; deceptions or strategic manipulation of information or processes; or bad luck. Delusion and deception have each been addressed in the management literature before, but here they are jointly considered for the first time. They are specifically applied to infrastructure problems in a manner that allows both academics and practitioners to understand and implement the suggested corrective procedures. The article provides a framework for analyzing the relative explanatory power of delusion and deception. It also suggests a simplified framework for analyzing the complex principal-agent relationships that are involved in the approval and construction of large infrastructure projects, which can be used to improve forecasts. Finally, the article illustrates reference class forecasting, an outside view de-biasing technique that has proven successful in overcoming both delusion and deception in private and public investment decisions.

Case Authors : Bent Flyvbjerg, Massimo Garbuio, Dan Lovallo

Topic : Organizational Development

Related Areas : International business, Strategic planning

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Calculating Net Present Value (NPV) at 6% for Delusion and Deception in Large Infrastructure Projects: Two Models for Explaining and Preventing Executive Disaster Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10008888)	-10008888	-	-
Year 1	3449114	-6559774	3449114	0.9434	3253881
Year 2	3956623	-2603151	7405737	0.89	3521380
Year 3	3968409	1365258	11374146	0.8396	3331953
Year 4	3231504	4596762	14605650	0.7921	2559654
TOTAL			14605650		12666868

The Net Present Value at 6% discount rate is 2657980

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. Timing of the expected cash flows – stockholders of Delusion Deception 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. Delusion Deception shareholders have preference for diversified projects investment rather than prospective high income from a single capital intensive project.

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Formula and Steps to Calculate Net Present Value (NPV) of Delusion and Deception in Large Infrastructure Projects: Two Models for Explaining and Preventing Executive Disaster

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 Organizational Development 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 Delusion Deception 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 Delusion Deception 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	(10008888)	-10008888	-	-
Year 1	3449114	-6559774	3449114	0.8696	2999230
Year 2	3956623	-2603151	7405737	0.7561	2991775
Year 3	3968409	1365258	11374146	0.6575	2609293
Year 4	3231504	4596762	14605650	0.5718	1847623
TOTAL					10447921

The Net NPV after 4 years is 439033

(10447921 - 10008888 )

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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	(10008888)	-10008888	-	-
Year 1	3449114	-6559774	3449114	0.8333	2874262
Year 2	3956623	-2603151	7405737	0.6944	2747655
Year 3	3968409	1365258	11374146	0.5787	2296533
Year 4	3231504	4596762	14605650	0.4823	1558403
TOTAL					9476852

The Net NPV after 4 years is -532036

At 20% discount rate the NPV is negative (9476852 - 10008888 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Delusion Deception 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 Delusion Deception has a NPV value higher than Zero then finance managers at Delusion Deception 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 Delusion Deception, then the stock price of the Delusion Deception 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 Delusion Deception 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.

What can impact the cash flow of the project.

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 Delusion and Deception in Large Infrastructure Projects: Two Models for Explaining and Preventing Executive Disaster

References & Further Readings

Bent Flyvbjerg, Massimo Garbuio, Dan Lovallo (2018), "Delusion and Deception in Large Infrastructure Projects: Two Models for Explaining and Preventing Executive Disaster Harvard Business Review Case Study. Published by HBR Publications.