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. Green Gold -an Innovative Sustainable Mining Scheme case study is a Harvard Business School (HBR) case study written by Ivan Dario Lobo, Ezequiel Reficco, Ana Lucia Trujillo. The Green Gold -an Innovative Sustainable Mining Scheme (referred as “Choca Mining” from here on) case study provides evaluation & decision scenario in field of Strategy & Execution. It also touches upon business topics such as - Value proposition, Social enterprise, Strategy, Sustainability.
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.
AMICHOCA? Foundation was a private non-profit organization operating since 1996 in the Colombian department of ChocA?, one of the poorest in the country and characterized by being largely inhabited by ethnic minorities of African origin and enjoying one of the highest levels of biodiversity in the world. The Foundation implemented productive projects that help improve the living conditions in communities within a framework of social and environmental sustainability. In this line, in 2000, the Foundation encouraged the creation of Oro Verde Corporation (hereinafter, OVC), a cross-sector alliance involving, in addition to AMICHOCA?, three local social organizations. OVC developed the Green Gold program that considered conventional small- scale mining as a productive alternative that could be integrated to specific market niches. The case depicts the overall situation of ChocA? department and the importance of the mining industry to its economy. It also describes OVC's inception and the role played by AMICHOCA? in its creation, and provides a detailed account of the Green Gold program, with an emphasis on its value proposition: a business model that articulated traditional gold production in ChocA? with green international markets. In addition, it recounts the concerns expressed by community representatives with regard to the model's efficiency and its capacity to create economic value. These concerns raised the possibility of building alliances with medium-scale private mechanized mining companies in order to enhance the model's economic impact. Exhibits provide information on the characteristics of ChocA? department, social and environmental impacts of medium-scale mining, environmental conservation criteria governing the Green Gold model, and estimated economic results for conventional mining and mechanized mining operations.
| Years | Cash Flow | Net Cash Flow | Cumulative Cash Flow |
Discount Rate @ 6 % |
Discounted Cash Flows |
|---|---|---|---|---|---|
| Year 0 | (10009640) | -10009640 | - | - | |
| Year 1 | 3455198 | -6554442 | 3455198 | 0.9434 | 3259621 |
| Year 2 | 3961914 | -2592528 | 7417112 | 0.89 | 3526089 |
| Year 3 | 3973984 | 1381456 | 11391096 | 0.8396 | 3336634 |
| Year 4 | 3235070 | 4616526 | 14626166 | 0.7921 | 2562478 |
| TOTAL | 14626166 | 12684822 |
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. Payback Period
2. Net Present Value
3. Profitability Index
4. Internal Rate of Return
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 Choca Mining 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. Choca Mining 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 Choca Mining 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 Choca Mining 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 | (10009640) | -10009640 | - | - | |
| Year 1 | 3455198 | -6554442 | 3455198 | 0.8696 | 3004520 |
| Year 2 | 3961914 | -2592528 | 7417112 | 0.7561 | 2995776 |
| Year 3 | 3973984 | 1381456 | 11391096 | 0.6575 | 2612959 |
| Year 4 | 3235070 | 4616526 | 14626166 | 0.5718 | 1849662 |
| TOTAL | 10462917 |
(10462917 - 10009640 )
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 | (10009640) | -10009640 | - | - | |
| Year 1 | 3455198 | -6554442 | 3455198 | 0.8333 | 2879332 |
| Year 2 | 3961914 | -2592528 | 7417112 | 0.6944 | 2751329 |
| Year 3 | 3973984 | 1381456 | 11391096 | 0.5787 | 2299759 |
| Year 4 | 3235070 | 4616526 | 14626166 | 0.4823 | 1560122 |
| TOTAL | 9490543 |
At 20% discount rate the NPV is negative (9490543 - 10009640 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Choca Mining to discount cash flow at lower discount rates such as 15%.
Simplest Approach – If the investment project of Choca Mining has a NPV value higher than Zero then finance managers at Choca Mining 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 Choca Mining, then the stock price of the Choca Mining 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 Choca Mining 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 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.
What are the key aspects of the projects that need to be monitored, refined, and retuned for continuous delivery of projected cash flows.
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.
Ivan Dario Lobo, Ezequiel Reficco, Ana Lucia Trujillo (2018), "Green Gold -an Innovative Sustainable Mining Scheme Harvard Business Review Case Study. Published by HBR Publications.
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