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. Samarco: the role of businesses in empowering people, Portuguese Version case study is a Harvard Business School (HBR) case study written by Rosa Maria Fischer, Paulo Da Rocha Ferreira Borba, Luciana Rocha De Mendonca, Monica Bose. The Samarco: the role of businesses in empowering people, Portuguese Version (referred as “Samarco Rodrigues” from here on) case study provides evaluation & decision scenario in field of Strategy & Execution. It also touches upon business topics such as - Value proposition, Organizational culture, Social responsibility, Strategy.
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.
Samarco produced iron ore pellets used for making steel. In 2003, the company had a 17% share of the global market of the product. At the time it had 1,286 employees, split between its units in Germano, in the State of Minas Gerais, and Ponta de Ubu, in the State of EspA?rito Santo.The two units were linked by an ore conveyor 396 km long, with a maximum carrying capacity of 15.5 million tons a year. The company's mission was "to be a Brazilian supplier of high quality iron for the global steel industry, creating value for all its stakeholders". In line with this guideline, between 1997 and 2003, Samarco coordinated and financed the Bento Rodrigues Popular Environmental Education program. The aim was to contribute to the development of the community living in the Bento Rodrigues district, by gaining the commitment of the residents for identifying community problems and seeking solutions that might increase local development. In spite of the reach of concrete results, after the end of the direct intervention undertaken by the company, a decline in the participation of the community was perceived, along with the discontinuity of the actions begun. In 2003, the need to build a second ore conveyor provided Samarco with a new opportunity for interacting with the communities. Its prior experience with the Bento Rodrigues Popular Environmental Education Program caused the Environment Manager to propose a new social project concept for the company, called the Social Responsibility Education and Communication Program - PROECOS. This program, to be implemented in partnership with GAIA (Group for Interdisciplinary Application to Learning) had broad objectives: to improve the company's image; to involve the communities in the preparation of sustainable social-environmental projects and to build a network of partners for meeting local demands and proceeding with development actions after the end of the company's involvement in the Program. For other managers, however, simpler technical projects had achieved more satisfactory results and would be more in line with the company's business strategy. So, why not continue to pursue projects already tried and tested rather than betting on such extensive and complex ones? These fierce internal controversies culminated in a dilemma as to whether or not the company's way of operating socially should be changed.
| Years | Cash Flow | Net Cash Flow | Cumulative Cash Flow |
Discount Rate @ 6 % |
Discounted Cash Flows |
|---|---|---|---|---|---|
| Year 0 | (10002506) | -10002506 | - | - | |
| Year 1 | 3462514 | -6539992 | 3462514 | 0.9434 | 3266523 |
| Year 2 | 3971681 | -2568311 | 7434195 | 0.89 | 3534782 |
| Year 3 | 3964975 | 1396664 | 11399170 | 0.8396 | 3329069 |
| Year 4 | 3235538 | 4632202 | 14634708 | 0.7921 | 2562849 |
| TOTAL | 14634708 | 12693223 |
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. Internal Rate of Return
2. Profitability Index
3. Net Present Value
4. Payback Period
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 Samarco Rodrigues 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. Samarco Rodrigues 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 Samarco Rodrigues 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 Samarco Rodrigues 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 | (10002506) | -10002506 | - | - | |
| Year 1 | 3462514 | -6539992 | 3462514 | 0.8696 | 3010882 |
| Year 2 | 3971681 | -2568311 | 7434195 | 0.7561 | 3003161 |
| Year 3 | 3964975 | 1396664 | 11399170 | 0.6575 | 2607035 |
| Year 4 | 3235538 | 4632202 | 14634708 | 0.5718 | 1849929 |
| TOTAL | 10471008 |
(10471008 - 10002506 )
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 | (10002506) | -10002506 | - | - | |
| Year 1 | 3462514 | -6539992 | 3462514 | 0.8333 | 2885428 |
| Year 2 | 3971681 | -2568311 | 7434195 | 0.6944 | 2758112 |
| Year 3 | 3964975 | 1396664 | 11399170 | 0.5787 | 2294546 |
| Year 4 | 3235538 | 4632202 | 14634708 | 0.4823 | 1560348 |
| TOTAL | 9498434 |
At 20% discount rate the NPV is negative (9498434 - 10002506 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Samarco Rodrigues to discount cash flow at lower discount rates such as 15%.
Simplest Approach – If the investment project of Samarco Rodrigues has a NPV value higher than Zero then finance managers at Samarco Rodrigues 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 Samarco Rodrigues, then the stock price of the Samarco Rodrigues 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 Samarco Rodrigues 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 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 will be a multi year spillover effect of various taxation regulations.
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.
What can impact the cash flow of the project.
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.
Rosa Maria Fischer, Paulo Da Rocha Ferreira Borba, Luciana Rocha De Mendonca, Monica Bose (2018), "Samarco: the role of businesses in empowering people, Portuguese Version Harvard Business Review Case Study. Published by HBR Publications.
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