Tata Chemicals Magadi: Confronting Poverty in Rural Africa 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 Tata Chemicals Magadi: Confronting Poverty in Rural Africa case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Tata Chemicals Magadi: Confronting Poverty in Rural Africa case study is a Harvard Business School (HBR) case study written by Michael Valente. The Tata Chemicals Magadi: Confronting Poverty in Rural Africa (referred as “Magadi Tata” from here on) case study provides evaluation & decision scenario in field of Strategy & Execution. It also touches upon business topics such as - Value proposition, .

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 Tata Chemicals Magadi: Confronting Poverty in Rural Africa Case Study

In the summer of 2013, the managing director of Tata Chemicals Magadi, Africa's largest soda ash manufacturer and one of the oldest and largest export earners in Kenya, was wondering how he was going to respond to a growing number of challenges. As a producer of a commodity product, the company was vulnerable to escalating energy costs, oversupply and economic cycles. Global growth had been sluggish since the 2008 economic recession and competition was intense, especially since the emergence of Chinese producers. Magadi Township, where the company's production facility was located, was one of the poorest in the country, subject to droughts and without many of the basic public services typically provided by government such as roads, health care, electricity, water and education. To address these needs, the company migrated from a top-down, paternal, ad hoc and resource-intensive approach to a bottom-up, collaborative, holistic and resource-sharing style that focused on community capacity building and self-governance. However, the issue now is how to best balance the strong need to reduce costs while remaining committed to the sustainability of the surrounding community. Michael Valente is affiliated with York University.

Case Authors : Michael Valente

Topic : Strategy & Execution

Related Areas :

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Calculating Net Present Value (NPV) at 6% for Tata Chemicals Magadi: Confronting Poverty in Rural Africa Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10019774)	-10019774	-	-
Year 1	3446436	-6573338	3446436	0.9434	3251355
Year 2	3981754	-2591584	7428190	0.89	3543747
Year 3	3955515	1363931	11383705	0.8396	3321127
Year 4	3232758	4596689	14616463	0.7921	2560647
TOTAL			14616463		12676875

The Net Present Value at 6% discount rate is 2657101

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. Profitability Index
2. Net Present Value
3. Payback Period
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 Magadi Tata 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. Magadi Tata 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 Tata Chemicals Magadi: Confronting Poverty in Rural Africa

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 Strategy & Execution 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 Magadi Tata 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 Magadi Tata 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	(10019774)	-10019774	-	-
Year 1	3446436	-6573338	3446436	0.8696	2996901
Year 2	3981754	-2591584	7428190	0.7561	3010778
Year 3	3955515	1363931	11383705	0.6575	2600815
Year 4	3232758	4596689	14616463	0.5718	1848340
TOTAL					10456834

The Net NPV after 4 years is 437060

(10456834 - 10019774 )

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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	(10019774)	-10019774	-	-
Year 1	3446436	-6573338	3446436	0.8333	2872030
Year 2	3981754	-2591584	7428190	0.6944	2765107
Year 3	3955515	1363931	11383705	0.5787	2289071
Year 4	3232758	4596689	14616463	0.4823	1559008
TOTAL					9485216

The Net NPV after 4 years is -534558

At 20% discount rate the NPV is negative (9485216 - 10019774 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Magadi Tata 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 Magadi Tata has a NPV value higher than Zero then finance managers at Magadi Tata 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 Magadi Tata, then the stock price of the Magadi Tata 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 Magadi Tata 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.

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 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.

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 Tata Chemicals Magadi: Confronting Poverty in Rural Africa

References & Further Readings

Michael Valente (2018), "Tata Chemicals Magadi: Confronting Poverty in Rural Africa Harvard Business Review Case Study. Published by HBR Publications.