Aiming Toward a Hydrogen Economy: Icelandic New Energy Ltd. (Islensk Nyorka) 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 Aiming Toward a Hydrogen Economy: Icelandic New Energy Ltd. (Islensk Nyorka) case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Aiming Toward a Hydrogen Economy: Icelandic New Energy Ltd. (Islensk Nyorka) case study is a Harvard Business School (HBR) case study written by Pratima Bansal, Ken Mark, Jordan Mitchell. The Aiming Toward a Hydrogen Economy: Icelandic New Energy Ltd. (Islensk Nyorka) (referred as “Hydrogen Icelandic” from here on) case study provides evaluation & decision scenario in field of Strategy & Execution. It also touches upon business topics such as - Value proposition, 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 Aiming Toward a Hydrogen Economy: Icelandic New Energy Ltd. (Islensk Nyorka) Case Study

Icelandic New Energy Co., a research and development consortium based in Reykjavik, Iceland, is considering its future direction. The two-person team has met its first major goal--the installation of the world's first commercial hydrogen filling station and the coordination of a public transport test project involving the operation of three hydrogen-fuelled city buses. The company was founded with the overall objective of investigating the potential for eventually replacing the use of fossil fuels in Iceland with hydrogen-based fuels and creating the first hydrogen society in the world. Working toward the goal of self-sufficiency from fossil fuels, Icelandic New Energy Co. was set up in 1999 by the consortium Vistorka and three major partners, each contributing a part to the testing--Royal Dutch Shell (the refueling station), Norsk Hydro (the electrolysis technology to make the hydrogen), and DaimlerChrysler (fuel cell vehicles using hydrogen fuel). The shareholder agreement, established with the company's start in 1999, is set to expire in 2005. With all of the major activities being outsourced and contracted, the team wondered how it could keep the company as a going concern and contribute to Iceland's transition to a hydrogen economy--a feat that could take more than 15 years.

Case Authors : Pratima Bansal, Ken Mark, Jordan Mitchell

Topic : Strategy & Execution

Related Areas : Strategic planning

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Calculating Net Present Value (NPV) at 6% for Aiming Toward a Hydrogen Economy: Icelandic New Energy Ltd. (Islensk Nyorka) Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10023807)	-10023807	-	-
Year 1	3454184	-6569623	3454184	0.9434	3258664
Year 2	3972369	-2597254	7426553	0.89	3535394
Year 3	3953571	1356317	11380124	0.8396	3319494
Year 4	3228768	4585085	14608892	0.7921	2557487
TOTAL			14608892		12671040

The Net Present Value at 6% discount rate is 2647233

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. Internal Rate of Return
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 Hydrogen Icelandic 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. Hydrogen Icelandic 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 Aiming Toward a Hydrogen Economy: Icelandic New Energy Ltd. (Islensk Nyorka)

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 Hydrogen Icelandic 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 Hydrogen Icelandic 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	(10023807)	-10023807	-	-
Year 1	3454184	-6569623	3454184	0.8696	3003638
Year 2	3972369	-2597254	7426553	0.7561	3003682
Year 3	3953571	1356317	11380124	0.6575	2599537
Year 4	3228768	4585085	14608892	0.5718	1846059
TOTAL					10452916

The Net NPV after 4 years is 429109

(10452916 - 10023807 )

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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	(10023807)	-10023807	-	-
Year 1	3454184	-6569623	3454184	0.8333	2878487
Year 2	3972369	-2597254	7426553	0.6944	2758590
Year 3	3953571	1356317	11380124	0.5787	2287946
Year 4	3228768	4585085	14608892	0.4823	1557083
TOTAL					9482106

The Net NPV after 4 years is -541701

At 20% discount rate the NPV is negative (9482106 - 10023807 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Hydrogen Icelandic 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 Hydrogen Icelandic has a NPV value higher than Zero then finance managers at Hydrogen Icelandic 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 Hydrogen Icelandic, then the stock price of the Hydrogen Icelandic 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 Hydrogen Icelandic 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 can impact the cash flow of the project.

What will be a multi year spillover effect of various taxation regulations.

What are the key aspects of the projects that need to be monitored, refined, and retuned for continuous delivery of projected cash flows.

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.

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 Aiming Toward a Hydrogen Economy: Icelandic New Energy Ltd. (Islensk Nyorka)

References & Further Readings

Pratima Bansal, Ken Mark, Jordan Mitchell (2018), "Aiming Toward a Hydrogen Economy: Icelandic New Energy Ltd. (Islensk Nyorka) Harvard Business Review Case Study. Published by HBR Publications.