Privatization of Telecommunications in Peru 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 Privatization of Telecommunications in Peru case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Privatization of Telecommunications in Peru case study is a Harvard Business School (HBR) case study written by Merilee Grindle, Esther Scott. The Privatization of Telecommunications in Peru (referred as “Privatization Phone” from here on) case study provides evaluation & decision scenario in field of Strategy & Execution. It also touches upon business topics such as - Value proposition, Economy, Entrepreneurship, IT, Operations management, Regulation, 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 Privatization of Telecommunications in Peru Case Study

When the administration of Peru president Alberto Fujimori embarks on an ambitious privatization program, it turns inevitably to the nation's creaking telephone system. With but 2.5 phone lines per 100 persons, Peru, in the mid-1990s, had the lowest phone "density" in Latin America; installation of a new line took years, except via a thriving black market in existing lines. But the privatization committee which begins to plot the role of both the existing local and long distance phone monopolies, knows that it faces formidable obstacles to change: a suspicious and powerful military which nationalized the phone system in the 1970s; an influential cellular phone operator with his own agenda; existing unions, doubtful legislators who must approve a constitutional amendment to allow privatization to go forward. This case is about the political management of privatization. It describes the "interest group map" developed by the privatization committee and poses the question of what tactical approach should be taken with each. Case users must envision the potential conflicts, the objective desired, and the most useful tactics. The sequel describes the early success of the privatization process, after the phone system's sale to the Spanish phone giant, Telefonica. HKS Case Number 1404.0

Case Authors : Merilee Grindle, Esther Scott

Topic : Strategy & Execution

Related Areas : Economy, Entrepreneurship, IT, Operations management, Regulation, Strategic planning

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Calculating Net Present Value (NPV) at 6% for Privatization of Telecommunications in Peru Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10010424)	-10010424	-	-
Year 1	3451631	-6558793	3451631	0.9434	3256256
Year 2	3959126	-2599667	7410757	0.89	3523608
Year 3	3945615	1345948	11356372	0.8396	3312814
Year 4	3242718	4588666	14599090	0.7921	2568536
TOTAL			14599090		12661215

The Net Present Value at 6% discount rate is 2650791

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. Payback Period
4. Net Present Value

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 Privatization Phone 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. Privatization Phone 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 Privatization of Telecommunications in Peru

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 Privatization Phone 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 Privatization Phone 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	(10010424)	-10010424	-	-
Year 1	3451631	-6558793	3451631	0.8696	3001418
Year 2	3959126	-2599667	7410757	0.7561	2993668
Year 3	3945615	1345948	11356372	0.6575	2594306
Year 4	3242718	4588666	14599090	0.5718	1854035
TOTAL					10443427

The Net NPV after 4 years is 433003

(10443427 - 10010424 )

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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	(10010424)	-10010424	-	-
Year 1	3451631	-6558793	3451631	0.8333	2876359
Year 2	3959126	-2599667	7410757	0.6944	2749393
Year 3	3945615	1345948	11356372	0.5787	2283342
Year 4	3242718	4588666	14599090	0.4823	1563811
TOTAL					9472905

The Net NPV after 4 years is -537519

At 20% discount rate the NPV is negative (9472905 - 10010424 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Privatization Phone 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 Privatization Phone has a NPV value higher than Zero then finance managers at Privatization Phone 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 Privatization Phone, then the stock price of the Privatization Phone 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 Privatization Phone 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 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.

What can impact the cash flow of the project.

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

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 Privatization of Telecommunications in Peru

References & Further Readings

Merilee Grindle, Esther Scott (2018), "Privatization of Telecommunications in Peru Harvard Business Review Case Study. Published by HBR Publications.