China's National Oil Companies: Restructuring the Three Dragons 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 China's National Oil Companies: Restructuring the Three Dragons case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. China's National Oil Companies: Restructuring the Three Dragons case study is a Harvard Business School (HBR) case study written by Kannan Ramaswamy. The China's National Oil Companies: Restructuring the Three Dragons (referred as “Nocs Shale” 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 China's National Oil Companies: Restructuring the Three Dragons Case Study

China's three National Oil Companies (NOCs) collectively represent a potent force in the world of oil and gas. While they have been mostly focused on domestic priorities since their founding, they started a methodical program of globalization at the behest of the Chinese government in the mid 1990's. By 2016, they had completed a string of overseas acquisitions and seemed poised to gain enough strength to become contenders in the competitive battles against the more established International oil Companies (IOCs). The government had announced its intent to reform the NOCs in order to make them more efficient such that they would be able to compete against the best globally. The idea was to create a Chinese ExxonMobil out of the three NOCs. However, the road ahead appeared rocky. There were three main issues that posed formidable obstacles. First, the governance structure and state control had bred a culture that did not seem ready for transformative change. Political interference and lack of a clear strategic direction were just two of the outcomes associated with the resistive culture. These shortcomings manifested themselves in the second major obstacle namely the instinct to protect resources although the NOCs themselves did not seem to have the technology to monetize the reserves. The slow development of shale was a case in point. Despite controlling the world's largest reserves of shale, China had not been able to come anywhere close to replicating the runaway success that the US had demonstrated. The government had not articulated a clear shale development strategy, and had been dragging its feet with respect to trying imported technology and allowing foreign companies to operate leases. Lastly, there were clouds on the horizon with respect to global expansion as well. The decline in energy prices and a slowing down of domestic economic growth in China had stifled the global march of the NOCs. The case study builds on this complex context to explore whether reforms are likely to be implemented and whether they are likely to succeed.

Case Authors : Kannan Ramaswamy

Topic : Strategy & Execution

Related Areas :

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Calculating Net Present Value (NPV) at 6% for China's National Oil Companies: Restructuring the Three Dragons Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10021047)	-10021047	-	-
Year 1	3471954	-6549093	3471954	0.9434	3275428
Year 2	3957638	-2591455	7429592	0.89	3522284
Year 3	3941371	1349916	11370963	0.8396	3309251
Year 4	3226914	4576830	14597877	0.7921	2556018
TOTAL			14597877		12662981

The Net Present Value at 6% discount rate is 2641934

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. 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. Magnitude of both incoming and outgoing cash flows – Projects can be capital intensive, time intensive, or both. Nocs Shale shareholders have preference for diversified projects investment rather than prospective high income from a single capital intensive project.
2. Timing of the expected cash flows – stockholders of Nocs Shale have higher preference for cash returns over 4-5 years rather than 10-15 years given the nature of the volatility in the industry.

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Formula and Steps to Calculate Net Present Value (NPV) of China's National Oil Companies: Restructuring the Three Dragons

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 Nocs Shale 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 Nocs Shale 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	(10021047)	-10021047	-	-
Year 1	3471954	-6549093	3471954	0.8696	3019090
Year 2	3957638	-2591455	7429592	0.7561	2992543
Year 3	3941371	1349916	11370963	0.6575	2591515
Year 4	3226914	4576830	14597877	0.5718	1844999
TOTAL					10448147

The Net NPV after 4 years is 427100

(10448147 - 10021047 )

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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	(10021047)	-10021047	-	-
Year 1	3471954	-6549093	3471954	0.8333	2893295
Year 2	3957638	-2591455	7429592	0.6944	2748360
Year 3	3941371	1349916	11370963	0.5787	2280886
Year 4	3226914	4576830	14597877	0.4823	1556189
TOTAL					9478730

The Net NPV after 4 years is -542317

At 20% discount rate the NPV is negative (9478730 - 10021047 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Nocs Shale 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 Nocs Shale has a NPV value higher than Zero then finance managers at Nocs Shale 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 Nocs Shale, then the stock price of the Nocs Shale 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 Nocs Shale 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 –

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.

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

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 China's National Oil Companies: Restructuring the Three Dragons

References & Further Readings

Kannan Ramaswamy (2018), "China's National Oil Companies: Restructuring the Three Dragons Harvard Business Review Case Study. Published by HBR Publications.