The Volkswagen Emissions Scandal 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 The Volkswagen Emissions Scandal case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. The Volkswagen Emissions Scandal case study is a Harvard Business School (HBR) case study written by Luann J. Lynch, Cameron Cutro, Elizabeth Bird. The The Volkswagen Emissions Scandal (referred as “Vw Defeat” from here on) case study provides evaluation & decision scenario in field of Strategy & Execution. It also touches upon business topics such as - Value proposition, Crisis communication.

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 The Volkswagen Emissions Scandal Case Study

In September 2015, VW had admitted to United States regulators that it had deliberately installed "defeat devices" in many of its diesel cars, which enabled the cars to cheat on federal and state emissions tests, making them able to pass the tests and hit ambitious mileage and performance targets while actually emitting up to 40 times more hazardous gases into the atmosphere than legally allowed. The discovery had prompted the U.S. Environmental Protection Agency (EPA) to halt final certification of VW's 2016 diesel models, and VW itself had halted sales of its 2015 models. As fallout from the defeat devices developed, VW posted its first quarterly loss in more than 15 years, and its stock plummeted. Top executives were replaced, and VW abandoned its goal of becoming the world's largest automaker. Stakeholders around the world had been asking since the scandal broke: "How could this have happened at Volkswagen?"

Case Authors : Luann J. Lynch, Cameron Cutro, Elizabeth Bird

Topic : Strategy & Execution

Related Areas : Crisis communication

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Calculating Net Present Value (NPV) at 6% for The Volkswagen Emissions Scandal Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10020174)	-10020174	-	-
Year 1	3446137	-6574037	3446137	0.9434	3251073
Year 2	3979332	-2594705	7425469	0.89	3541591
Year 3	3956436	1361731	11381905	0.8396	3321900
Year 4	3245768	4607499	14627673	0.7921	2570952
TOTAL			14627673		12685516

The Net Present Value at 6% discount rate is 2665342

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. Internal Rate of Return
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 Vw Defeat 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. Vw Defeat 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 The Volkswagen Emissions Scandal

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 Vw Defeat 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 Vw Defeat 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	(10020174)	-10020174	-	-
Year 1	3446137	-6574037	3446137	0.8696	2996641
Year 2	3979332	-2594705	7425469	0.7561	3008947
Year 3	3956436	1361731	11381905	0.6575	2601421
Year 4	3245768	4607499	14627673	0.5718	1855778
TOTAL					10462787

The Net NPV after 4 years is 442613

(10462787 - 10020174 )

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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	(10020174)	-10020174	-	-
Year 1	3446137	-6574037	3446137	0.8333	2871781
Year 2	3979332	-2594705	7425469	0.6944	2763425
Year 3	3956436	1361731	11381905	0.5787	2289604
Year 4	3245768	4607499	14627673	0.4823	1565282
TOTAL					9490092

The Net NPV after 4 years is -530082

At 20% discount rate the NPV is negative (9490092 - 10020174 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Vw Defeat 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 Vw Defeat has a NPV value higher than Zero then finance managers at Vw Defeat 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 Vw Defeat, then the stock price of the Vw Defeat 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 Vw Defeat 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.

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.

Understanding of risks involved in the project.

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 The Volkswagen Emissions Scandal

References & Further Readings

Luann J. Lynch, Cameron Cutro, Elizabeth Bird (2018), "The Volkswagen Emissions Scandal Harvard Business Review Case Study. Published by HBR Publications.