Introduction to Net Present Value (NPV) - What is Net Present Value (NPV) ? How it impacts financial decisions regarding project management?
At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. TransCanada's Keystone XL Pipeline: Unfinished Business case study is a Harvard Business School (HBR) case study written by Guy Holburn, Margaret Loudermilk, Dennis McConaghy. The TransCanada's Keystone XL Pipeline: Unfinished Business (referred as “Xl Keystone” from here on) case study provides evaluation & decision scenario in field of Strategy & Execution. It also touches upon business topics such as - Value proposition, Government, Sustainability.
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.
The senior management team at TransCanada Corporation in Calgary, Alberta, was stunned by the U.S. Department of State announcement that it was deferring its decision on a presidential permit, which was required for all construction of infrastructure crossing U.S. international borders. The infrastructure in question was the proposed Keystone XL pipeline, which would create a 2,735-kilometre direct route for Canadian crude from the Alberta oil sands to refineries in Oklahoma and the Gulf Coast. Because the pipeline would pass through environmentally sensitive landscapes, especially in the state of Nebraska, non-governmental organizations, climate change activists, citizens, celebrities and federal and state politicians pressured the Obama administration to halt the project. Company executives had initially seen the Keystone XL pipeline as a readily achievable, financially significant and strategically compelling venture but now wondered whether they had missed the indications and opportunities to avoid controversy. Extensive advertising campaigns and intensive lobbying in Washington did not seem to have improved the likelihood of the pipeline's construction. What could be done now to increase the likelihood of permit approval and bring the Keystone XL pipeline to fruition?
| Years | Cash Flow | Net Cash Flow | Cumulative Cash Flow |
Discount Rate @ 6 % |
Discounted Cash Flows |
|---|---|---|---|---|---|
| Year 0 | (10028741) | -10028741 | - | - | |
| Year 1 | 3455678 | -6573063 | 3455678 | 0.9434 | 3260074 |
| Year 2 | 3982129 | -2590934 | 7437807 | 0.89 | 3544081 |
| Year 3 | 3950206 | 1359272 | 11388013 | 0.8396 | 3316669 |
| Year 4 | 3243737 | 4603009 | 14631750 | 0.7921 | 2569344 |
| TOTAL | 14631750 | 12690167 |
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 -
Capital Budgeting Approaches
There are four types of capital budgeting techniques that are widely used in the corporate world –
1. Net Present Value
2. Profitability Index
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 Xl Keystone 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. Xl Keystone shareholders have preference for diversified projects investment rather than prospective high income from a single capital intensive project.
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
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 Xl Keystone 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 Xl Keystone 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.
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 | (10028741) | -10028741 | - | - | |
| Year 1 | 3455678 | -6573063 | 3455678 | 0.8696 | 3004937 |
| Year 2 | 3982129 | -2590934 | 7437807 | 0.7561 | 3011062 |
| Year 3 | 3950206 | 1359272 | 11388013 | 0.6575 | 2597325 |
| Year 4 | 3243737 | 4603009 | 14631750 | 0.5718 | 1854617 |
| TOTAL | 10467941 |
(10467941 - 10028741 )
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 | (10028741) | -10028741 | - | - | |
| Year 1 | 3455678 | -6573063 | 3455678 | 0.8333 | 2879732 |
| Year 2 | 3982129 | -2590934 | 7437807 | 0.6944 | 2765367 |
| Year 3 | 3950206 | 1359272 | 11388013 | 0.5787 | 2285999 |
| Year 4 | 3243737 | 4603009 | 14631750 | 0.4823 | 1564302 |
| TOTAL | 9495400 |
At 20% discount rate the NPV is negative (9495400 - 10028741 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Xl Keystone to discount cash flow at lower discount rates such as 15%.
Simplest Approach – If the investment project of Xl Keystone has a NPV value higher than Zero then finance managers at Xl Keystone 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 Xl Keystone, then the stock price of the Xl Keystone 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.
Project selection is often a far more complex decision than just choosing it based on the NPV number. Finance managers at Xl Keystone 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.
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 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.
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.
Guy Holburn, Margaret Loudermilk, Dennis McConaghy (2018), "TransCanada's Keystone XL Pipeline: Unfinished Business Harvard Business Review Case Study. Published by HBR Publications.
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