Lack of Coordination in Management of the Three Cross Harbour Tunnels in Hong Kong 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 Lack of Coordination in Management of the Three Cross Harbour Tunnels in Hong Kong case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Lack of Coordination in Management of the Three Cross Harbour Tunnels in Hong Kong case study is a Harvard Business School (HBR) case study written by Ka-Fu Wong, Carola Ramon-Berjano. The Lack of Coordination in Management of the Three Cross Harbour Tunnels in Hong Kong (referred as “Tunnel Harbour” from here on) case study provides evaluation & decision scenario in field of Technology & Operations. It also touches upon business topics such as - Value proposition, Negotiations, Project management.

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 Lack of Coordination in Management of the Three Cross Harbour Tunnels in Hong Kong Case Study

Hong Kong had three Cross Harbour Tunnels linking Hong Kong Island with the Kowloon Peninsula and the New Territories. All three projects were undertaken under Build Operate and Transfer (BOT) contracts, and after 30 years, the management would revert to the government. The government managed the oldest tunnel, the Cross Harbour Tunnel (CHT), whereas private companies still managed the Eastern Harbour Tunnel (EHT) and the Western Harbour Tunnel (WHT). In 2002, the New Hong Kong Tunnel Co., which managed the EHT, had applied for a toll increase. Following the government's rejection, the case was handled by two independent arbitrators, who ruled that the company should raise the toll by 62.5% for all vehicles effective May 1, 2005. This increase in toll sparked a controversy. As a result of the toll increase, it was estimated that traffic in the EHT would fall by 17%, whereas the CHT, which was already heavily congested, would receive most of the diversion in traffic.

Case Authors : Ka-Fu Wong, Carola Ramon-Berjano

Topic : Technology & Operations

Related Areas : Negotiations, Project management

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Calculating Net Present Value (NPV) at 6% for Lack of Coordination in Management of the Three Cross Harbour Tunnels in Hong Kong Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10005257)	-10005257	-	-
Year 1	3449486	-6555771	3449486	0.9434	3254232
Year 2	3969570	-2586201	7419056	0.89	3532903
Year 3	3942506	1356305	11361562	0.8396	3310204
Year 4	3243446	4599751	14605008	0.7921	2569113
TOTAL			14605008		12666452

The Net Present Value at 6% discount rate is 2661195

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 Tunnel Harbour 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. Tunnel Harbour 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 Lack of Coordination in Management of the Three Cross Harbour Tunnels in Hong Kong

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 Technology & Operations 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 Tunnel Harbour 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 Tunnel Harbour 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	(10005257)	-10005257	-	-
Year 1	3449486	-6555771	3449486	0.8696	2999553
Year 2	3969570	-2586201	7419056	0.7561	3001565
Year 3	3942506	1356305	11361562	0.6575	2592262
Year 4	3243446	4599751	14605008	0.5718	1854451
TOTAL					10447831

The Net NPV after 4 years is 442574

(10447831 - 10005257 )

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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	(10005257)	-10005257	-	-
Year 1	3449486	-6555771	3449486	0.8333	2874572
Year 2	3969570	-2586201	7419056	0.6944	2756646
Year 3	3942506	1356305	11361562	0.5787	2281543
Year 4	3243446	4599751	14605008	0.4823	1564162
TOTAL					9476922

The Net NPV after 4 years is -528335

At 20% discount rate the NPV is negative (9476922 - 10005257 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Tunnel Harbour 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 Tunnel Harbour has a NPV value higher than Zero then finance managers at Tunnel Harbour 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 Tunnel Harbour, then the stock price of the Tunnel Harbour 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 Tunnel Harbour 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 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.

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.

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 Lack of Coordination in Management of the Three Cross Harbour Tunnels in Hong Kong

References & Further Readings

Ka-Fu Wong, Carola Ramon-Berjano (2018), "Lack of Coordination in Management of the Three Cross Harbour Tunnels in Hong Kong Harvard Business Review Case Study. Published by HBR Publications.