Indore City Bus Transport Service (B) 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 Indore City Bus Transport Service (B) case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Indore City Bus Transport Service (B) case study is a Harvard Business School (HBR) case study written by G. Raghuram, Satyam Shivam Sundaram, Himanshu Patni. The Indore City Bus Transport Service (B) (referred as “Transport Indore” from here on) case study provides evaluation & decision scenario in field of Technology & Operations. 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 Indore City Bus Transport Service (B) Case Study

Supplement to case A00024. Towards the end of 90s, mounting losses forced Madhya Pradesh State Road Transport Corporation (MPSRTC), the sole provider of public transport in Madhya Pradesh, to suspend their urban services. As a consequence, organized public transport services ceased to exist in Indore, the largest metropolitan city of the state of Madhya Pradesh. This void was filled by Intermediate Public Transport (IPT) consisting of minibuses, tempos and auto rickshaws. As of January 2004, 300 private minibuses, 150 tempos, and 10,000 auto rickshaws were plying as IPT, but with poor service levels. Lack of public transport was a catalyst for rapid increase in personalized vehicles, and high level of pollution and accidents. Worried over the rapid growth of personalized vehicles, and high levels of pollution and accidents in Indore, policy makers and administrators had made several attempts of reviving the public transport system in the city. In 2005, the Collector and District Magistrate of Indore decided to make another attempt of reviving the public transport. The two cases, Indore City Bus Transport Service (A) and Indore City Bus Transport Service (B) discuss the complexity involved in the planning, rolling out, and running of public transport services in Indore on a sustainable basis. Case (A) details the prevalent socio-economic condition, travel characteristics, and positions taken by various stakeholders on provisioning of public transport service in Indore as of November 2005. Case (B) discusses the challenges during the growth and operation of the services as of June 2008. Unprecedented rise in crude oil prices along with (i) increase in maintenance cost of buses, price of new buses, and bank interest and (ii) decrease/marginal increase in the fare box revenue (more people were shifting to passes) and advertisement revenue depleted the margin of the operators. The fares had not been increased since the launch of services in February 2006. It was clear that Indore City Transport Service Limited (ICTSL), the SPV created to run the transport system, would survive only if operators were able to survive. The readers have to take the position of the board of ICTSL and consider various options available to them for running the services on a sustainable basis.

Case Authors : G. Raghuram, Satyam Shivam Sundaram, Himanshu Patni

Topic : Technology & Operations

Related Areas :

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Calculating Net Present Value (NPV) at 6% for Indore City Bus Transport Service (B) Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10010095)	-10010095	-	-
Year 1	3460336	-6549759	3460336	0.9434	3264468
Year 2	3970889	-2578870	7431225	0.89	3534077
Year 3	3962714	1383844	11393939	0.8396	3327171
Year 4	3232010	4615854	14625949	0.7921	2560055
TOTAL			14625949		12685771

The Net Present Value at 6% discount rate is 2675676

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 Transport Indore 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. Transport Indore 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 Indore City Bus Transport Service (B)

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 Transport Indore 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 Transport Indore 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	(10010095)	-10010095	-	-
Year 1	3460336	-6549759	3460336	0.8696	3008988
Year 2	3970889	-2578870	7431225	0.7561	3002563
Year 3	3962714	1383844	11393939	0.6575	2605549
Year 4	3232010	4615854	14625949	0.5718	1847912
TOTAL					10465011

The Net NPV after 4 years is 454916

(10465011 - 10010095 )

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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	(10010095)	-10010095	-	-
Year 1	3460336	-6549759	3460336	0.8333	2883613
Year 2	3970889	-2578870	7431225	0.6944	2757562
Year 3	3962714	1383844	11393939	0.5787	2293237
Year 4	3232010	4615854	14625949	0.4823	1558647
TOTAL					9493059

The Net NPV after 4 years is -517036

At 20% discount rate the NPV is negative (9493059 - 10010095 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Transport Indore 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 Transport Indore has a NPV value higher than Zero then finance managers at Transport Indore 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 Transport Indore, then the stock price of the Transport Indore 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 Transport Indore 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 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.

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 Indore City Bus Transport Service (B)

References & Further Readings

G. Raghuram, Satyam Shivam Sundaram, Himanshu Patni (2018), "Indore City Bus Transport Service (B) Harvard Business Review Case Study. Published by HBR Publications.