The Quest for Sustainable Public Transit Funding: SEPTA's 2013 Capital Budget Crisis 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 Quest for Sustainable Public Transit Funding: SEPTA's 2013 Capital Budget Crisis case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. The Quest for Sustainable Public Transit Funding: SEPTA's 2013 Capital Budget Crisis case study is a Harvard Business School (HBR) case study written by Jose Gomez-Ibanez, Jay K. Rosengard, Pamela Varley. The The Quest for Sustainable Public Transit Funding: SEPTA's 2013 Capital Budget Crisis (referred as “Septa Transit” from here on) case study provides evaluation & decision scenario in field of Finance & Accounting. It also touches upon business topics such as - Value proposition, Policy.

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 Quest for Sustainable Public Transit Funding: SEPTA's 2013 Capital Budget Crisis Case Study

Designed for a course in public finance or in transportation, this case describes the financial crisis that, in 2013, loomed over the Southeastern Pennsylvania Transportation Authority (SEPTA), the transit system serving Philadelphia and four surrounding counties. The difficulties were predominantly in the system's long-inadequate capital budget, which funded maintenance, repair, and replacement costs for the aging legacy system, but these problems were severe enough that they were threatening day-to-day operations. SEPTA had been forced to delay needed reinvestment in the system for so many years that, absent significant new funding, the SEPTA board and general manager warned that they would be forced to shrink its system dramatically over the next 10 years, reducing service in the city of Philadelphia and nearly eliminating suburban commuter rail service. To ground the discussion, the case provides political and structural background about SEPTA, alongside the recent financial history of both operating and capital budgets, allowing students to understand the nature of the funding difficulties that had historically beset the authority. The case also provides enough information on transit finance to support a more general conversation. Case exhibits include demographic and commuting data for the five counties served by SEPTA; fare and subsidy information by mode of transport; fare elasticity by mode of transport; sources of subsidy in both operating and capital budgets; information about the tax burden in Pennsylvania; the projected consequences of abolishing SEPTA for commuting costs, jobs, and property values; and pros and cons of using different kinds of state funding to finance transit. A brief 2-page sequel describes how proponents were eventually able to win legislative approval for additional funding, and what the legislature ultimately chose as its revenue source. Case number 2047.0

Case Authors : Jose Gomez-Ibanez, Jay K. Rosengard, Pamela Varley

Topic : Finance & Accounting

Related Areas : Policy

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Calculating Net Present Value (NPV) at 6% for The Quest for Sustainable Public Transit Funding: SEPTA's 2013 Capital Budget Crisis Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10000511)	-10000511	-	-
Year 1	3472182	-6528329	3472182	0.9434	3275643
Year 2	3979524	-2548805	7451706	0.89	3541762
Year 3	3942521	1393716	11394227	0.8396	3310217
Year 4	3227148	4620864	14621375	0.7921	2556203
TOTAL			14621375		12683826

The Net Present Value at 6% discount rate is 2683315

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. Payback Period
3. Profitability Index
4. Net Present Value

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. Septa Transit 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 Septa Transit 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 The Quest for Sustainable Public Transit Funding: SEPTA's 2013 Capital Budget Crisis

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 Finance & Accounting 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 Septa Transit 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 Septa Transit 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	(10000511)	-10000511	-	-
Year 1	3472182	-6528329	3472182	0.8696	3019289
Year 2	3979524	-2548805	7451706	0.7561	3009092
Year 3	3942521	1393716	11394227	0.6575	2592272
Year 4	3227148	4620864	14621375	0.5718	1845132
TOTAL					10465784

The Net NPV after 4 years is 465273

(10465784 - 10000511 )

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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	(10000511)	-10000511	-	-
Year 1	3472182	-6528329	3472182	0.8333	2893485
Year 2	3979524	-2548805	7451706	0.6944	2763558
Year 3	3942521	1393716	11394227	0.5787	2281552
Year 4	3227148	4620864	14621375	0.4823	1556302
TOTAL					9494897

The Net NPV after 4 years is -505614

At 20% discount rate the NPV is negative (9494897 - 10000511 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Septa Transit 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 Septa Transit has a NPV value higher than Zero then finance managers at Septa Transit 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 Septa Transit, then the stock price of the Septa Transit 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 Septa Transit 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 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.

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 Quest for Sustainable Public Transit Funding: SEPTA's 2013 Capital Budget Crisis

References & Further Readings

Jose Gomez-Ibanez, Jay K. Rosengard, Pamela Varley (2018), "The Quest for Sustainable Public Transit Funding: SEPTA's 2013 Capital Budget Crisis Harvard Business Review Case Study. Published by HBR Publications.