SMRT: Getting Back on Track 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 SMRT: Getting Back on Track case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. SMRT: Getting Back on Track case study is a Harvard Business School (HBR) case study written by Thompson SH Teo, Cherie Heng, Cheryl Lee, Zhuoran Liu. The SMRT: Getting Back on Track (referred as “Smrt Breakdown” from here on) case study provides evaluation & decision scenario in field of Technology & Operations. It also touches upon business topics such as - Value proposition, Supply chain.

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

---

Case Description of SMRT: Getting Back on Track Case Study

On July 7, 2015, a power fault during the evening commute led to a system-wide disruption on SMRT, Singapore's heavily used mass rapid transit lines. Train service on both lines was shut down for more than two hours, affecting more than 413,000 commuters. The public was outraged at the scale of the breakdown and how ineffectively it was handled. Detailed investigations revealed the breakdown to be a result of maintenance lapses, and SMRT was criticized for its failure to provide clear and timely information and instructions to passengers. Following the breakdown, the company embarked on a service recovery process encompassing various new initiatives. This case illustrates the tensions SMRT faced during and after the breakdown, and its journey to recover the public's confidence in is transit services. Thompson S.H. Teo is affiliated with National University of Singapore.

Case Authors : Thompson SH Teo, Cherie Heng, Cheryl Lee, Zhuoran Liu

Topic : Technology & Operations

Related Areas : Supply chain

---

Calculating Net Present Value (NPV) at 6% for SMRT: Getting Back on Track Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10004702)	-10004702	-	-
Year 1	3443809	-6560893	3443809	0.9434	3248876
Year 2	3956411	-2604482	7400220	0.89	3521192
Year 3	3938071	1333589	11338291	0.8396	3306480
Year 4	3240396	4573985	14578687	0.7921	2566697
TOTAL			14578687		12643246

The Net Present Value at 6% discount rate is 2638544

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.

---

Capital Budgeting Approaches

Methods of Capital Budgeting

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. Magnitude of both incoming and outgoing cash flows – Projects can be capital intensive, time intensive, or both. Smrt Breakdown 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 Smrt Breakdown have higher preference for cash returns over 4-5 years rather than 10-15 years given the nature of the volatility in the industry.

---

Formula and Steps to Calculate Net Present Value (NPV) of SMRT: Getting Back on Track

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 Smrt Breakdown 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 Smrt Breakdown 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	(10004702)	-10004702	-	-
Year 1	3443809	-6560893	3443809	0.8696	2994617
Year 2	3956411	-2604482	7400220	0.7561	2991615
Year 3	3938071	1333589	11338291	0.6575	2589346
Year 4	3240396	4573985	14578687	0.5718	1852707
TOTAL					10428284

The Net NPV after 4 years is 423582

(10428284 - 10004702 )

---

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	(10004702)	-10004702	-	-
Year 1	3443809	-6560893	3443809	0.8333	2869841
Year 2	3956411	-2604482	7400220	0.6944	2747508
Year 3	3938071	1333589	11338291	0.5787	2278976
Year 4	3240396	4573985	14578687	0.4823	1562691
TOTAL					9459016

The Net NPV after 4 years is -545686

At 20% discount rate the NPV is negative (9459016 - 10004702 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Smrt Breakdown 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 Smrt Breakdown has a NPV value higher than Zero then finance managers at Smrt Breakdown 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 Smrt Breakdown, then the stock price of the Smrt Breakdown 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 Smrt Breakdown 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 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 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.

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.

---

Negotiation Strategy of SMRT: Getting Back on Track

References & Further Readings

Thompson SH Teo, Cherie Heng, Cheryl Lee, Zhuoran Liu (2018), "SMRT: Getting Back on Track Harvard Business Review Case Study. Published by HBR Publications.