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. The Flint Water Crisis case study is a Harvard Business School (HBR) case study written by Marie McKendall, Nancy M. Levenburg. The The Flint Water Crisis (referred as “Flint Water” from here on) case study provides evaluation & decision scenario in field of Organizational Development. It also touches upon business topics such as - Value proposition, Ethics, Leadership.
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 city of Flint, Michigan, a previous hub for General Motors auto manufacturing, began to experience budget shortfalls in 2007. By 2011, the city was running a deficit of nearly $26 million, and the state assumed control of Flint through the appointment of an emergency manager. In 2014, immediately after state officials decided to begin sourcing Flint's tap water from the Flint River in order to save money, residents began complaining about the cost, color, and quality of their water. Over the next 18 months, residents reported suffering from various illnesses and an outbreak of Legionnaire's Disease occurred in the area. During this time, state officials continued to assure residents that their water was safe despite three water-boil advisories, the water rusting parts at General Motors' Flint engine plant, and the straightforward warnings from an EPA employee that an unsafe situation existed. Public pressure built as an ACLU reporter broke the story, an outside researcher's tests uncovered unsafe levels of lead in the water, and a Michigan State University pediatrician found elevated lead levels in children coinciding with the switch to Flint River water. In October of 2015, Flint switched back to sourcing water from Detroit; finally, in January of 2016, Michigan's Governor (Rick Snyder) declared a state of emergency and activated the Michigan National Guard to patrol the city and assist the American Red Cross with the distribution of bottled water and water filters. The citizens of Flint had been exposed to poisoned water for 18 months. What went wrong? What dysfunctions and conditions in federal and state organizations led to flawed decision making and catastrophic outcomes? The case provides a general overview of the city of Flint, events leading up to the Flint water crisis, information about the involved government agencies, and a chronology of the tap water sourcing decision. The case prompts readers to analyze and understand that a variety of factors, including multiple actors, ambiguities, corporate structures, and organizational complexities can combine to result in unethical decisions and outcomes.
| Years | Cash Flow | Net Cash Flow | Cumulative Cash Flow |
Discount Rate @ 6 % |
Discounted Cash Flows |
|---|---|---|---|---|---|
| Year 0 | (10011659) | -10011659 | - | - | |
| Year 1 | 3450647 | -6561012 | 3450647 | 0.9434 | 3255327 |
| Year 2 | 3973476 | -2587536 | 7424123 | 0.89 | 3536379 |
| Year 3 | 3975603 | 1388067 | 11399726 | 0.8396 | 3337993 |
| Year 4 | 3243299 | 4631366 | 14643025 | 0.7921 | 2568997 |
| TOTAL | 14643025 | 12698696 |
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. Payback Period
2. Profitability Index
3. Net Present Value
4. Internal Rate of Return
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. Flint Water 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 Flint Water have higher preference for cash returns over 4-5 years rather than 10-15 years given the nature of the volatility in the industry.
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 Flint Water 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 Flint Water 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 | (10011659) | -10011659 | - | - | |
| Year 1 | 3450647 | -6561012 | 3450647 | 0.8696 | 3000563 |
| Year 2 | 3973476 | -2587536 | 7424123 | 0.7561 | 3004519 |
| Year 3 | 3975603 | 1388067 | 11399726 | 0.6575 | 2614024 |
| Year 4 | 3243299 | 4631366 | 14643025 | 0.5718 | 1854367 |
| TOTAL | 10473472 |
(10473472 - 10011659 )
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 | (10011659) | -10011659 | - | - | |
| Year 1 | 3450647 | -6561012 | 3450647 | 0.8333 | 2875539 |
| Year 2 | 3973476 | -2587536 | 7424123 | 0.6944 | 2759358 |
| Year 3 | 3975603 | 1388067 | 11399726 | 0.5787 | 2300696 |
| Year 4 | 3243299 | 4631366 | 14643025 | 0.4823 | 1564091 |
| TOTAL | 9499685 |
At 20% discount rate the NPV is negative (9499685 - 10011659 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Flint Water to discount cash flow at lower discount rates such as 15%.
Simplest Approach – If the investment project of Flint Water has a NPV value higher than Zero then finance managers at Flint Water 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 Flint Water, then the stock price of the Flint Water 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 Flint Water 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 can impact the cash flow of the project.
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.
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.
Marie McKendall, Nancy M. Levenburg (2018), "The Flint Water Crisis Harvard Business Review Case Study. Published by HBR Publications.
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