BE Oil 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 BE Oil case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. BE Oil case study is a Harvard Business School (HBR) case study written by Daniel Murphy, Marc Lipson. The BE Oil (referred as “Oil Drill” from here on) case study provides evaluation & decision scenario in field of Global Business. 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 BE Oil Case Study

Quentin Bell, the owner of a small oil extraction firm, BE Oil, owns the rights to drill on six different wells. Drilling requires substantial up-front costs, and each well has different drilling costs and production capability. Bell's challenge is to decide which wells to drill based on his expectation of the price of oil when it is extracted. The case was written for use in Darden's global economies and markets (GEM) core course during a class on the economics of competitive markets. The concepts of supply, demand, and equilibrium are often obscure to students at this early stage in the course, and this case provides a concrete example of how a firm in a competitive commodity market determines how much oil to produce. Students are asked to derive the firm's supply curve, relate that to the oil market supply curve, and ultimately recommend how much oil the firm should plan to produce. The plan pushes students to think about marginal cost/ marginal benefit analysis, implicitly at first and explicitly at the end of class. Students are also asked to consider how exogenous variables in the oil market affect the oil price and the firm's decision.

Case Authors : Daniel Murphy, Marc Lipson

Topic : Global Business

Related Areas :

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Calculating Net Present Value (NPV) at 6% for BE Oil Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10018665)	-10018665	-	-
Year 1	3456518	-6562147	3456518	0.9434	3260866
Year 2	3958725	-2603422	7415243	0.89	3523251
Year 3	3953153	1349731	11368396	0.8396	3319143
Year 4	3230857	4580588	14599253	0.7921	2559141
TOTAL			14599253		12662402

The Net Present Value at 6% discount rate is 2643737

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. Payback Period
2. Net Present Value
3. Internal Rate of Return
4. Profitability Index

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 Oil Drill 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. Oil Drill 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 BE Oil

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 Global Business 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 Oil Drill 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 Oil Drill 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	(10018665)	-10018665	-	-
Year 1	3456518	-6562147	3456518	0.8696	3005668
Year 2	3958725	-2603422	7415243	0.7561	2993365
Year 3	3953153	1349731	11368396	0.6575	2599262
Year 4	3230857	4580588	14599253	0.5718	1847253
TOTAL					10445548

The Net NPV after 4 years is 426883

(10445548 - 10018665 )

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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	(10018665)	-10018665	-	-
Year 1	3456518	-6562147	3456518	0.8333	2880432
Year 2	3958725	-2603422	7415243	0.6944	2749115
Year 3	3953153	1349731	11368396	0.5787	2287704
Year 4	3230857	4580588	14599253	0.4823	1558091
TOTAL					9475341

The Net NPV after 4 years is -543324

At 20% discount rate the NPV is negative (9475341 - 10018665 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Oil Drill 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 Oil Drill has a NPV value higher than Zero then finance managers at Oil Drill 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 Oil Drill, then the stock price of the Oil Drill 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 Oil Drill 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 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 will be a multi year spillover effect of various taxation regulations.

What can impact the cash flow of 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 BE Oil

References & Further Readings

Daniel Murphy, Marc Lipson (2018), "BE Oil Harvard Business Review Case Study. Published by HBR Publications.