Coal, Nuclear, Natural Gas, Oil, or Renewable: Which Type of Power Plant Should We Build? 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 Coal, Nuclear, Natural Gas, Oil, or Renewable: Which Type of Power Plant Should We Build? case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Coal, Nuclear, Natural Gas, Oil, or Renewable: Which Type of Power Plant Should We Build? case study is a Harvard Business School (HBR) case study written by Gary Clendenen, Paul W. Thurston, Fang Zhao, Stephen Kidwell. The Coal, Nuclear, Natural Gas, Oil, or Renewable: Which Type of Power Plant Should We Build? (referred as “Varied Plant” from here on) case study provides evaluation & decision scenario in field of Finance & Accounting. It also touches upon business topics such as - Value proposition, Corporate governance, Sustainability.

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 Coal, Nuclear, Natural Gas, Oil, or Renewable: Which Type of Power Plant Should We Build? Case Study

A utility company must replace an aging coal-fired power plant. Accordingly, management must develop an Integrated Resource Plan that carefully explores all reasonable options considering the varied interests of many stakeholders, including electricity users, regulators, environmentalists, and the community in which a new power plant will be built. State regulators require that the utility company minimize the costs to ratepayers, but costs are difficult to determine given the potential for high taxes on carbon emissions as well as volatile fuel costs during the multi-decade lifetime of the replacement. The analysis is further complicated by the differences in project risk associated with the different technologies. The senior vice-president must choose carefully, because he will be required to defend that choice to many varied and passionate stakeholders. A capital budget analysis should be conducted that takes into consideration the many uncertainties associated with this problem.

Case Authors : Gary Clendenen, Paul W. Thurston, Fang Zhao, Stephen Kidwell

Topic : Finance & Accounting

Related Areas : Corporate governance, Sustainability

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Calculating Net Present Value (NPV) at 6% for Coal, Nuclear, Natural Gas, Oil, or Renewable: Which Type of Power Plant Should We Build? Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10021030)	-10021030	-	-
Year 1	3471273	-6549757	3471273	0.9434	3274786
Year 2	3964244	-2585513	7435517	0.89	3528163
Year 3	3950442	1364929	11385959	0.8396	3316867
Year 4	3240339	4605268	14626298	0.7921	2566652
TOTAL			14626298		12686468

The Net Present Value at 6% discount rate is 2665438

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. 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. Varied Plant 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 Varied Plant 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 Coal, Nuclear, Natural Gas, Oil, or Renewable: Which Type of Power Plant Should We Build?

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 Varied Plant 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 Varied Plant 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	(10021030)	-10021030	-	-
Year 1	3471273	-6549757	3471273	0.8696	3018498
Year 2	3964244	-2585513	7435517	0.7561	2997538
Year 3	3950442	1364929	11385959	0.6575	2597480
Year 4	3240339	4605268	14626298	0.5718	1852674
TOTAL					10466190

The Net NPV after 4 years is 445160

(10466190 - 10021030 )

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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	(10021030)	-10021030	-	-
Year 1	3471273	-6549757	3471273	0.8333	2892728
Year 2	3964244	-2585513	7435517	0.6944	2752947
Year 3	3950442	1364929	11385959	0.5787	2286135
Year 4	3240339	4605268	14626298	0.4823	1562663
TOTAL					9494474

The Net NPV after 4 years is -526556

At 20% discount rate the NPV is negative (9494474 - 10021030 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Varied Plant 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 Varied Plant has a NPV value higher than Zero then finance managers at Varied Plant 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 Varied Plant, then the stock price of the Varied Plant 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 Varied Plant 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.

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.

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 Coal, Nuclear, Natural Gas, Oil, or Renewable: Which Type of Power Plant Should We Build?

References & Further Readings

Gary Clendenen, Paul W. Thurston, Fang Zhao, Stephen Kidwell (2018), "Coal, Nuclear, Natural Gas, Oil, or Renewable: Which Type of Power Plant Should We Build? Harvard Business Review Case Study. Published by HBR Publications.