Water Funds: Financing Nature's Ability to Protect Water Supplies 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 Water Funds: Financing Nature's Ability to Protect Water Supplies case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Water Funds: Financing Nature's Ability to Protect Water Supplies case study is a Harvard Business School (HBR) case study written by Erica Plambeck, Gretchen Daily, David W. Hoyt. The Water Funds: Financing Nature's Ability to Protect Water Supplies (referred as “Water Pes” from here on) case study provides evaluation & decision scenario in field of Finance & Accounting. 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 Water Funds: Financing Nature's Ability to Protect Water Supplies Case Study

Nature plays an important role in maintaining the flow and purity of water. Human activities often degrade the quality and/or quantity of water flowing to downstream users, but the maintenance of natural ecosystems and the sound conservation management by those living upstream in watersheds can help provide a clean, reliable supply of water for downstream water users. Water funds are a way for downstream water users to preserve their water supply, by paying to restore and conserve natural ecosystems. They also enable upstream and downstream communities to work together for mutual benefit, preserving or restoring nature's ability to improve water quality and reliable flow while providing economic opportunities for upstream communities. This case introduces the concept of ecosystem services (the role that natural ecosystems play in sustaining and fulfilling human life) and payment for ecosystem services (PES), in which stakeholders pay in order to preserve or restore the ability of nature to provide these services. It describes water funds and other PES arrangements, as well as some of the challenges that water funds face. Several examples are provided of water funds and other PES programs.

Case Authors : Erica Plambeck, Gretchen Daily, David W. Hoyt

Topic : Finance & Accounting

Related Areas :

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Calculating Net Present Value (NPV) at 6% for Water Funds: Financing Nature's Ability to Protect Water Supplies Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10027883)	-10027883	-	-
Year 1	3452074	-6575809	3452074	0.9434	3256674
Year 2	3970168	-2605641	7422242	0.89	3533435
Year 3	3974847	1369206	11397089	0.8396	3337358
Year 4	3232478	4601684	14629567	0.7921	2560425
TOTAL			14629567		12687892

The Net Present Value at 6% discount rate is 2660009

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. Profitability Index
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. Water Pes 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 Water Pes 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 Water Funds: Financing Nature's Ability to Protect Water Supplies

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 Water Pes 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 Water Pes 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	(10027883)	-10027883	-	-
Year 1	3452074	-6575809	3452074	0.8696	3001803
Year 2	3970168	-2605641	7422242	0.7561	3002017
Year 3	3974847	1369206	11397089	0.6575	2613526
Year 4	3232478	4601684	14629567	0.5718	1848180
TOTAL					10465527

The Net NPV after 4 years is 437644

(10465527 - 10027883 )

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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	(10027883)	-10027883	-	-
Year 1	3452074	-6575809	3452074	0.8333	2876728
Year 2	3970168	-2605641	7422242	0.6944	2757061
Year 3	3974847	1369206	11397089	0.5787	2300259
Year 4	3232478	4601684	14629567	0.4823	1558872
TOTAL					9492921

The Net NPV after 4 years is -534962

At 20% discount rate the NPV is negative (9492921 - 10027883 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Water Pes 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 Water Pes has a NPV value higher than Zero then finance managers at Water Pes 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 Water Pes, then the stock price of the Water Pes 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 Water Pes 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.

What will be a multi year spillover effect of various taxation regulations.

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.

What can impact the cash flow of 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.

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Negotiation Strategy of Water Funds: Financing Nature's Ability to Protect Water Supplies

References & Further Readings

Erica Plambeck, Gretchen Daily, David W. Hoyt (2018), "Water Funds: Financing Nature's Ability to Protect Water Supplies Harvard Business Review Case Study. Published by HBR Publications.