Goats: The Green Alternative (B) 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 Goats: The Green Alternative (B) case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Goats: The Green Alternative (B) case study is a Harvard Business School (HBR) case study written by David Currie, Kyle S. Meyer. The Goats: The Green Alternative (B) (referred as “Trailer Truck” from here on) case study provides evaluation & decision scenario in field of Finance & Accounting. It also touches upon business topics such as - Value proposition, Analytics, Budgeting, Business models, Entrepreneurship.

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 Goats: The Green Alternative (B) Case Study

The owner of a goat herd had successfully rented a portion of his herd to clear land at a nearby resort. The resort land clearing job generated a small profit and now the owner is evaluating the prospects of bidding on similar land clearing projects in the area. The owner believes that profitability for this line of business is constrained by the size of the truck and trailer used to transport the goats to the job site. He reasons that a larger truck and trailer would allow him to transport more goats to the job site each day, generating incremental revenues. He also realizes that a larger truck and trailer would result in increased operating costs. The owner determines the investment needed to upgrade the truck and trailer. He must then determine if incremental revenues and costs associated with the larger truck and trailer would justify the initial investment. This case provides a realistic analysis of incremental revenues and costs in the context of capital budgeting. The (B) case can be used independently of the (A) case if the professor wishes to focus exclusively on capital budgeting.

Case Authors : David Currie, Kyle S. Meyer

Topic : Finance & Accounting

Related Areas : Analytics, Budgeting, Business models, Entrepreneurship

---

Calculating Net Present Value (NPV) at 6% for Goats: The Green Alternative (B) Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10002724)	-10002724	-	-
Year 1	3450995	-6551729	3450995	0.9434	3255656
Year 2	3956590	-2595139	7407585	0.89	3521351
Year 3	3962294	1367155	11369879	0.8396	3326818
Year 4	3241027	4608182	14610906	0.7921	2567197
TOTAL			14610906		12671022

The Net Present Value at 6% discount rate is 2668298

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. Payback Period
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. Trailer Truck 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 Trailer Truck 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 Goats: The Green Alternative (B)

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 Trailer Truck 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 Trailer Truck 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	(10002724)	-10002724	-	-
Year 1	3450995	-6551729	3450995	0.8696	3000865
Year 2	3956590	-2595139	7407585	0.7561	2991750
Year 3	3962294	1367155	11369879	0.6575	2605273
Year 4	3241027	4608182	14610906	0.5718	1853068
TOTAL					10450956

The Net NPV after 4 years is 448232

(10450956 - 10002724 )

---

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	(10002724)	-10002724	-	-
Year 1	3450995	-6551729	3450995	0.8333	2875829
Year 2	3956590	-2595139	7407585	0.6944	2747632
Year 3	3962294	1367155	11369879	0.5787	2292994
Year 4	3241027	4608182	14610906	0.4823	1562995
TOTAL					9479451

The Net NPV after 4 years is -523273

At 20% discount rate the NPV is negative (9479451 - 10002724 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Trailer Truck 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 Trailer Truck has a NPV value higher than Zero then finance managers at Trailer Truck 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 Trailer Truck, then the stock price of the Trailer Truck 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 Trailer Truck 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 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.

Understanding of risks involved in the project.

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.

---

Negotiation Strategy of Goats: The Green Alternative (B)

References & Further Readings

David Currie, Kyle S. Meyer (2018), "Goats: The Green Alternative (B) Harvard Business Review Case Study. Published by HBR Publications.