Environmental Risk Management at Chevron Corp. 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 Environmental Risk Management at Chevron Corp. case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Environmental Risk Management at Chevron Corp. case study is a Harvard Business School (HBR) case study written by Forest Reinhardt, Monica Mandelli, Jennifer Burns. The Environmental Risk Management at Chevron Corp. (referred as “Chevron Environmental” from here on) case study provides evaluation & decision scenario in field of Global Business. It also touches upon business topics such as - Value proposition, International business, Organizational structure, Risk management, Supply chain, 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 Environmental Risk Management at Chevron Corp. Case Study

Chevron Corp., headquartered in San Francisco, manages a worldwide, vertically integrated value chain from the oil well to the gasoline station. Mishandling of oil at any stage of production can damage the natural environment, human health, corporate profitability, or all three. But at the same time Chevron needs to be prudent about the amount of money it spends on measures to manage these risks, and environmental programs within the firm can conflict with a long-standing tradition of decentralized management. To manage risks more efficiently, Chevron executives are contemplating the use of quantitative decision tools that enable operating managers to compute rough benefit-cost ratios for various alternative risk management projects. The case focuses on the pros and cons of using such tools within the context of Chevron's overall system for environmental risk management.

Case Authors : Forest Reinhardt, Monica Mandelli, Jennifer Burns

Topic : Global Business

Related Areas : International business, Organizational structure, Risk management, Supply chain, Sustainability

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Calculating Net Present Value (NPV) at 6% for Environmental Risk Management at Chevron Corp. Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10025966)	-10025966	-	-
Year 1	3459077	-6566889	3459077	0.9434	3263280
Year 2	3976151	-2590738	7435228	0.89	3538760
Year 3	3945913	1355175	11381141	0.8396	3313065
Year 4	3235635	4590810	14616776	0.7921	2562926
TOTAL			14616776		12678031

The Net Present Value at 6% discount rate is 2652065

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

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 Chevron Environmental 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. Chevron Environmental 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 Environmental Risk Management at Chevron Corp.

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 Chevron Environmental 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 Chevron Environmental 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	(10025966)	-10025966	-	-
Year 1	3459077	-6566889	3459077	0.8696	3007893
Year 2	3976151	-2590738	7435228	0.7561	3006541
Year 3	3945913	1355175	11381141	0.6575	2594502
Year 4	3235635	4590810	14616776	0.5718	1849985
TOTAL					10458921

The Net NPV after 4 years is 432955

(10458921 - 10025966 )

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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	(10025966)	-10025966	-	-
Year 1	3459077	-6566889	3459077	0.8333	2882564
Year 2	3976151	-2590738	7435228	0.6944	2761216
Year 3	3945913	1355175	11381141	0.5787	2283514
Year 4	3235635	4590810	14616776	0.4823	1560395
TOTAL					9487690

The Net NPV after 4 years is -538276

At 20% discount rate the NPV is negative (9487690 - 10025966 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Chevron Environmental 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 Chevron Environmental has a NPV value higher than Zero then finance managers at Chevron Environmental 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 Chevron Environmental, then the stock price of the Chevron Environmental 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 Chevron Environmental 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.

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.

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 Environmental Risk Management at Chevron Corp.

References & Further Readings

Forest Reinhardt, Monica Mandelli, Jennifer Burns (2018), "Environmental Risk Management at Chevron Corp. Harvard Business Review Case Study. Published by HBR Publications.