RWE and the Proposal for a German Electricity Regulator, Spanish Version 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 RWE and the Proposal for a German Electricity Regulator, Spanish Version case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. RWE and the Proposal for a German Electricity Regulator, Spanish Version case study is a Harvard Business School (HBR) case study written by Alexander Dyck, Jose Gomez-Ibanez, Christopher Meier. The RWE and the Proposal for a German Electricity Regulator, Spanish Version (referred as “Rwe Electricity” 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 RWE and the Proposal for a German Electricity Regulator, Spanish Version Case Study

In April 2001, Dietmar Kuhnt, CEO of the German energy giant RWE, had to make a decision that would affect his company's future. Profits in the electricity sector depended heavily on regulatory rules that influenced industry structure and pricing. RWE had emerged through deregulation as one of the largest electricity companies in Germany and a multiutility. Now there was a proposal on the table to replace the largely lighthanded regulatory model based on negotiation between private parties with a more traditional regulatory model of an industry-specific regulator. What type of regulatory regime would be best suited to RWE's ambitious strategy to grow and prosper?

Case Authors : Alexander Dyck, Jose Gomez-Ibanez, Christopher Meier

Topic : Global Business

Related Areas :

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Calculating Net Present Value (NPV) at 6% for RWE and the Proposal for a German Electricity Regulator, Spanish Version Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10006860)	-10006860	-	-
Year 1	3464495	-6542365	3464495	0.9434	3268392
Year 2	3966733	-2575632	7431228	0.89	3530378
Year 3	3965351	1389719	11396579	0.8396	3329385
Year 4	3243150	4632869	14639729	0.7921	2568879
TOTAL			14639729		12697033

The Net Present Value at 6% discount rate is 2690173

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. Profitability Index
2. Internal Rate of Return
3. Net Present Value
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 Rwe Electricity 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. Rwe Electricity 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 RWE and the Proposal for a German Electricity Regulator, Spanish Version

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 Rwe Electricity 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 Rwe Electricity 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	(10006860)	-10006860	-	-
Year 1	3464495	-6542365	3464495	0.8696	3012604
Year 2	3966733	-2575632	7431228	0.7561	2999420
Year 3	3965351	1389719	11396579	0.6575	2607283
Year 4	3243150	4632869	14639729	0.5718	1854282
TOTAL					10473589

The Net NPV after 4 years is 466729

(10473589 - 10006860 )

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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	(10006860)	-10006860	-	-
Year 1	3464495	-6542365	3464495	0.8333	2887079
Year 2	3966733	-2575632	7431228	0.6944	2754676
Year 3	3965351	1389719	11396579	0.5787	2294763
Year 4	3243150	4632869	14639729	0.4823	1564019
TOTAL					9500537

The Net NPV after 4 years is -506323

At 20% discount rate the NPV is negative (9500537 - 10006860 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Rwe Electricity 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 Rwe Electricity has a NPV value higher than Zero then finance managers at Rwe Electricity 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 Rwe Electricity, then the stock price of the Rwe Electricity 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 Rwe Electricity 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 will be a multi year spillover effect of various taxation regulations.

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 can impact the cash flow of the project.

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 RWE and the Proposal for a German Electricity Regulator, Spanish Version

References & Further Readings

Alexander Dyck, Jose Gomez-Ibanez, Christopher Meier (2018), "RWE and the Proposal for a German Electricity Regulator, Spanish Version Harvard Business Review Case Study. Published by HBR Publications.