AEP: Carbon Capture and Storage 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 AEP: Carbon Capture and Storage case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. AEP: Carbon Capture and Storage case study is a Harvard Business School (HBR) case study written by Richard H.K. Vietor. The AEP: Carbon Capture and Storage (referred as “Aep Carbon” from here on) case study provides evaluation & decision scenario in field of Global Business. It also touches upon business topics such as - Value proposition, Economic development, Government, Innovation, Joint ventures, Sustainability, Technology.

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 AEP: Carbon Capture and Storage Case Study

By October 2010, American Electric Power, the largest coal-fired, electric utility in the United States, had been operating a carbon capture and sequestration pilot plant for one year. Using a proprietary, Alstom chilled ammonia technology, AEP was capturing and sequestering 90% of the carbon dioxide in a small waste stream at its Mountaineer plant in West Virginia. As part of its larger carbon reduction strategy, AEP was launching construction of a $680 million demonstration plan, partially funded with DOE money. Mike Morris, AEP's chairman, was frustrated though, that Congress had not passed a cap-and-trade bill, and was worried how he would recover AEP's share of this huge investment. Could he find partners in this cutting-edge demonstration, or at least, add it to his utility rate base?

Case Authors : Richard H.K. Vietor

Topic : Global Business

Related Areas : Economic development, Government, Innovation, Joint ventures, Sustainability, Technology

---

Calculating Net Present Value (NPV) at 6% for AEP: Carbon Capture and Storage Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10003338)	-10003338	-	-
Year 1	3466605	-6536733	3466605	0.9434	3270382
Year 2	3955748	-2580985	7422353	0.89	3520602
Year 3	3956487	1375502	11378840	0.8396	3321943
Year 4	3245738	4621240	14624578	0.7921	2570929
TOTAL			14624578		12683855

The Net Present Value at 6% discount rate is 2680517

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. Profitability Index
2. Net Present Value
3. Payback Period
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. Timing of the expected cash flows – stockholders of Aep Carbon 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. Aep Carbon shareholders have preference for diversified projects investment rather than prospective high income from a single capital intensive project.

---

Formula and Steps to Calculate Net Present Value (NPV) of AEP: Carbon Capture and Storage

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 Aep Carbon 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 Aep Carbon 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	(10003338)	-10003338	-	-
Year 1	3466605	-6536733	3466605	0.8696	3014439
Year 2	3955748	-2580985	7422353	0.7561	2991114
Year 3	3956487	1375502	11378840	0.6575	2601454
Year 4	3245738	4621240	14624578	0.5718	1855761
TOTAL					10462769

The Net NPV after 4 years is 459431

(10462769 - 10003338 )

---

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	(10003338)	-10003338	-	-
Year 1	3466605	-6536733	3466605	0.8333	2888838
Year 2	3955748	-2580985	7422353	0.6944	2747047
Year 3	3956487	1375502	11378840	0.5787	2289634
Year 4	3245738	4621240	14624578	0.4823	1565267
TOTAL					9490786

The Net NPV after 4 years is -512552

At 20% discount rate the NPV is negative (9490786 - 10003338 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Aep Carbon 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 Aep Carbon has a NPV value higher than Zero then finance managers at Aep Carbon 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 Aep Carbon, then the stock price of the Aep Carbon 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 Aep Carbon 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.

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.

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.

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 AEP: Carbon Capture and Storage

References & Further Readings

Richard H.K. Vietor (2018), "AEP: Carbon Capture and Storage Harvard Business Review Case Study. Published by HBR Publications.