Reading Energy 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 Reading Energy case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Reading Energy case study is a Harvard Business School (HBR) case study written by Forest Reinhardt, Peggy Duxbury. The Reading Energy (referred as “Waste Reading's” from here on) case study provides evaluation & decision scenario in field of Global Business. It also touches upon business topics such as - Value proposition, Public relations, Risk management, Social responsibility, Strategic planning, 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

Case Description of Reading Energy Case Study

Reading Energy builds facilities that produce energy from nontraditional fuels. A privately held, entrepreneurial organization, it has spent six years developing a plan to build a waste-to-energy plant in the town of Robbins, Illinois. The plant would burn municipal solid waste, producing electricity for sale to the local utility. Its economics are driven by the cost of alternative waste disposal technologies (mostly landfills) and by the Public Regulatory Policy Act of 1978, which ensures a market for the power. Reading's project has been delayed by political opposition at both the local and state levels. Robbins is a poor community, and some of Reading's antagonists have invoked environmental justice as a reason to oppose the project. Tom Cassel, the engineer who founded Reading, is negotiating contracts for waste with nearby municipalities. He needs to consider price, risk allocation, and other economic factors, in addition to political and social issues, in designing his firm's strategy and tactics.

Case Authors : Forest Reinhardt, Peggy Duxbury

Topic : Global Business

Related Areas : Public relations, Risk management, Social responsibility, Strategic planning, Sustainability

Calculating Net Present Value (NPV) at 6% for Reading Energy Case Study

Years              Cash Flow     Net Cash Flow     Cumulative    
Cash Flow
Discount Rate
@ 6 %
Cash Flows
Year 0 (10017610) -10017610 - -
Year 1 3446262 -6571348 3446262 0.9434 3251191
Year 2 3981534 -2589814 7427796 0.89 3543551
Year 3 3950668 1360854 11378464 0.8396 3317057
Year 4 3233175 4594029 14611639 0.7921 2560977
TOTAL 14611639 12672776

The Net Present Value at 6% discount rate is 2655166

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. Payback Period
3. Net Present Value
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. Waste Reading's 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 Waste Reading's 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 Reading Energy

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 Waste Reading's 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 Waste Reading's 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 %
Cash Flows
Year 0 (10017610) -10017610 - -
Year 1 3446262 -6571348 3446262 0.8696 2996750
Year 2 3981534 -2589814 7427796 0.7561 3010612
Year 3 3950668 1360854 11378464 0.6575 2597628
Year 4 3233175 4594029 14611639 0.5718 1848578
TOTAL 10453568

The Net NPV after 4 years is 435958

(10453568 - 10017610 )

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 %
Cash Flows
Year 0 (10017610) -10017610 - -
Year 1 3446262 -6571348 3446262 0.8333 2871885
Year 2 3981534 -2589814 7427796 0.6944 2764954
Year 3 3950668 1360854 11378464 0.5787 2286266
Year 4 3233175 4594029 14611639 0.4823 1559209
TOTAL 9482314

The Net NPV after 4 years is -535296

At 20% discount rate the NPV is negative (9482314 - 10017610 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Waste Reading's 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 Waste Reading's has a NPV value higher than Zero then finance managers at Waste Reading's 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 Waste Reading's, then the stock price of the Waste Reading's 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 Waste Reading's 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.

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 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.

References & Further Readings

Forest Reinhardt, Peggy Duxbury (2018), "Reading Energy Harvard Business Review Case Study. Published by HBR Publications.