Introduction to Net Present Value (NPV) - What is Net Present Value (NPV) ? How it impacts financial decisions regarding project management?
At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Mubadala: Forging Development in Abu Dhabi case study is a Harvard Business School (HBR) case study written by Rawi Abdelal, Irina Tarsis. The Mubadala: Forging Development in Abu Dhabi (referred as “Abu Dhabi” from here on) case study provides evaluation & decision scenario in field of Global Business. It also touches upon business topics such as - Value proposition, Global strategy, Globalization, Leadership, 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.
In 2007, Khaldoon Khalifa Al Mubarak, the CEO of Mubadala Development Company (Mubadala), had every reason to be optimistic about the future of his home, Abu Dhabi, one of the emirates comprising the United Arab Emirates (UAE). The tiny, sandy, and dry emirate with a population of 1.5 million, only 420,000 of whom were citizens, was nestled upon nearly 10% of the world's known reserves of oil and the 4th largest proven reserve of natural gas. With the price of oil doubling every 10 years between 1970 and the 2000s, the state-owned Abu Dhabi National Oil Company (ADNOC) had enjoyed an era of increasing profitability. Another state-owned firm, Abu Dhabi Investment Authority (ADIA), had been investing extra oil revenues outside of the county for more than 30 years, and the intensely secretive organization had amassed assets worth an astonishing--and still rapidly growing--$500 billion to $900 billion. A common refrain held that Abu Dhabi nationals could live off of the returns generated by ADIA forever. Some accordingly referred to the emirate as "the richest city in the world." Yet Al Mubarak, trusted advisor to the crown prince Mohamed bin Zayed Al Nahayan, and Mubadala were charged with transforming the economy of the emirate. Many were concerned that Abu Dhabi was in danger of suffering from the so-called "resource curse," as its economy focused on fossil fuels and little else. Not only would Abu Dhabi's economy continue to be subjected to the vagaries of world energy prices, there would be little for its citizens to do. Not everyone could work for ADNOC or ADIA. Not everyone was from one of Abu Dhabi's handful of incredibly wealthy families. To be a developed country, Abu Dhabi needed change. Fortune had already played perhaps too large a role.
| Years | Cash Flow | Net Cash Flow | Cumulative Cash Flow |
Discount Rate @ 6 % |
Discounted Cash Flows |
|---|---|---|---|---|---|
| Year 0 | (10021713) | -10021713 | - | - | |
| Year 1 | 3471747 | -6549966 | 3471747 | 0.9434 | 3275233 |
| Year 2 | 3971717 | -2578249 | 7443464 | 0.89 | 3534814 |
| Year 3 | 3948420 | 1370171 | 11391884 | 0.8396 | 3315170 |
| Year 4 | 3248302 | 4618473 | 14640186 | 0.7921 | 2572959 |
| TOTAL | 14640186 | 12698176 |
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 -
Capital Budgeting Approaches
There are four types of capital budgeting techniques that are widely used in the corporate world –
1. Internal Rate of Return
2. Profitability Index
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 Abu Dhabi 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. Abu Dhabi shareholders have preference for diversified projects investment rather than prospective high income from a single capital intensive project.
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
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 Abu Dhabi 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 Abu Dhabi 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.
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 | (10021713) | -10021713 | - | - | |
| Year 1 | 3471747 | -6549966 | 3471747 | 0.8696 | 3018910 |
| Year 2 | 3971717 | -2578249 | 7443464 | 0.7561 | 3003189 |
| Year 3 | 3948420 | 1370171 | 11391884 | 0.6575 | 2596150 |
| Year 4 | 3248302 | 4618473 | 14640186 | 0.5718 | 1857227 |
| TOTAL | 10475477 |
(10475477 - 10021713 )
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 | (10021713) | -10021713 | - | - | |
| Year 1 | 3471747 | -6549966 | 3471747 | 0.8333 | 2893123 |
| Year 2 | 3971717 | -2578249 | 7443464 | 0.6944 | 2758137 |
| Year 3 | 3948420 | 1370171 | 11391884 | 0.5787 | 2284965 |
| Year 4 | 3248302 | 4618473 | 14640186 | 0.4823 | 1566504 |
| TOTAL | 9502728 |
At 20% discount rate the NPV is negative (9502728 - 10021713 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Abu Dhabi to discount cash flow at lower discount rates such as 15%.
Simplest Approach – If the investment project of Abu Dhabi has a NPV value higher than Zero then finance managers at Abu Dhabi 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 Abu Dhabi, then the stock price of the Abu Dhabi 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.
Project selection is often a far more complex decision than just choosing it based on the NPV number. Finance managers at Abu Dhabi 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 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.
What are the key aspects of the projects that need to be monitored, refined, and retuned for continuous delivery of projected cash flows.
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.
Rawi Abdelal, Irina Tarsis (2018), "Mubadala: Forging Development in Abu Dhabi Harvard Business Review Case Study. Published by HBR Publications.
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