City of Somerville:Using Activity-Based Budgeting to Improve Performance in the Somerville Traffic Unit 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 City of Somerville:Using Activity-Based Budgeting to Improve Performance in the Somerville Traffic Unit case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. City of Somerville:Using Activity-Based Budgeting to Improve Performance in the Somerville Traffic Unit case study is a Harvard Business School (HBR) case study written by Linda J. Bilmes. The City of Somerville:Using Activity-Based Budgeting to Improve Performance in the Somerville Traffic Unit (referred as “Budgeting Somerville” from here on) case study provides evaluation & decision scenario in field of Global Business. It also touches upon business topics such as - Value proposition, Assessing performance, Costs, Government, Leadership.

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 City of Somerville:Using Activity-Based Budgeting to Improve Performance in the Somerville Traffic Unit Case Study

Since 2004, City of Somerville Mayor Joseph Curtatone has undertaken a series of fiscal reforms that have allowed the City to improve municipal services during financial hard times. A key reform has been the City's adoption of the budgeting approach called activity-based costing (ABC budgeting). With ABC budgeting, City officials have been able to make budgetary decisions based on detailed information about the expenses and revenues associated with discrete City activities. The transition to ABC budgeting from line-item budgeting that most municipalities use has not been easy, however.As first step, Somerville officials developed an inventory of the main programs of each of Somerville's 18 departments and the costs associated with each program. Calculating costs at the program level required a less detailed analysis than calculating costs at the activity level. They identified the activities associated with each program and established performance objectives for each activity. During the fall of 2004, HKS Prof. Linda Bilmes and her students helped Somerville officials accomplish these steps. Together, this information allowed officials and residents to understand for the first time how the City's expenditure of tax dollars translated directly into the City's delivery of services that constituents valued. Encouraged by the results, the Mayor asked Prof. Bilmes and her students to focus on a municipal activity of particular concern to officials and residents: traffic enforcement. Mayor Curtatone asked whether increasing enforcement of the City's traffic laws might pay for itself through increased citation revenue. The case walks through the steps Bilmes and her students took to determine the answer, including allocating personnel expenditures to the activity of traffic enforcement, allocating non-personnel expenditures to that activity through selection and use of an appropriate cost driver, and calculation of the revenue generated from traffic enforcement.

Case Authors : Linda J. Bilmes

Topic : Global Business

Related Areas : Assessing performance, Costs, Government, Leadership

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Calculating Net Present Value (NPV) at 6% for City of Somerville:Using Activity-Based Budgeting to Improve Performance in the Somerville Traffic Unit Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10017844)	-10017844	-	-
Year 1	3447273	-6570571	3447273	0.9434	3252144
Year 2	3954911	-2615660	7402184	0.89	3519857
Year 3	3947109	1331449	11349293	0.8396	3314069
Year 4	3243281	4574730	14592574	0.7921	2568982
TOTAL			14592574		12655052

The Net Present Value at 6% discount rate is 2637208

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. Profitability Index
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. Magnitude of both incoming and outgoing cash flows – Projects can be capital intensive, time intensive, or both. Budgeting Somerville 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 Budgeting Somerville have higher preference for cash returns over 4-5 years rather than 10-15 years given the nature of the volatility in the industry.

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Formula and Steps to Calculate Net Present Value (NPV) of City of Somerville:Using Activity-Based Budgeting to Improve Performance in the Somerville Traffic Unit

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 Budgeting Somerville 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 Budgeting Somerville 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	(10017844)	-10017844	-	-
Year 1	3447273	-6570571	3447273	0.8696	2997629
Year 2	3954911	-2615660	7402184	0.7561	2990481
Year 3	3947109	1331449	11349293	0.6575	2595288
Year 4	3243281	4574730	14592574	0.5718	1854356
TOTAL					10437754

The Net NPV after 4 years is 419910

(10437754 - 10017844 )

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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	(10017844)	-10017844	-	-
Year 1	3447273	-6570571	3447273	0.8333	2872728
Year 2	3954911	-2615660	7402184	0.6944	2746466
Year 3	3947109	1331449	11349293	0.5787	2284207
Year 4	3243281	4574730	14592574	0.4823	1564082
TOTAL					9467482

The Net NPV after 4 years is -550362

At 20% discount rate the NPV is negative (9467482 - 10017844 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Budgeting Somerville 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 Budgeting Somerville has a NPV value higher than Zero then finance managers at Budgeting Somerville 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 Budgeting Somerville, then the stock price of the Budgeting Somerville 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 Budgeting Somerville 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 –

Understanding of risks involved in the project.

What will be a multi year spillover effect of various taxation regulations.

What can impact the cash flow of 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 are the key aspects of the projects that need to be monitored, refined, and retuned for continuous delivery of projected cash flows.

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 City of Somerville:Using Activity-Based Budgeting to Improve Performance in the Somerville Traffic Unit

References & Further Readings

Linda J. Bilmes (2018), "City of Somerville:Using Activity-Based Budgeting to Improve Performance in the Somerville Traffic Unit Harvard Business Review Case Study. Published by HBR Publications.