Creating and Managing Economic Competitiveness: The Saudi Arabia General Investment Authority 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 Creating and Managing Economic Competitiveness: The Saudi Arabia General Investment Authority case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Creating and Managing Economic Competitiveness: The Saudi Arabia General Investment Authority case study is a Harvard Business School (HBR) case study written by Stephen Goldsmith, Khalid O. Al-Yahya. The Creating and Managing Economic Competitiveness: The Saudi Arabia General Investment Authority (referred as “Arabia Saudi” from here on) case study provides evaluation & decision scenario in field of Global Business. It also touches upon business topics such as - Value proposition, Economy, Globalization, Government, Human resource management, Innovation, Joint ventures, Project management, Strategic planning.

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 Creating and Managing Economic Competitiveness: The Saudi Arabia General Investment Authority Case Study

The Saudi Arabia General Investment Authority (SAGIA) is an agency established in 2000 to improve the business environment and encourage foreign investment in the Kingdom of Saudi Arabia. This agency was created out of the Kingdom's landmark Foreign Investment Law of 2000 with the mandate to diversify the economy and provide jobs for its burgeoning young population. The fledgling agency was expected to enlist the aid of other government ministries and agencies in reducing barriers to investment-including the politically sensitive "Saudization" policy, which gave employment preference to Saudis over foreign workers-and in marketing Saudi Arabia as a welcoming location for foreign investors. However, the law that had formed SAGIA, gave it few tools to work with. Therefore, it had to find a way to cooperate with the rest of the government to effect change. SAGIA's first governor, Prince Abdullah, retired in 2004, and it would be the task of his successor, Amr Al Dabbagh, to advance SAGIA's mission. It remains to be seen whether Al Dabbagh, a successful businessman, could overcome the challenges that had thus far stymied the young agency. The case should be used for class discussions of several important themes: the difficulty of collaboration across government bureaucracy with little authority or resources; effecting change in an unfavorable political climate - both external and internal; human capital development with the skill for strategic planning and communications; and the impact of an individual dynamic leader on an organization. HKS Case Number 1926.0

Case Authors : Stephen Goldsmith, Khalid O. Al-Yahya

Topic : Global Business

Related Areas : Economy, Globalization, Government, Human resource management, Innovation, Joint ventures, Project management, Strategic planning

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Calculating Net Present Value (NPV) at 6% for Creating and Managing Economic Competitiveness: The Saudi Arabia General Investment Authority Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10000124)	-10000124	-	-
Year 1	3458101	-6542023	3458101	0.9434	3262359
Year 2	3958241	-2583782	7416342	0.89	3522820
Year 3	3937271	1353489	11353613	0.8396	3305809
Year 4	3243973	4597462	14597586	0.7921	2569530
TOTAL			14597586		12660519

The Net Present Value at 6% discount rate is 2660395

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. Payback Period
3. Internal Rate of Return
4. Net Present Value

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 Arabia Saudi 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. Arabia Saudi 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 Creating and Managing Economic Competitiveness: The Saudi Arabia General Investment Authority

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 Arabia Saudi 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 Arabia Saudi 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	(10000124)	-10000124	-	-
Year 1	3458101	-6542023	3458101	0.8696	3007044
Year 2	3958241	-2583782	7416342	0.7561	2992999
Year 3	3937271	1353489	11353613	0.6575	2588820
Year 4	3243973	4597462	14597586	0.5718	1854752
TOTAL					10443615

The Net NPV after 4 years is 443491

(10443615 - 10000124 )

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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	(10000124)	-10000124	-	-
Year 1	3458101	-6542023	3458101	0.8333	2881751
Year 2	3958241	-2583782	7416342	0.6944	2748778
Year 3	3937271	1353489	11353613	0.5787	2278513
Year 4	3243973	4597462	14597586	0.4823	1564416
TOTAL					9473459

The Net NPV after 4 years is -526665

At 20% discount rate the NPV is negative (9473459 - 10000124 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Arabia Saudi 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 Arabia Saudi has a NPV value higher than Zero then finance managers at Arabia Saudi 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 Arabia Saudi, then the stock price of the Arabia Saudi 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 Arabia Saudi 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 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 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.

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 Creating and Managing Economic Competitiveness: The Saudi Arabia General Investment Authority

References & Further Readings

Stephen Goldsmith, Khalid O. Al-Yahya (2018), "Creating and Managing Economic Competitiveness: The Saudi Arabia General Investment Authority Harvard Business Review Case Study. Published by HBR Publications.