ABC Energy Limited: Culture and Formalization 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 ABC Energy Limited: Culture and Formalization case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. ABC Energy Limited: Culture and Formalization case study is a Harvard Business School (HBR) case study written by Pavitra Mishra, Rajen Gupta. The ABC Energy Limited: Culture and Formalization (referred as “Abcel Formalization” from here on) case study provides evaluation & decision scenario in field of Innovation & Entrepreneurship. It also touches upon business topics such as - Value proposition, Growth strategy, Human resource management, International business, Organizational culture.

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 ABC Energy Limited: Culture and Formalization Case Study

AWARD WINNING CASE: Adjudged third best case at the ISB Case Competition 2010 held in partnership with the Richard Ivey School of Business and the Association of Indian Management Schools and sponsored by the Chartered Institute of Management Accountants.ABC Energy Limited (ABCEL) was created in March 2007 by ABC Infra Private Limited and XYG Private Limited. In September 2007, MNP Finance Limited joined ABCEL as an equity partner. In 2010, ABCEL operated in power generation and had plans to diversify into transmission and distribution. It aspired to be a world-class energy company with operations in India and neighbouring countries. Over the last few years, ABCEL had grown by investing in greenfield projects and by acquiring existing operations. The promoters of ABCEL had set a target of achieving a project portfolio of 30,000 MW by 2015, with the current portfolio being 8,655 MW. The chief executive officer of ABCEL wanted to discuss the following issues at the board meeting on July 31, 2010, with regard to the opportunities and challenges in the growing market: 1) the key organizational needs ABCEL might face in achieving its target by 2015 2) the present culture of ABCEL 3) the relationship between the culture and extent of formalization and hence the ramp-up of formalization ABCEL might require, and 4) the method of introducing this formalization.

Case Authors : Pavitra Mishra, Rajen Gupta

Topic : Innovation & Entrepreneurship

Related Areas : Growth strategy, Human resource management, International business, Organizational culture

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Calculating Net Present Value (NPV) at 6% for ABC Energy Limited: Culture and Formalization Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10006892)	-10006892	-	-
Year 1	3461499	-6545393	3461499	0.9434	3265565
Year 2	3958576	-2586817	7420075	0.89	3523119
Year 3	3965327	1378510	11385402	0.8396	3329365
Year 4	3243491	4622001	14628893	0.7921	2569149
TOTAL			14628893		12687197

The Net Present Value at 6% discount rate is 2680305

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. Internal Rate of Return
2. Net Present Value
3. Profitability Index
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. Magnitude of both incoming and outgoing cash flows – Projects can be capital intensive, time intensive, or both. Abcel Formalization 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 Abcel Formalization 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 ABC Energy Limited: Culture and Formalization

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 Innovation & Entrepreneurship 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 Abcel Formalization 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 Abcel Formalization 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	(10006892)	-10006892	-	-
Year 1	3461499	-6545393	3461499	0.8696	3009999
Year 2	3958576	-2586817	7420075	0.7561	2993252
Year 3	3965327	1378510	11385402	0.6575	2607267
Year 4	3243491	4622001	14628893	0.5718	1854477
TOTAL					10464995

The Net NPV after 4 years is 458103

(10464995 - 10006892 )

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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	(10006892)	-10006892	-	-
Year 1	3461499	-6545393	3461499	0.8333	2884583
Year 2	3958576	-2586817	7420075	0.6944	2749011
Year 3	3965327	1378510	11385402	0.5787	2294749
Year 4	3243491	4622001	14628893	0.4823	1564184
TOTAL					9492527

The Net NPV after 4 years is -514365

At 20% discount rate the NPV is negative (9492527 - 10006892 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Abcel Formalization 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 Abcel Formalization has a NPV value higher than Zero then finance managers at Abcel Formalization 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 Abcel Formalization, then the stock price of the Abcel Formalization 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 Abcel Formalization 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.

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

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 ABC Energy Limited: Culture and Formalization

References & Further Readings

Pavitra Mishra, Rajen Gupta (2018), "ABC Energy Limited: Culture and Formalization Harvard Business Review Case Study. Published by HBR Publications.