Optima Environment S.A.: Turning a Wonder Tree Into an Eco-Business 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 Optima Environment S.A.: Turning a Wonder Tree Into an Eco-Business case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Optima Environment S.A.: Turning a Wonder Tree Into an Eco-Business case study is a Harvard Business School (HBR) case study written by Jean-Philippe Deschamps, Benoit Leleux, Atul Pahwa. The Optima Environment S.A.: Turning a Wonder Tree Into an Eco-Business (referred as “Optima Extract” from here on) case study provides evaluation & decision scenario in field of Innovation & Entrepreneurship. It also touches upon business topics such as - Value proposition, Entrepreneurship.

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 Optima Environment S.A.: Turning a Wonder Tree Into an Eco-Business Case Study

Optima Environment S.A., a biotech startup in Switzerland, has developed a environmentally safe alternative to chemicals used in the water treatment industry using a plant based extract. Subsequent research has led to discoveries of proteins with medicinal properties and an oil extract with several cosmetics applications. With limited resources and promising opportunities in multiple industries, the company must attempt to break into markets where it has no prior experience and generate a revenue stream to keep it afloat through the complex sales cycle in introducing (potentially) disruptive technologies in existing industries. The case study discusses elements of entrepreneurship, business strategy, and new product development within mature industries as well as the importance of developing strategic alliances to enter new markets.

Case Authors : Jean-Philippe Deschamps, Benoit Leleux, Atul Pahwa

Topic : Innovation & Entrepreneurship

Related Areas : Entrepreneurship

---

Calculating Net Present Value (NPV) at 6% for Optima Environment S.A.: Turning a Wonder Tree Into an Eco-Business Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10024257)	-10024257	-	-
Year 1	3449950	-6574307	3449950	0.9434	3254670
Year 2	3972484	-2601823	7422434	0.89	3535497
Year 3	3940707	1338884	11363141	0.8396	3308694
Year 4	3231437	4570321	14594578	0.7921	2559601
TOTAL			14594578		12658461

The Net Present Value at 6% discount rate is 2634204

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. Internal Rate of Return
3. Payback Period
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. Magnitude of both incoming and outgoing cash flows – Projects can be capital intensive, time intensive, or both. Optima Extract 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 Optima Extract 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 Optima Environment S.A.: Turning a Wonder Tree Into an Eco-Business

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 Optima Extract 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 Optima Extract 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	(10024257)	-10024257	-	-
Year 1	3449950	-6574307	3449950	0.8696	2999957
Year 2	3972484	-2601823	7422434	0.7561	3003769
Year 3	3940707	1338884	11363141	0.6575	2591079
Year 4	3231437	4570321	14594578	0.5718	1847585
TOTAL					10442389

The Net NPV after 4 years is 418132

(10442389 - 10024257 )

---

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	(10024257)	-10024257	-	-
Year 1	3449950	-6574307	3449950	0.8333	2874958
Year 2	3972484	-2601823	7422434	0.6944	2758669
Year 3	3940707	1338884	11363141	0.5787	2280502
Year 4	3231437	4570321	14594578	0.4823	1558370
TOTAL					9472500

The Net NPV after 4 years is -551757

At 20% discount rate the NPV is negative (9472500 - 10024257 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Optima Extract 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 Optima Extract has a NPV value higher than Zero then finance managers at Optima Extract 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 Optima Extract, then the stock price of the Optima Extract 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 Optima Extract 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 key aspects of the projects that need to be monitored, refined, and retuned for continuous delivery of projected cash flows.

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.

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.

---

Negotiation Strategy of Optima Environment S.A.: Turning a Wonder Tree Into an Eco-Business

References & Further Readings

Jean-Philippe Deschamps, Benoit Leleux, Atul Pahwa (2018), "Optima Environment S.A.: Turning a Wonder Tree Into an Eco-Business Harvard Business Review Case Study. Published by HBR Publications.