An Overview of Project Finance and Infrastructure Finance--2009 Update 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 An Overview of Project Finance and Infrastructure Finance--2009 Update case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. An Overview of Project Finance and Infrastructure Finance--2009 Update case study is a Harvard Business School (HBR) case study written by Benjamin C. Esty, Aldo Sesia. The An Overview of Project Finance and Infrastructure Finance--2009 Update (referred as “Finance Project” from here on) case study provides evaluation & decision scenario in field of Finance & Accounting. It also touches upon business topics such as - Value proposition, International business, Negotiations, Project management.

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 An Overview of Project Finance and Infrastructure Finance--2009 Update Case Study

Provides an introduction to the fields of project finance and infrastructure finance, and gives a statistical overview of project-financed investments over the years from 2005 to 2009. Examples of project-financed investments include the $1.4 billion Mozal aluminum smelter in Mozambique, $4 billion Chad-Cameroon pipeline, $6 billion Iridium global satellite telecommunications system, a‚¬900 million A2 Toll Road in Poland, $20 billion Sakhalin II gas field in Russia, and the $28 billion Dabhol power project. Globally, firms financed $240 billion of capital expenditures using project finance in 2009, down from $409 billion in 2008 as the financial crisis hit the Western markets. The use of project finance has grown at a compound rate of 0% over the last five years, 4% over the past 10 years, and 12% over the past 15 years. This note focuses primarily on private sector investment in industrial and infrastructure projects, and contains four sections. The first section defines project finance and contrasts it with other well-known financing mechanisms. The second section describes the evolution of project finance from its beginnings in the natural resources industry in the 1970s, to the U.S. power industry in the 1980s, to a much wider range of industry applications and geographic locations in the 1990s, and most recently to infrastructure finance in the 2000s. The third section provides a statistical overview of project-financed investment over the last five years (2005 to 2009), and looks at industry, project, and participant specific data. The third section also provides recent data on infrastructure investments and public-private partnerships. The final section discusses current and likely future trends.

Case Authors : Benjamin C. Esty, Aldo Sesia

Topic : Finance & Accounting

Related Areas : International business, Negotiations, Project management

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Calculating Net Present Value (NPV) at 6% for An Overview of Project Finance and Infrastructure Finance--2009 Update Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10017782)	-10017782	-	-
Year 1	3454188	-6563594	3454188	0.9434	3258668
Year 2	3956426	-2607168	7410614	0.89	3521205
Year 3	3954563	1347395	11365177	0.8396	3320327
Year 4	3222520	4569915	14587697	0.7921	2552538
TOTAL			14587697		12652738

The Net Present Value at 6% discount rate is 2634956

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. Internal Rate of Return
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. Finance Project 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 Finance Project 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 An Overview of Project Finance and Infrastructure Finance--2009 Update

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 Finance & Accounting 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 Finance Project 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 Finance Project 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	(10017782)	-10017782	-	-
Year 1	3454188	-6563594	3454188	0.8696	3003642
Year 2	3956426	-2607168	7410614	0.7561	2991626
Year 3	3954563	1347395	11365177	0.6575	2600189
Year 4	3222520	4569915	14587697	0.5718	1842486
TOTAL					10437944

The Net NPV after 4 years is 420162

(10437944 - 10017782 )

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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	(10017782)	-10017782	-	-
Year 1	3454188	-6563594	3454188	0.8333	2878490
Year 2	3956426	-2607168	7410614	0.6944	2747518
Year 3	3954563	1347395	11365177	0.5787	2288520
Year 4	3222520	4569915	14587697	0.4823	1554070
TOTAL					9468599

The Net NPV after 4 years is -549183

At 20% discount rate the NPV is negative (9468599 - 10017782 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Finance Project 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 Finance Project has a NPV value higher than Zero then finance managers at Finance Project 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 Finance Project, then the stock price of the Finance Project 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 Finance Project 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 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.

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 An Overview of Project Finance and Infrastructure Finance--2009 Update

References & Further Readings

Benjamin C. Esty, Aldo Sesia (2018), "An Overview of Project Finance and Infrastructure Finance--2009 Update Harvard Business Review Case Study. Published by HBR Publications.