FERROVIAL CONQUERS THE UK: FOLLOWING IN THE STEPS OF PHILIP II (B) 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 FERROVIAL CONQUERS THE UK: FOLLOWING IN THE STEPS OF PHILIP II (B) case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. FERROVIAL CONQUERS THE UK: FOLLOWING IN THE STEPS OF PHILIP II (B) case study is a Harvard Business School (HBR) case study written by Arturo Bris, Sophie Coughlan. The FERROVIAL CONQUERS THE UK: FOLLOWING IN THE STEPS OF PHILIP II (B) (referred as “Ferrovial Baa” from here on) case study provides evaluation & decision scenario in field of Leadership & Managing People. It also touches upon business topics such as - Value proposition, Supply chain.

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 FERROVIAL CONQUERS THE UK: FOLLOWING IN THE STEPS OF PHILIP II (B) Case Study

Grupo Ferrovial from Spain acquired BAA PLC, the UK airport operator, in June 2006 following one of the most interesting battles for control in recent years in Europe.BAA was an extremely successful and profitable company, managing Heathrow and Gatwick airports in London, among others.The A case, Financial Strategy at BAA PLC, discusses the structure of the target company and specifically its capital structure. BAA's asset base was very stable, low risk and very well protected from competition. The firm had been generating substantial cash flows over the past few years and had completed some acquisitions at home and abroad. Yet, it was underleveraged, not only according to the simple capital structure theory but also compared to its peers. Therefore, Grupo Ferrovial (and Goldman Sachs, which was competing to acquire BAA) found a great value opportunity by leveraging up BAA's assets. The B case, Ferrovial Conquers the UK, guides us through the acquisition process and in particular through the financing aspects of the deal. The BAA-Ferrovial Acquisition received the Finance Package of the Year Award by Acquisitions Monthly Magazine. The deal was the largest infrastructure acquisition financing ever undertaken in the debt markets; it contained the largest second lien tranche ever, which maximized liquidity, tapping interest among both banks and fund investors; and had a groundbreaking structure designed potentially to survive a whole-business securitization. Learning objectives: The case can be used with a broad range of audiences and provides opportunities to discuss the basics of capital structure and financial policy; to describe the functioning of debt markets; to follow a complex acquisition that went from hostile to friendly; to discuss syndication in the credit markets; and to analyze the challenges that CFOs face in order to balance the threat of acquisitions with the need for a conservative capital structure. It can be used in a basic finance course to introduce capital structure and debt financing. It can also be used with finance teams and with executives in general as a way to discuss the complex terms of the transaction.

Case Authors : Arturo Bris, Sophie Coughlan

Topic : Leadership & Managing People

Related Areas : Supply chain

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Calculating Net Present Value (NPV) at 6% for FERROVIAL CONQUERS THE UK: FOLLOWING IN THE STEPS OF PHILIP II (B) Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10007290)	-10007290	-	-
Year 1	3451066	-6556224	3451066	0.9434	3255723
Year 2	3959004	-2597220	7410070	0.89	3523499
Year 3	3945785	1348565	11355855	0.8396	3312957
Year 4	3225900	4574465	14581755	0.7921	2555215
TOTAL			14581755		12647394

The Net Present Value at 6% discount rate is 2640104

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. Payback Period
2. Profitability Index
3. Net Present Value
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. Timing of the expected cash flows – stockholders of Ferrovial Baa 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. Ferrovial Baa 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 FERROVIAL CONQUERS THE UK: FOLLOWING IN THE STEPS OF PHILIP II (B)

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 Leadership & Managing People 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 Ferrovial Baa 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 Ferrovial Baa 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	(10007290)	-10007290	-	-
Year 1	3451066	-6556224	3451066	0.8696	3000927
Year 2	3959004	-2597220	7410070	0.7561	2993576
Year 3	3945785	1348565	11355855	0.6575	2594418
Year 4	3225900	4574465	14581755	0.5718	1844419
TOTAL					10433339

The Net NPV after 4 years is 426049

(10433339 - 10007290 )

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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	(10007290)	-10007290	-	-
Year 1	3451066	-6556224	3451066	0.8333	2875888
Year 2	3959004	-2597220	7410070	0.6944	2749308
Year 3	3945785	1348565	11355855	0.5787	2283440
Year 4	3225900	4574465	14581755	0.4823	1555700
TOTAL					9464337

The Net NPV after 4 years is -542953

At 20% discount rate the NPV is negative (9464337 - 10007290 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Ferrovial Baa 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 Ferrovial Baa has a NPV value higher than Zero then finance managers at Ferrovial Baa 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 Ferrovial Baa, then the stock price of the Ferrovial Baa 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 Ferrovial Baa 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.

Understanding of risks involved in 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.

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.

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 FERROVIAL CONQUERS THE UK: FOLLOWING IN THE STEPS OF PHILIP II (B)

References & Further Readings

Arturo Bris, Sophie Coughlan (2018), "FERROVIAL CONQUERS THE UK: FOLLOWING IN THE STEPS OF PHILIP II (B) Harvard Business Review Case Study. Published by HBR Publications.