BP and the Gulf of Mexico Oil Spill 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 BP and the Gulf of Mexico Oil Spill case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. BP and the Gulf of Mexico Oil Spill case study is a Harvard Business School (HBR) case study written by Michael A. Roberto. The BP and the Gulf of Mexico Oil Spill (referred as “Bp Spill” 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, Decision making, International business, Leadership, Organizational culture, Personnel policies, Risk 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 BP and the Gulf of Mexico Oil Spill Case Study

On the night of April 20, 2010, a series of explosions rocked the Deepwater Horizon oil rig in the Gulf of Mexico. Gas in the Macondo well had surged upward unexpectedly, causing a mix of drilling mud and seawater to spew uncontrollably into the air much like a volcanic eruption. Eleven crew members died during the explosion. The nation mourned their loss, and people watched as BP struggled to contain the environmental damage. Millions of barrels of oil spilled into the Gulf of Mexico in the weeks that followed. The federal government relied on BP to manage the accident's aftermath, in part because government officials lacked the expertise required to stop the spill. Meanwhile, BP downplayed their responsibility for the failure. As the firm failed repeatedly to stop the spill, the public became angry. This industrial disaster became the largest offshore oil spill in U.S. history. Drawing on the Presidential Commission's investigation, as well as numerous journalistic accounts, the case provides a detailed description of the events leading up to this catastrophic accident. Readers examine the key decisions that BP and its partners made as they drilled this well. They discover the alternative choices that could have been made and learn about the disagreements that took place (as well as those that failed to surface). Moreover, the case provides an opportunity to examine how BP's history and organizational culture shaped the way those decisions were made. The case describes how Tony Hayward and his predecessor, John Browne, led the firm and shaped the culture during the past two decades. In addition, the case explains how the regulatory environment and political forces shaped decision-making in the oil industry. The case concludes by examining the aftermath of the accident, particularly the public relations miscues that BP experienced as it tried to manage the crisis.

Case Authors : Michael A. Roberto

Topic : Leadership & Managing People

Related Areas : Decision making, International business, Leadership, Organizational culture, Personnel policies, Risk management

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Calculating Net Present Value (NPV) at 6% for BP and the Gulf of Mexico Oil Spill Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10024557)	-10024557	-	-
Year 1	3470541	-6554016	3470541	0.9434	3274095
Year 2	3964815	-2589201	7435356	0.89	3528671
Year 3	3955324	1366123	11390680	0.8396	3320966
Year 4	3241503	4607626	14632183	0.7921	2567574
TOTAL			14632183		12691307

The Net Present Value at 6% discount rate is 2666750

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. Payback Period
3. Profitability Index
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. Magnitude of both incoming and outgoing cash flows – Projects can be capital intensive, time intensive, or both. Bp Spill 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 Bp Spill 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 BP and the Gulf of Mexico Oil Spill

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 Bp Spill 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 Bp Spill 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	(10024557)	-10024557	-	-
Year 1	3470541	-6554016	3470541	0.8696	3017862
Year 2	3964815	-2589201	7435356	0.7561	2997970
Year 3	3955324	1366123	11390680	0.6575	2600690
Year 4	3241503	4607626	14632183	0.5718	1853340
TOTAL					10469861

The Net NPV after 4 years is 445304

(10469861 - 10024557 )

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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	(10024557)	-10024557	-	-
Year 1	3470541	-6554016	3470541	0.8333	2892118
Year 2	3964815	-2589201	7435356	0.6944	2753344
Year 3	3955324	1366123	11390680	0.5787	2288961
Year 4	3241503	4607626	14632183	0.4823	1563225
TOTAL					9497647

The Net NPV after 4 years is -526910

At 20% discount rate the NPV is negative (9497647 - 10024557 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Bp Spill 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 Bp Spill has a NPV value higher than Zero then finance managers at Bp Spill 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 Bp Spill, then the stock price of the Bp Spill 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 Bp Spill 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 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 will be a multi year spillover effect of various taxation regulations.

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 BP and the Gulf of Mexico Oil Spill

References & Further Readings

Michael A. Roberto (2018), "BP and the Gulf of Mexico Oil Spill Harvard Business Review Case Study. Published by HBR Publications.