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Automating the Paris Subway (A) 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 Automating the Paris Subway (A) case study


At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Automating the Paris Subway (A) case study is a Harvard Business School (HBR) case study written by Michel Anteby, Elena Corsi, Emilie Billaud. The Automating the Paris Subway (A) (referred as “Subway Paris” 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, Collaboration, Conflict, Ethics, Innovation, Labor, Marketing, Operations management, Technology.

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 Automating the Paris Subway (A) Case Study


In 2001, the head of the Paris Subway reflected on how to transform Line 1 into a driverless line without triggering a social conflict. After the shock of the 2000 Notre Dame de Lorette subway accident, in which a train derailed and caused 25 injuries in a Paris subway station, the state-owned Paris subway operator Regie Autonome des Transports Parisiens (RATP) decided to adopt new security measures and considered the opportunity to automate the oldest and the busiest line of the network. The Head of the Paris Subway, Serge Lagrange, believed that automating Line 1 would improve security as well as performance. However, the automation would bring about the downsizing of 219 drivers' positions. Lagrange had to figure out how to get the RATP employees on board, particularly drivers and trade unions. How could he convince them of the necessity to automate Line 1? How could he prevent the potentially major social conflict that might result from downsizing the drivers' positions?


Case Authors : Michel Anteby, Elena Corsi, Emilie Billaud

Topic : Leadership & Managing People

Related Areas : Collaboration, Conflict, Ethics, Innovation, Labor, Marketing, Operations management, Technology




Calculating Net Present Value (NPV) at 6% for Automating the Paris Subway (A) Case Study


Years              Cash Flow     Net Cash Flow     Cumulative    
Cash Flow
Discount Rate
@ 6 %
Discounted
Cash Flows
Year 0 (10025974) -10025974 - -
Year 1 3465339 -6560635 3465339 0.9434 3269188
Year 2 3962875 -2597760 7428214 0.89 3526945
Year 3 3942944 1345184 11371158 0.8396 3310572
Year 4 3224235 4569419 14595393 0.7921 2553896
TOTAL 14595393 12660600


The Net Present Value at 6% discount rate is 2634626

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. Net Present Value
2. Profitability Index
3. Payback Period
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. Subway Paris 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 Subway Paris 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 Automating the Paris Subway (A)

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 Subway Paris 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 Subway Paris 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 (10025974) -10025974 - -
Year 1 3465339 -6560635 3465339 0.8696 3013338
Year 2 3962875 -2597760 7428214 0.7561 2996503
Year 3 3942944 1345184 11371158 0.6575 2592550
Year 4 3224235 4569419 14595393 0.5718 1843467
TOTAL 10445858


The Net NPV after 4 years is 419884

(10445858 - 10025974 )






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 (10025974) -10025974 - -
Year 1 3465339 -6560635 3465339 0.8333 2887783
Year 2 3962875 -2597760 7428214 0.6944 2751997
Year 3 3942944 1345184 11371158 0.5787 2281796
Year 4 3224235 4569419 14595393 0.4823 1554897
TOTAL 9476473


The Net NPV after 4 years is -549501

At 20% discount rate the NPV is negative (9476473 - 10025974 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Subway Paris 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 Subway Paris has a NPV value higher than Zero then finance managers at Subway Paris 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 Subway Paris, then the stock price of the Subway Paris 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 Subway Paris 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.

Understanding of risks involved in the project.

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.

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.




References & Further Readings

Michel Anteby, Elena Corsi, Emilie Billaud (2018), "Automating the Paris Subway (A) Harvard Business Review Case Study. Published by HBR Publications.