Change in Chignahuapan: Reforming a Municipal Government in Mexico 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 Change in Chignahuapan: Reforming a Municipal Government in Mexico case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Change in Chignahuapan: Reforming a Municipal Government in Mexico case study is a Harvard Business School (HBR) case study written by Jonathan Schlefer, Merilee Grindle. The Change in Chignahuapan: Reforming a Municipal Government in Mexico (referred as “Reform Chignahuapan” 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, Government, Innovation, Leadership, Operations management, Social responsibility, Strategic planning.

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 Change in Chignahuapan: Reforming a Municipal Government in Mexico Case Study

For more than 70 years, beginning in 1929, one party-the Party of Institutional Revolution, known by its Spanish initials PRI-dominated political life in Mexico, at all levels of government. But when Vicente Fox, a candidate of the rival National Action Party (PAN) won the presidency in 2000, change rippled through the country's overall political structure. This case tells the story of the emergence of competitive elections at the municipal level-in particular, one municipality emblematic of larger change. In describing the change in political life in Chignahuapan, a jurisdiction of some 50,000 in the Sierra Norte mountains northeast of Mexico City, the case frames the question of whether electoral change can lead to sustainable reform of local government. It is a question which arises when, surprisingly, a reform-minded PAN administration gains power in the locality in February 2002-and proceeds to change both administrative processes (opening meetings of the local Council for the first time) and moving generally toward transparency and improved local services. The reform administration, was, however, limited by law to just one term-thus, posing the central question of the case: in what ways can a reform administration seek to ensure that the changes it initiates will not be transitory? HKS Case Number 1841.0

Case Authors : Jonathan Schlefer, Merilee Grindle

Topic : Leadership & Managing People

Related Areas : Government, Innovation, Leadership, Operations management, Social responsibility, Strategic planning

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Calculating Net Present Value (NPV) at 6% for Change in Chignahuapan: Reforming a Municipal Government in Mexico Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10017215)	-10017215	-	-
Year 1	3454618	-6562597	3454618	0.9434	3259074
Year 2	3981764	-2580833	7436382	0.89	3543756
Year 3	3945234	1364401	11381616	0.8396	3312495
Year 4	3233196	4597597	14614812	0.7921	2560994
TOTAL			14614812		12676318

The Net Present Value at 6% discount rate is 2659103

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. Profitability Index
2. Net Present Value
3. Internal Rate of Return
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. Reform Chignahuapan 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 Reform Chignahuapan 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 Change in Chignahuapan: Reforming a Municipal Government in Mexico

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 Reform Chignahuapan 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 Reform Chignahuapan 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	(10017215)	-10017215	-	-
Year 1	3454618	-6562597	3454618	0.8696	3004016
Year 2	3981764	-2580833	7436382	0.7561	3010786
Year 3	3945234	1364401	11381616	0.6575	2594055
Year 4	3233196	4597597	14614812	0.5718	1848590
TOTAL					10457447

The Net NPV after 4 years is 440232

(10457447 - 10017215 )

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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	(10017215)	-10017215	-	-
Year 1	3454618	-6562597	3454618	0.8333	2878848
Year 2	3981764	-2580833	7436382	0.6944	2765114
Year 3	3945234	1364401	11381616	0.5787	2283122
Year 4	3233196	4597597	14614812	0.4823	1559219
TOTAL					9486303

The Net NPV after 4 years is -530913

At 20% discount rate the NPV is negative (9486303 - 10017215 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Reform Chignahuapan 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 Reform Chignahuapan has a NPV value higher than Zero then finance managers at Reform Chignahuapan 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 Reform Chignahuapan, then the stock price of the Reform Chignahuapan 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 Reform Chignahuapan 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 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.

What can impact the cash flow of the project.

What will be a multi year spillover effect of various taxation regulations.

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 Change in Chignahuapan: Reforming a Municipal Government in Mexico

References & Further Readings

Jonathan Schlefer, Merilee Grindle (2018), "Change in Chignahuapan: Reforming a Municipal Government in Mexico Harvard Business Review Case Study. Published by HBR Publications.