BP's Office of the Chief Technology Officer: Driving Open Innovation through an Advocate Team 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's Office of the Chief Technology Officer: Driving Open Innovation through an Advocate Team case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. BP's Office of the Chief Technology Officer: Driving Open Innovation through an Advocate Team case study is a Harvard Business School (HBR) case study written by Robert C. Wolcott, Michael J. Lippitz. The BP's Office of the Chief Technology Officer: Driving Open Innovation through an Advocate Team (referred as “Cto Office” 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, Innovation, International business, Organizational culture, 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

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Case Description of BP's Office of the Chief Technology Officer: Driving Open Innovation through an Advocate Team Case Study

The case describes the evolution between 1999 and 2005 of an unusual innovation team within the office of the Chief Information Officer of BP. The team leader, Vice President and Chief Technology Officer (CTO) Phiroz Darukhanavala ("Daru"), eschewed a large group and a venture budget in favor of a small, lean team intimately engaged with BP's business units. The case described several mechanisms created by the CTO office during its early evolution, aimed at expanding executives' appreciation of emerging technology capabilities, building a network of relationships through which emerging technologies are scouted and vetted, and providing structured mechanisms for technology transfer. In late 2005 the CIO's Advisory Group challenged the CTO office to "keep reinventing yourselves." Students are asked to assume Daru's role and suggest new processes and structures to continue the evolution of the CTO office. The teaching note describes what the team actually did, and addresses questions raised at the end of the case.

Case Authors : Robert C. Wolcott, Michael J. Lippitz

Topic : Leadership & Managing People

Related Areas : Innovation, International business, Organizational culture, Technology

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Calculating Net Present Value (NPV) at 6% for BP's Office of the Chief Technology Officer: Driving Open Innovation through an Advocate Team Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10011474)	-10011474	-	-
Year 1	3452400	-6559074	3452400	0.9434	3256981
Year 2	3978490	-2580584	7430890	0.89	3540842
Year 3	3945984	1365400	11376874	0.8396	3313124
Year 4	3229007	4594407	14605881	0.7921	2557676
TOTAL			14605881		12668623

The Net Present Value at 6% discount rate is 2657149

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. Internal Rate of Return
2. Payback Period
3. Profitability Index
4. Net Present Value

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. Cto Office 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 Cto Office 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's Office of the Chief Technology Officer: Driving Open Innovation through an Advocate Team

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 Cto Office 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 Cto Office 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	(10011474)	-10011474	-	-
Year 1	3452400	-6559074	3452400	0.8696	3002087
Year 2	3978490	-2580584	7430890	0.7561	3008310
Year 3	3945984	1365400	11376874	0.6575	2594549
Year 4	3229007	4594407	14605881	0.5718	1846195
TOTAL					10451141

The Net NPV after 4 years is 439667

(10451141 - 10011474 )

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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	(10011474)	-10011474	-	-
Year 1	3452400	-6559074	3452400	0.8333	2877000
Year 2	3978490	-2580584	7430890	0.6944	2762840
Year 3	3945984	1365400	11376874	0.5787	2283556
Year 4	3229007	4594407	14605881	0.4823	1557199
TOTAL					9480594

The Net NPV after 4 years is -530880

At 20% discount rate the NPV is negative (9480594 - 10011474 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Cto Office 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 Cto Office has a NPV value higher than Zero then finance managers at Cto Office 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 Cto Office, then the stock price of the Cto Office 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 Cto Office 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.

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 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.

Understanding of risks involved in 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.

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Negotiation Strategy of BP's Office of the Chief Technology Officer: Driving Open Innovation through an Advocate Team

References & Further Readings

Robert C. Wolcott, Michael J. Lippitz (2018), "BP's Office of the Chief Technology Officer: Driving Open Innovation through an Advocate Team Harvard Business Review Case Study. Published by HBR Publications.