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Mistral Energy: A Tale of Two Power Markets 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 Mistral Energy: A Tale of Two Power Markets case study


At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Mistral Energy: A Tale of Two Power Markets case study is a Harvard Business School (HBR) case study written by Mehmet Begen, Andrew Cornhill. The Mistral Energy: A Tale of Two Power Markets (referred as “Mistral Saskatchewan” 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, Pricing.

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 Mistral Energy: A Tale of Two Power Markets Case Study


Mistral Energy is looking to build a $40 million power plant in close proximity to both the Alberta and Saskatchewan power markets. The Alberta market is deregulated and the price fluctuates hourly with supply and demand. The Saskatchewan market, on the other hand, is a regulated monopoly. Mistral Energy needs to understand into which market they should sell their power. Because the prices available in Saskatchewan are unknown, Mistral is particularly interested in what power price would make the company indifferent between markets. Additionally, because the power plant is roughly equidistant between Alberta and Saskatchewan transmission lines, it might be possible to choose between markets on an hourly basis. Mistral is interested in investigating the value of this inter-market connection. Unfortunately, for technical reasons, this switch is not instantaneous, and the plant must be shut down for 30 minutes before supplying power into the other market. Another challenge is predicting when the power price in Alberta will be greater than the contract price available in Saskatchewan. Because the future Alberta price is unknown and highly variable, the risk exists that high prices might not be sustained long enough for Mistral to realize any value.


Case Authors : Mehmet Begen, Andrew Cornhill

Topic : Leadership & Managing People

Related Areas : Pricing




Calculating Net Present Value (NPV) at 6% for Mistral Energy: A Tale of Two Power Markets Case Study


Years              Cash Flow     Net Cash Flow     Cumulative    
Cash Flow
Discount Rate
@ 6 %
Discounted
Cash Flows
Year 0 (10024018) -10024018 - -
Year 1 3448168 -6575850 3448168 0.9434 3252989
Year 2 3965234 -2610616 7413402 0.89 3529044
Year 3 3962281 1351665 11375683 0.8396 3326808
Year 4 3250030 4601695 14625713 0.7921 2574328
TOTAL 14625713 12683169


The Net Present Value at 6% discount rate is 2659151

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. Internal Rate of Return
2. Net Present Value
3. Profitability Index
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. Timing of the expected cash flows – stockholders of Mistral Saskatchewan 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. Mistral Saskatchewan shareholders have preference for diversified projects investment rather than prospective high income from a single capital intensive project.




Formula and Steps to Calculate Net Present Value (NPV) of Mistral Energy: A Tale of Two Power Markets

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 Mistral Saskatchewan 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 Mistral Saskatchewan 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 (10024018) -10024018 - -
Year 1 3448168 -6575850 3448168 0.8696 2998407
Year 2 3965234 -2610616 7413402 0.7561 2998287
Year 3 3962281 1351665 11375683 0.6575 2605264
Year 4 3250030 4601695 14625713 0.5718 1858215
TOTAL 10460173


The Net NPV after 4 years is 436155

(10460173 - 10024018 )






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 (10024018) -10024018 - -
Year 1 3448168 -6575850 3448168 0.8333 2873473
Year 2 3965234 -2610616 7413402 0.6944 2753635
Year 3 3962281 1351665 11375683 0.5787 2292987
Year 4 3250030 4601695 14625713 0.4823 1567337
TOTAL 9487432


The Net NPV after 4 years is -536586

At 20% discount rate the NPV is negative (9487432 - 10024018 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Mistral Saskatchewan 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 Mistral Saskatchewan has a NPV value higher than Zero then finance managers at Mistral Saskatchewan 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 Mistral Saskatchewan, then the stock price of the Mistral Saskatchewan 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 Mistral Saskatchewan 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 will be a multi year spillover effect of various taxation regulations.

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.

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.

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

Mehmet Begen, Andrew Cornhill (2018), "Mistral Energy: A Tale of Two Power Markets Harvard Business Review Case Study. Published by HBR Publications.