10b5-1 Plans: Mortgaging a Defense against Insider Trading 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 10b5-1 Plans: Mortgaging a Defense against Insider Trading case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. 10b5-1 Plans: Mortgaging a Defense against Insider Trading case study is a Harvard Business School (HBR) case study written by David F. Larcker, Brian Tayan. The 10b5-1 Plans: Mortgaging a Defense against Insider Trading (referred as “10b5 Insider” 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, Ethics, Executive compensation, Financial 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

Case Description of 10b5-1 Plans: Mortgaging a Defense against Insider Trading Case Study

In 2006, David Zucker, chief executive officer of Midway Games, came under fire for selling a significant amount of Midway stock just weeks before a precipitous decline in the company's share price. One year later, Angelo Mozilo, chairman and chief executive officer of Countrywide Financial, also increased the pace of his stock sales in the months before troubles in the U.S. mortgage lending market led to a similar drop off in Countrywide's share price. Both executives placed their trades through prearranged programs known as 10b5-1 plans. 10b5-1 plans, named after the Securities and Exchange Commission rule which led to their creation, provided a systematic method for corporate executives who were routinely in the possession of material nonpublic information to engage in the sale of company stock. When implemented appropriately, 10b5-1 plans provided a safe haven that shielded these individuals from liability under insider trading laws by demonstrating that certain safeguard conditions were in place at the time the trades were executed. However, the circumstances under which both executives carried out their programs led to an outcry from shareholders that the programs were being abused. Regulators and shareholders were left to decide whether the two men executed their 10b5-1 plans in good faith as required or whether their actions amounted to a sophisticated form of illegal insider trading.

Case Authors : David F. Larcker, Brian Tayan

Topic : Leadership & Managing People

Related Areas : Ethics, Executive compensation, Financial management

Calculating Net Present Value (NPV) at 6% for 10b5-1 Plans: Mortgaging a Defense against Insider Trading Case Study

Years              Cash Flow     Net Cash Flow     Cumulative    
Cash Flow
Discount Rate
@ 6 %
Cash Flows
Year 0 (10010053) -10010053 - -
Year 1 3465527 -6544526 3465527 0.9434 3269365
Year 2 3977212 -2567314 7442739 0.89 3539705
Year 3 3957226 1389912 11399965 0.8396 3322563
Year 4 3223225 4613137 14623190 0.7921 2553096
TOTAL 14623190 12684729

The Net Present Value at 6% discount rate is 2674676

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. Payback Period
2. Net Present Value
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. 10b5 Insider 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 10b5 Insider 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 10b5-1 Plans: Mortgaging a Defense against Insider Trading

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 10b5 Insider 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 10b5 Insider 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 %
Cash Flows
Year 0 (10010053) -10010053 - -
Year 1 3465527 -6544526 3465527 0.8696 3013502
Year 2 3977212 -2567314 7442739 0.7561 3007344
Year 3 3957226 1389912 11399965 0.6575 2601940
Year 4 3223225 4613137 14623190 0.5718 1842889
TOTAL 10465675

The Net NPV after 4 years is 455622

(10465675 - 10010053 )

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 %
Cash Flows
Year 0 (10010053) -10010053 - -
Year 1 3465527 -6544526 3465527 0.8333 2887939
Year 2 3977212 -2567314 7442739 0.6944 2761953
Year 3 3957226 1389912 11399965 0.5787 2290061
Year 4 3223225 4613137 14623190 0.4823 1554410
TOTAL 9494363

The Net NPV after 4 years is -515690

At 20% discount rate the NPV is negative (9494363 - 10010053 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of 10b5 Insider 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 10b5 Insider has a NPV value higher than Zero then finance managers at 10b5 Insider 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 10b5 Insider, then the stock price of the 10b5 Insider 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 10b5 Insider 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.

What can impact the cash flow of the project.

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

Understanding of risks involved in 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.

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

David F. Larcker, Brian Tayan (2018), "10b5-1 Plans: Mortgaging a Defense against Insider Trading Harvard Business Review Case Study. Published by HBR Publications.