Flawed by design: Why Penn State's recent governance reforms won't work and what should be done instead 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 Flawed by design: Why Penn State's recent governance reforms won't work and what should be done instead case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Flawed by design: Why Penn State's recent governance reforms won't work and what should be done instead case study is a Harvard Business School (HBR) case study written by David Ketchen Jr., Charles C. Snow, Alice W. Pope. The Flawed by design: Why Penn State's recent governance reforms won't work and what should be done instead (referred as “Penn Board's” 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, Leadership.

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 Flawed by design: Why Penn State's recent governance reforms won't work and what should be done instead Case Study

By 2017, higher education is expected to be a $2 trillion industry worldwide. Within this huge economic engine, the boards of trustees that provide governance to universities and colleges face a complex challenge in that they must serve a variety of stakeholders. Without effective governance, an academic institution's performance is likely to suffer. Penn State University is plagued by an ineffective board of trustees. As a complement to past work that has documented this board's unwise and costly decisions, we examine how five design issues--board size, board composition, fiduciary responsibility, term limits, and transparency--helped create a culture in which poor choices were more likely to occur. We discuss why the board's recent self-imposed reforms are inadequate. We then offer more substantive reforms that could fix the Penn State board's flaws. In particular, we recommend that academic boards should be (1) small enough to allow full participation of all members, (2) composed such that no one stakeholder group can dominate decision making, (3) designed to eliminate actual and perceived conflicts of interest, (4) governed by term limits, and (5) appropriately transparent in their strategic decision making and communications. We leverage these principles to propose a reduction of the Penn State board from 30 voting members to 19. More broadly, other academic boards might benefit from undergoing a self-analysis based on the Penn State case.

Case Authors : David Ketchen Jr., Charles C. Snow, Alice W. Pope

Topic : Leadership & Managing People

Related Areas : Leadership

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Calculating Net Present Value (NPV) at 6% for Flawed by design: Why Penn State's recent governance reforms won't work and what should be done instead Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10020171)	-10020171	-	-
Year 1	3451787	-6568384	3451787	0.9434	3256403
Year 2	3975374	-2593010	7427161	0.89	3538069
Year 3	3970640	1377630	11397801	0.8396	3333826
Year 4	3241869	4619499	14639670	0.7921	2567864
TOTAL			14639670		12696161

The Net Present Value at 6% discount rate is 2675990

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. Net Present Value
4. Profitability Index

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 Penn Board's 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. Penn Board's shareholders have preference for diversified projects investment rather than prospective high income from a single capital intensive project.

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Formula and Steps to Calculate Net Present Value (NPV) of Flawed by design: Why Penn State's recent governance reforms won't work and what should be done instead

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 Penn Board's 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 Penn Board's 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	(10020171)	-10020171	-	-
Year 1	3451787	-6568384	3451787	0.8696	3001554
Year 2	3975374	-2593010	7427161	0.7561	3005954
Year 3	3970640	1377630	11397801	0.6575	2610760
Year 4	3241869	4619499	14639670	0.5718	1853549
TOTAL					10471817

The Net NPV after 4 years is 451646

(10471817 - 10020171 )

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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	(10020171)	-10020171	-	-
Year 1	3451787	-6568384	3451787	0.8333	2876489
Year 2	3975374	-2593010	7427161	0.6944	2760676
Year 3	3970640	1377630	11397801	0.5787	2297824
Year 4	3241869	4619499	14639670	0.4823	1563401
TOTAL					9498391

The Net NPV after 4 years is -521780

At 20% discount rate the NPV is negative (9498391 - 10020171 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Penn Board's 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 Penn Board's has a NPV value higher than Zero then finance managers at Penn Board's 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 Penn Board's, then the stock price of the Penn Board's 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 Penn Board's 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.

Understanding of risks involved in the project.

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.

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 Flawed by design: Why Penn State's recent governance reforms won't work and what should be done instead

References & Further Readings

David Ketchen Jr., Charles C. Snow, Alice W. Pope (2018), "Flawed by design: Why Penn State's recent governance reforms won't work and what should be done instead Harvard Business Review Case Study. Published by HBR Publications.