CalPERS' Emerging Equity in the Markets Principles 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 CalPERS' Emerging Equity in the Markets Principles case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. CalPERS' Emerging Equity in the Markets Principles case study is a Harvard Business School (HBR) case study written by Robert G. Eccles, Aldo Sesia. The CalPERS' Emerging Equity in the Markets Principles (referred as “Calpers Principles” from here on) case study provides evaluation & decision scenario in field of Organizational Development. It also touches upon business topics such as - Value proposition, Financial management, Innovation, Strategy.

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 CalPERS' Emerging Equity in the Markets Principles Case Study

The California Public Employees' Retirement System (CaIPERS)-the largest public pension fund in the U.S.-had adopted a new principles-based approach to investing in emerging market equities in November 2007. Previously, CalPERS internal and external money managers were prohibited from investing in certain developing countries because the countries failed to meet certain standards for political stability, human rights, market regulation, etc. The new principles-based approach would allow CalPERS money managers to invest in companies that were financially attractive and competitively positioned provided their business practices were sound from an environmental, social, & governance (ESG) perspective regardless of where they were located. By allowing investment in these types of companies regardless of where they operated, CalPERS had hoped to improve its investment returns. The case is set in January 2009, a little more than a year from the time the principles-based approach had been adopted. It is a good time to review the implementation process and how the new principles-based approach changed CaIPERS' emerging market equities portfolios and their returns. The case focuses on one of CalPERS' external fund managers, Dimensional Fund Advisors, and a service provider to DFA and CalPERS, KLD Research & Analytics. One question facing CalPERS with this new approach is whether to invest in PetroChina, which had been off-limits previously due to the screening criteria that were used to identify which countries qualified for emerging markets investments. The case also raises the issue of the difference between "value" and "values" investing and the future importance of ESG investing.

Case Authors : Robert G. Eccles, Aldo Sesia

Topic : Organizational Development

Related Areas : Financial management, Innovation, Strategy

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Calculating Net Present Value (NPV) at 6% for CalPERS' Emerging Equity in the Markets Principles Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10013081)	-10013081	-	-
Year 1	3456208	-6556873	3456208	0.9434	3260574
Year 2	3964014	-2592859	7420222	0.89	3527958
Year 3	3957753	1364894	11377975	0.8396	3323006
Year 4	3251441	4616335	14629416	0.7921	2575446
TOTAL			14629416		12686983

The Net Present Value at 6% discount rate is 2673902

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. Payback Period
2. Net Present Value
3. Internal Rate of Return
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. Magnitude of both incoming and outgoing cash flows – Projects can be capital intensive, time intensive, or both. Calpers Principles 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 Calpers Principles 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 CalPERS' Emerging Equity in the Markets Principles

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 Organizational Development 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 Calpers Principles 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 Calpers Principles 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	(10013081)	-10013081	-	-
Year 1	3456208	-6556873	3456208	0.8696	3005398
Year 2	3964014	-2592859	7420222	0.7561	2997364
Year 3	3957753	1364894	11377975	0.6575	2602287
Year 4	3251441	4616335	14629416	0.5718	1859022
TOTAL					10464071

The Net NPV after 4 years is 450990

(10464071 - 10013081 )

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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	(10013081)	-10013081	-	-
Year 1	3456208	-6556873	3456208	0.8333	2880173
Year 2	3964014	-2592859	7420222	0.6944	2752788
Year 3	3957753	1364894	11377975	0.5787	2290366
Year 4	3251441	4616335	14629416	0.4823	1568017
TOTAL					9491345

The Net NPV after 4 years is -521736

At 20% discount rate the NPV is negative (9491345 - 10013081 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Calpers Principles 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 Calpers Principles has a NPV value higher than Zero then finance managers at Calpers Principles 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 Calpers Principles, then the stock price of the Calpers Principles 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 Calpers Principles 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.

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 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 CalPERS' Emerging Equity in the Markets Principles

References & Further Readings

Robert G. Eccles, Aldo Sesia (2018), "CalPERS' Emerging Equity in the Markets Principles Harvard Business Review Case Study. Published by HBR Publications.