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Arthur Andersen (C): The Collapse of Arthur Andersen 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 Arthur Andersen (C): The Collapse of Arthur Andersen case study


At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Arthur Andersen (C): The Collapse of Arthur Andersen case study is a Harvard Business School (HBR) case study written by Daniel Diermeier, Robert J. Crawford, Charlotte Snyder. The Arthur Andersen (C): The Collapse of Arthur Andersen (referred as “Andersen Arthur” from here on) case study provides evaluation & decision scenario in field of Finance & Accounting. It also touches upon business topics such as - Value proposition, Competitive strategy, Crisis management, Leadership, Organizational culture, Public relations.

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 Arthur Andersen (C): The Collapse of Arthur Andersen Case Study


The cases describe the demise of Arthur Andersen, a firm that had long set the industry standard for professionalism in accounting and auditing. Once an example of strong corporate culture with a commitment to public service and independent integrity, Andersen saw its culture and standards weaken as it grew explosively and changed its mode of governance. The (A) case describes a crisis precipitated by the admission of Waste Management, a major Andersen client, that it overstated its pretax earnings by $1.43 billion from 1992 to 1996. The resulting Securities and Exchange Commission (SEC) investigation ended with Andersen paying a $7 million fine, the largest ever levied against an accounting firm, and agreeing to an injunction that effectively placed the accounting giant on probation. Students analyze the causes of Andersen's problems and advise Andersen leadership. The (B) case covers Arthur Andersen's relationship with Enron, one of the great success stories of the "new economy" boom. When Enron's aggressive use of off-balance sheet partnerships became impossible to hide in autumn 2001, news reports stated that Andersen auditors had engaged in extensive shredding of draft documents and associated communications with Enron. Students are asked to act as crisis management consultants to Andersen CEO Joe Berardino. The (C) case details Andersen's collapse following its indictment and conviction on criminal charges of obstructing justice in the Enron case. Its conviction was later overturned by the U.S. Supreme Court on narrow technical grounds, but by then Andersen had ceased to exist, eighty-nine years after Arthur E. Andersen had taken over a small accounting firm in Chicago. Students can focus on the impact of media on a reputational crisis.


Case Authors : Daniel Diermeier, Robert J. Crawford, Charlotte Snyder

Topic : Finance & Accounting

Related Areas : Competitive strategy, Crisis management, Leadership, Organizational culture, Public relations




Calculating Net Present Value (NPV) at 6% for Arthur Andersen (C): The Collapse of Arthur Andersen Case Study


Years              Cash Flow     Net Cash Flow     Cumulative    
Cash Flow
Discount Rate
@ 6 %
Discounted
Cash Flows
Year 0 (10006509) -10006509 - -
Year 1 3467883 -6538626 3467883 0.9434 3271588
Year 2 3975934 -2562692 7443817 0.89 3538567
Year 3 3970126 1407434 11413943 0.8396 3333394
Year 4 3237216 4644650 14651159 0.7921 2564178
TOTAL 14651159 12707727


The Net Present Value at 6% discount rate is 2701218

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. Net Present Value
2. Profitability Index
3. Payback Period
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. Andersen Arthur 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 Andersen Arthur 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 Arthur Andersen (C): The Collapse of Arthur Andersen

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 Finance & Accounting 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 Andersen Arthur 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 Andersen Arthur 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 (10006509) -10006509 - -
Year 1 3467883 -6538626 3467883 0.8696 3015550
Year 2 3975934 -2562692 7443817 0.7561 3006377
Year 3 3970126 1407434 11413943 0.6575 2610422
Year 4 3237216 4644650 14651159 0.5718 1850889
TOTAL 10483239


The Net NPV after 4 years is 476730

(10483239 - 10006509 )






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 (10006509) -10006509 - -
Year 1 3467883 -6538626 3467883 0.8333 2889903
Year 2 3975934 -2562692 7443817 0.6944 2761065
Year 3 3970126 1407434 11413943 0.5787 2297527
Year 4 3237216 4644650 14651159 0.4823 1561157
TOTAL 9509652


The Net NPV after 4 years is -496857

At 20% discount rate the NPV is negative (9509652 - 10006509 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Andersen Arthur 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 Andersen Arthur has a NPV value higher than Zero then finance managers at Andersen Arthur 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 Andersen Arthur, then the stock price of the Andersen Arthur 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 Andersen Arthur 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 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 will be a multi year spillover effect of various taxation regulations.

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.

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

Daniel Diermeier, Robert J. Crawford, Charlotte Snyder (2018), "Arthur Andersen (C): The Collapse of Arthur Andersen Harvard Business Review Case Study. Published by HBR Publications.