Corporate Governance at Citic Pacific 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 Corporate Governance at Citic Pacific case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Corporate Governance at Citic Pacific case study is a Harvard Business School (HBR) case study written by Stephen Ko, Havovi Joshi. The Corporate Governance at Citic Pacific (referred as “Citic Pacific” from here on) case study provides evaluation & decision scenario in field of Finance & Accounting. It also touches upon business topics such as - Value proposition, Corporate governance, Costs, Ethics, Executive compensation, Human resource management, Operations management, Social enterprise.

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 Corporate Governance at Citic Pacific Case Study

On the evening of 20 October 2008, Citic Pacific, the Hong Kong arm of the CITIC Group, China's largest state-owned investment company, stunned the stock markets by announcing that it would lose as much as HK$15.5 billion (approximately US$2 billion). The company stated that these losses were due to foreign exchange exposures that it had been aware of for six weeks, but had failed to tell the investors about. In an apologetic statement to the public, Larry Yung Chi-kin, the chairman of Citic Pacific, acknowledged the losses and admitted that the contracts had not been properly authorized. Investors and analysts subsequently attacked Citic Pacific for its corporate governance and internal control practices. They expressed shock that the company would make such risky transactions and that it would delay the disclosure of these large potential losses for six weeks. What does this incident say about Citic Pacific's internal risk management and its board of directors, particularly the independent directors? Has the company demonstrated effective corporate governance standards and mechanisms through alignment of its top-level managers' decisions with the interests of the shareholders?

Case Authors : Stephen Ko, Havovi Joshi

Topic : Finance & Accounting

Related Areas : Corporate governance, Costs, Ethics, Executive compensation, Human resource management, Operations management, Social enterprise

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Calculating Net Present Value (NPV) at 6% for Corporate Governance at Citic Pacific Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10020011)	-10020011	-	-
Year 1	3458626	-6561385	3458626	0.9434	3262855
Year 2	3953302	-2608083	7411928	0.89	3518425
Year 3	3940762	1332679	11352690	0.8396	3308740
Year 4	3223872	4556551	14576562	0.7921	2553609
TOTAL			14576562		12643628

The Net Present Value at 6% discount rate is 2623617

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. Profitability Index
2. Net Present Value
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. Citic Pacific 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 Citic Pacific 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 Corporate Governance at Citic Pacific

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 Citic Pacific 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 Citic Pacific 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	(10020011)	-10020011	-	-
Year 1	3458626	-6561385	3458626	0.8696	3007501
Year 2	3953302	-2608083	7411928	0.7561	2989264
Year 3	3940762	1332679	11352690	0.6575	2591115
Year 4	3223872	4556551	14576562	0.5718	1843259
TOTAL					10431139

The Net NPV after 4 years is 411128

(10431139 - 10020011 )

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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	(10020011)	-10020011	-	-
Year 1	3458626	-6561385	3458626	0.8333	2882188
Year 2	3953302	-2608083	7411928	0.6944	2745349
Year 3	3940762	1332679	11352690	0.5787	2280534
Year 4	3223872	4556551	14576562	0.4823	1554722
TOTAL					9462793

The Net NPV after 4 years is -557218

At 20% discount rate the NPV is negative (9462793 - 10020011 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Citic Pacific 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 Citic Pacific has a NPV value higher than Zero then finance managers at Citic Pacific 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 Citic Pacific, then the stock price of the Citic Pacific 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 Citic Pacific 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 –

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.

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

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 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.

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Negotiation Strategy of Corporate Governance at Citic Pacific

References & Further Readings

Stephen Ko, Havovi Joshi (2018), "Corporate Governance at Citic Pacific Harvard Business Review Case Study. Published by HBR Publications.