RBC Investments: Portfolio Planning Initiative 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 RBC Investments: Portfolio Planning Initiative case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. RBC Investments: Portfolio Planning Initiative case study is a Harvard Business School (HBR) case study written by Derrick Neufeld. The RBC Investments: Portfolio Planning Initiative (referred as “Rbci Expenses” from here on) case study provides evaluation & decision scenario in field of Strategy & Execution. It also touches upon business topics such as - Value proposition, IT, Strategic planning.

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 RBC Investments: Portfolio Planning Initiative Case Study

The newly hired head of Strategic Resources Planning and Management at Royal Bank of Canada Investments (RBCI) must develop a "dashboard" mechanism for strategically assessing and managing RBCI's non-interest expenses, excluding brokerage fees associated with providing value-added service to clients. After a week of analysis, two things became apparent: first, the four major business units within RBCI were operating independently, neither collaborating on projects nor sharing information; second, most of the non-interest expenses were related to information technology projects. Considering that RBCI was spending nearly $700,000 per day on service delivery, the senior management team was extremely eager to see what the head of Strategic Resources Planning and Management would propose. Presents information technology portfolio management challenges facing large organizations, and challenges students to develop performance metrics that will be useful at the most senior levels of the organization.

Case Authors : Derrick Neufeld

Topic : Strategy & Execution

Related Areas : IT, Strategic planning

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Calculating Net Present Value (NPV) at 6% for RBC Investments: Portfolio Planning Initiative Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10001130)	-10001130	-	-
Year 1	3461125	-6540005	3461125	0.9434	3265212
Year 2	3970190	-2569815	7431315	0.89	3533455
Year 3	3953898	1384083	11385213	0.8396	3319769
Year 4	3244802	4628885	14630015	0.7921	2570187
TOTAL			14630015		12688623

The Net Present Value at 6% discount rate is 2687493

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. Internal Rate of Return
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 Rbci Expenses 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. Rbci Expenses 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 RBC Investments: Portfolio Planning Initiative

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 Strategy & Execution 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 Rbci Expenses 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 Rbci Expenses 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	(10001130)	-10001130	-	-
Year 1	3461125	-6540005	3461125	0.8696	3009674
Year 2	3970190	-2569815	7431315	0.7561	3002034
Year 3	3953898	1384083	11385213	0.6575	2599752
Year 4	3244802	4628885	14630015	0.5718	1855226
TOTAL					10466686

The Net NPV after 4 years is 465556

(10466686 - 10001130 )

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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	(10001130)	-10001130	-	-
Year 1	3461125	-6540005	3461125	0.8333	2884271
Year 2	3970190	-2569815	7431315	0.6944	2757076
Year 3	3953898	1384083	11385213	0.5787	2288135
Year 4	3244802	4628885	14630015	0.4823	1564816
TOTAL					9494298

The Net NPV after 4 years is -506832

At 20% discount rate the NPV is negative (9494298 - 10001130 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Rbci Expenses 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 Rbci Expenses has a NPV value higher than Zero then finance managers at Rbci Expenses 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 Rbci Expenses, then the stock price of the Rbci Expenses 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 Rbci Expenses 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.

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 can impact the cash flow of 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.

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 RBC Investments: Portfolio Planning Initiative

References & Further Readings

Derrick Neufeld (2018), "RBC Investments: Portfolio Planning Initiative Harvard Business Review Case Study. Published by HBR Publications.