Budget Crisis: Who Should Bear the Burden of Reducing the Deficit and Debt? 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 Budget Crisis: Who Should Bear the Burden of Reducing the Deficit and Debt? case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Budget Crisis: Who Should Bear the Burden of Reducing the Deficit and Debt? case study is a Harvard Business School (HBR) case study written by David W. Conklin, Danielle Cadieux. The Budget Crisis: Who Should Bear the Burden of Reducing the Deficit and Debt? (referred as “Nations Debt” from here on) case study provides evaluation & decision scenario in field of Strategy & Execution. It also touches upon business topics such as - Value proposition, International business, Policy, 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 Budget Crisis: Who Should Bear the Burden of Reducing the Deficit and Debt? Case Study

By 2011, many nations had experienced an escalation in deficits and debt. It appeared that some might not be able to service their debt, and might have to default. The United States a budget crisis in which "left-wing liberal" Democrats wanted to raise taxes on the wealthy while "right-winged conservative" Republicans wanted to cut expenditures. A philosophical divide existed over the role of personal responsibility versus the role of government. In the European Union, the "PIIGS" - Portugal, Italy, Ireland, Greece and Spain - seemed on the verge of default, and other members of the euro zone created new loan programs to assist them in their budget crisis. However, these loans included a requirement to move towards balanced budgets. Citizens in the borrowing nations objected to the severe tax increases and expenditure cuts, while citizens of the successful nations asked why they should have to pay. It was not clear who would bear the burden of reducing the deficits and debt.

Case Authors : David W. Conklin, Danielle Cadieux

Topic : Strategy & Execution

Related Areas : International business, Policy, Strategy

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Calculating Net Present Value (NPV) at 6% for Budget Crisis: Who Should Bear the Burden of Reducing the Deficit and Debt? Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10021034)	-10021034	-	-
Year 1	3462770	-6558264	3462770	0.9434	3266764
Year 2	3976565	-2581699	7439335	0.89	3539129
Year 3	3959735	1378036	11399070	0.8396	3324670
Year 4	3247629	4625665	14646699	0.7921	2572426
TOTAL			14646699		12702989

The Net Present Value at 6% discount rate is 2681955

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. Net Present Value
2. Profitability Index
3. Internal Rate of Return
4. Payback Period

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. Nations Debt 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 Nations Debt 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 Budget Crisis: Who Should Bear the Burden of Reducing the Deficit and Debt?

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 Nations Debt 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 Nations Debt 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	(10021034)	-10021034	-	-
Year 1	3462770	-6558264	3462770	0.8696	3011104
Year 2	3976565	-2581699	7439335	0.7561	3006854
Year 3	3959735	1378036	11399070	0.6575	2603590
Year 4	3247629	4625665	14646699	0.5718	1856842
TOTAL					10478391

The Net NPV after 4 years is 457357

(10478391 - 10021034 )

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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	(10021034)	-10021034	-	-
Year 1	3462770	-6558264	3462770	0.8333	2885642
Year 2	3976565	-2581699	7439335	0.6944	2761503
Year 3	3959735	1378036	11399070	0.5787	2291513
Year 4	3247629	4625665	14646699	0.4823	1566179
TOTAL					9504838

The Net NPV after 4 years is -516196

At 20% discount rate the NPV is negative (9504838 - 10021034 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Nations Debt 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 Nations Debt has a NPV value higher than Zero then finance managers at Nations Debt 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 Nations Debt, then the stock price of the Nations Debt 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 Nations Debt 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.

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

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.

Understanding of risks involved in 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 Budget Crisis: Who Should Bear the Burden of Reducing the Deficit and Debt?

References & Further Readings

David W. Conklin, Danielle Cadieux (2018), "Budget Crisis: Who Should Bear the Burden of Reducing the Deficit and Debt? Harvard Business Review Case Study. Published by HBR Publications.