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James Woolsey and the CIA: The Aldrich Ames Spy Case 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 James Woolsey and the CIA: The Aldrich Ames Spy Case case study


At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. James Woolsey and the CIA: The Aldrich Ames Spy Case case study is a Harvard Business School (HBR) case study written by Philip Heymann, Howard Husock, Esther Scott. The James Woolsey and the CIA: The Aldrich Ames Spy Case (referred as “Woolsey Ames” from here on) case study provides evaluation & decision scenario in field of Strategy & Execution. It also touches upon business topics such as - Value proposition, Crisis management, Ethics, Government, Leadership, Marketing, Security & privacy, 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




Case Description of James Woolsey and the CIA: The Aldrich Ames Spy Case Case Study


When Washington attorney and longtime Capital Hill staff member James Woolsey became director of the Central Intelligence Agency in 1993, he inherited a bombshell that would soon become public. A joint CIA-FBI investigation had found that Aldrich Ames, a longtime Agency employee, had sold intelligence secrets to the Soviet Union. Ames had compromised the safety of Soviets, who had sought to help the US, in exchange for hundreds of thousands of dollars, with which he bought a large home and fancy cars. The public announcement of the Ames scandal in February 1994 would pose a dilemma for Woolsey. Public and Congressional reaction -- focused on the failure of the CIA itself to detect Ames' duplicity for almost a decade -- was harshly critical of the Agency. There was a widespread expectation that Woolsey would mete out harsh punishment for those who had failed to detect Ames' activity. For his part, however, Woolsey was unsure as to what sort of punishment, if any, was appropriate. As a public clamor grew for "heads to roll," Woolsey would have to consider what was fair to long-time CIA officials, what was best for the morale of a beleaguered agency, and what was expected by the public. HKS Case Number 1339.0.


Case Authors : Philip Heymann, Howard Husock, Esther Scott

Topic : Strategy & Execution

Related Areas : Crisis management, Ethics, Government, Leadership, Marketing, Security & privacy, Strategic planning




Calculating Net Present Value (NPV) at 6% for James Woolsey and the CIA: The Aldrich Ames Spy Case Case Study


Years              Cash Flow     Net Cash Flow     Cumulative    
Cash Flow
Discount Rate
@ 6 %
Discounted
Cash Flows
Year 0 (10013229) -10013229 - -
Year 1 3459135 -6554094 3459135 0.9434 3263335
Year 2 3963766 -2590328 7422901 0.89 3527738
Year 3 3944753 1354425 11367654 0.8396 3312091
Year 4 3245122 4599547 14612776 0.7921 2570441
TOTAL 14612776 12673604


The Net Present Value at 6% discount rate is 2660375

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. Profitability Index
2. Net Present Value
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. Timing of the expected cash flows – stockholders of Woolsey Ames 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. Woolsey Ames shareholders have preference for diversified projects investment rather than prospective high income from a single capital intensive project.




Formula and Steps to Calculate Net Present Value (NPV) of James Woolsey and the CIA: The Aldrich Ames Spy Case

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 Woolsey Ames 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 Woolsey Ames 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 (10013229) -10013229 - -
Year 1 3459135 -6554094 3459135 0.8696 3007943
Year 2 3963766 -2590328 7422901 0.7561 2997177
Year 3 3944753 1354425 11367654 0.6575 2593739
Year 4 3245122 4599547 14612776 0.5718 1855409
TOTAL 10454268


The Net NPV after 4 years is 441039

(10454268 - 10013229 )






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 (10013229) -10013229 - -
Year 1 3459135 -6554094 3459135 0.8333 2882613
Year 2 3963766 -2590328 7422901 0.6944 2752615
Year 3 3944753 1354425 11367654 0.5787 2282843
Year 4 3245122 4599547 14612776 0.4823 1564970
TOTAL 9483041


The Net NPV after 4 years is -530188

At 20% discount rate the NPV is negative (9483041 - 10013229 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Woolsey Ames 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 Woolsey Ames has a NPV value higher than Zero then finance managers at Woolsey Ames 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 Woolsey Ames, then the stock price of the Woolsey Ames 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 Woolsey Ames 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 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.

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.

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

Philip Heymann, Howard Husock, Esther Scott (2018), "James Woolsey and the CIA: The Aldrich Ames Spy Case Harvard Business Review Case Study. Published by HBR Publications.