Pilgrim Bank (A): Customer Profitability 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 Pilgrim Bank (A): Customer Profitability case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Pilgrim Bank (A): Customer Profitability case study is a Harvard Business School (HBR) case study written by Frances X. Frei, Dennis Campbell. The Pilgrim Bank (A): Customer Profitability (referred as “Policy Bank” from here on) case study provides evaluation & decision scenario in field of Technology & Operations. It also touches upon business topics such as - Value proposition, Financial management, Market research.

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 Pilgrim Bank (A): Customer Profitability Case Study

Used as part of the third module of a course on Managing Service Operations, which addresses how managers can inform their decisions with customer data (606-097).Provides a context in which students can explore managerial decision making that is critically informed by data analysis. The setting is a retail bank and the decision making relates to the bank's policy toward online banking. The management team is evaluating whether the bank should charge for access to online banking, provide incentives to use the service, or devise some other policy altogether. With thousands of customers already using the online site, the bank is well positioned to assess the impact of the service on customer profitability and retention before making final policy decisions. Told from the perspective of a recent MBA graduate who was charged with performing the necessary data analysis and ultimately coming up with policy recommendations.

Case Authors : Frances X. Frei, Dennis Campbell

Topic : Technology & Operations

Related Areas : Financial management, Market research

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Calculating Net Present Value (NPV) at 6% for Pilgrim Bank (A): Customer Profitability Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10004815)	-10004815	-	-
Year 1	3468463	-6536352	3468463	0.9434	3272135
Year 2	3962133	-2574219	7430596	0.89	3526284
Year 3	3937466	1363247	11368062	0.8396	3305972
Year 4	3225492	4588739	14593554	0.7921	2554892
TOTAL			14593554		12659283

The Net Present Value at 6% discount rate is 2654468

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. Profitability Index
4. Net Present Value

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 Policy Bank 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. Policy Bank 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 Pilgrim Bank (A): Customer Profitability

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 Technology & Operations 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 Policy Bank 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 Policy Bank 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	(10004815)	-10004815	-	-
Year 1	3468463	-6536352	3468463	0.8696	3016055
Year 2	3962133	-2574219	7430596	0.7561	2995942
Year 3	3937466	1363247	11368062	0.6575	2588948
Year 4	3225492	4588739	14593554	0.5718	1844186
TOTAL					10445130

The Net NPV after 4 years is 440315

(10445130 - 10004815 )

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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	(10004815)	-10004815	-	-
Year 1	3468463	-6536352	3468463	0.8333	2890386
Year 2	3962133	-2574219	7430596	0.6944	2751481
Year 3	3937466	1363247	11368062	0.5787	2278626
Year 4	3225492	4588739	14593554	0.4823	1555503
TOTAL					9475997

The Net NPV after 4 years is -528818

At 20% discount rate the NPV is negative (9475997 - 10004815 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Policy Bank 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 Policy Bank has a NPV value higher than Zero then finance managers at Policy Bank 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 Policy Bank, then the stock price of the Policy Bank 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 Policy Bank 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 can impact the cash flow of the project.

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.

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 Pilgrim Bank (A): Customer Profitability

References & Further Readings

Frances X. Frei, Dennis Campbell (2018), "Pilgrim Bank (A): Customer Profitability Harvard Business Review Case Study. Published by HBR Publications.