From Free Lunch to Black Hole: Credit Default Swaps at AIG 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 From Free Lunch to Black Hole: Credit Default Swaps at AIG case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. From Free Lunch to Black Hole: Credit Default Swaps at AIG case study is a Harvard Business School (HBR) case study written by Stefan Nagel. The From Free Lunch to Black Hole: Credit Default Swaps at AIG (referred as “Aigfp Cds” from here on) case study provides evaluation & decision scenario in field of Finance & Accounting. It also touches upon business topics such as - Value proposition, .

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 From Free Lunch to Black Hole: Credit Default Swaps at AIG Case Study

It is July of 2007 and Alan Frost, executive vice president for AIG Financial Products (AIGFP) has just received a heads up on a margin call from Goldman Sachs. The next day the company served AIGFP with an invoice for collateral worth $1.8 billion on $20 billion notional value of credit default swaps (CDS) related to the housing market. As the market fell, homeowners defaulted, making the value of the securities underlying the CDS plummet. AIGFP had up until this point thought that the prospect of every having to pay up on the CDS was virtually non-existent. Students will have to decide if the company underestimated the risk.

Case Authors : Stefan Nagel

Topic : Finance & Accounting

Related Areas :

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Calculating Net Present Value (NPV) at 6% for From Free Lunch to Black Hole: Credit Default Swaps at AIG Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10022203)	-10022203	-	-
Year 1	3465253	-6556950	3465253	0.9434	3269107
Year 2	3960868	-2596082	7426121	0.89	3525158
Year 3	3959807	1363725	11385928	0.8396	3324730
Year 4	3243741	4607466	14629669	0.7921	2569347
TOTAL			14629669		12688342

The Net Present Value at 6% discount rate is 2666139

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. Internal Rate of Return
3. Payback Period
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 Aigfp Cds 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. Aigfp Cds 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 From Free Lunch to Black Hole: Credit Default Swaps at AIG

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 Aigfp Cds 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 Aigfp Cds 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	(10022203)	-10022203	-	-
Year 1	3465253	-6556950	3465253	0.8696	3013263
Year 2	3960868	-2596082	7426121	0.7561	2994985
Year 3	3959807	1363725	11385928	0.6575	2603637
Year 4	3243741	4607466	14629669	0.5718	1854619
TOTAL					10466506

The Net NPV after 4 years is 444303

(10466506 - 10022203 )

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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	(10022203)	-10022203	-	-
Year 1	3465253	-6556950	3465253	0.8333	2887711
Year 2	3960868	-2596082	7426121	0.6944	2750603
Year 3	3959807	1363725	11385928	0.5787	2291555
Year 4	3243741	4607466	14629669	0.4823	1564304
TOTAL					9494173

The Net NPV after 4 years is -528030

At 20% discount rate the NPV is negative (9494173 - 10022203 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Aigfp Cds 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 Aigfp Cds has a NPV value higher than Zero then finance managers at Aigfp Cds 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 Aigfp Cds, then the stock price of the Aigfp Cds 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 Aigfp Cds 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 can impact the cash flow of 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 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.

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 From Free Lunch to Black Hole: Credit Default Swaps at AIG

References & Further Readings

Stefan Nagel (2018), "From Free Lunch to Black Hole: Credit Default Swaps at AIG Harvard Business Review Case Study. Published by HBR Publications.