Fraud at Bank of Baroda: Manage Risk or Manage Crisis 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 Fraud at Bank of Baroda: Manage Risk or Manage Crisis case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Fraud at Bank of Baroda: Manage Risk or Manage Crisis case study is a Harvard Business School (HBR) case study written by Sanjay Dhamija. The Fraud at Bank of Baroda: Manage Risk or Manage Crisis (referred as “Baroda Bank” from here on) case study provides evaluation & decision scenario in field of Finance & Accounting. It also touches upon business topics such as - Value proposition, Risk management.

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 Fraud at Bank of Baroda: Manage Risk or Manage Crisis Case Study

Bank of Baroda was the second-largest commercial bank in India, but it was struggling with a decline in profits and an increase in non-performing assets. Only a week before the new chief executive officer's term commenced, Bank of Baroda was in the news due to reports of fraud occurring at the bank's Ahmedabad and New Delhi operations. The frauds involved bill discounting schemes and money laundering. The bank's violations of its "know your client" and anti-money laundering standards raised concerns about its risk management practices-or lack of such practices. The new chief executive officer was only the second executive from the private sector to head a public sector bank. He needed to prove his value in the world of public sector banking by managing the crisis, implementing a strategy to stabilize the bank's financial health, and preventing a recurrence of the problems. Sanjay Dhamija is affiliated with International Management Institute-New Delhi.

Case Authors : Sanjay Dhamija

Topic : Finance & Accounting

Related Areas : Risk management

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Calculating Net Present Value (NPV) at 6% for Fraud at Bank of Baroda: Manage Risk or Manage Crisis Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10023859)	-10023859	-	-
Year 1	3452187	-6571672	3452187	0.9434	3256780
Year 2	3957164	-2614508	7409351	0.89	3521862
Year 3	3940104	1325596	11349455	0.8396	3308187
Year 4	3239122	4564718	14588577	0.7921	2565688
TOTAL			14588577		12652517

The Net Present Value at 6% discount rate is 2628658

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. Internal Rate of Return
3. Payback Period
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. Magnitude of both incoming and outgoing cash flows – Projects can be capital intensive, time intensive, or both. Baroda Bank 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 Baroda 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.

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Formula and Steps to Calculate Net Present Value (NPV) of Fraud at Bank of Baroda: Manage Risk or Manage Crisis

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 Baroda 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 Baroda 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	(10023859)	-10023859	-	-
Year 1	3452187	-6571672	3452187	0.8696	3001902
Year 2	3957164	-2614508	7409351	0.7561	2992184
Year 3	3940104	1325596	11349455	0.6575	2590682
Year 4	3239122	4564718	14588577	0.5718	1851979
TOTAL					10436747

The Net NPV after 4 years is 412888

(10436747 - 10023859 )

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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	(10023859)	-10023859	-	-
Year 1	3452187	-6571672	3452187	0.8333	2876823
Year 2	3957164	-2614508	7409351	0.6944	2748031
Year 3	3940104	1325596	11349455	0.5787	2280153
Year 4	3239122	4564718	14588577	0.4823	1562077
TOTAL					9467082

The Net NPV after 4 years is -556777

At 20% discount rate the NPV is negative (9467082 - 10023859 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Baroda 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 Baroda Bank has a NPV value higher than Zero then finance managers at Baroda 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 Baroda Bank, then the stock price of the Baroda 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 Baroda 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 –

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.

What can impact the cash flow of the project.

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.

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 Fraud at Bank of Baroda: Manage Risk or Manage Crisis

References & Further Readings

Sanjay Dhamija (2018), "Fraud at Bank of Baroda: Manage Risk or Manage Crisis Harvard Business Review Case Study. Published by HBR Publications.