New Audit Partner Identification Rules May Offer Opportunities and Benefits 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 New Audit Partner Identification Rules May Offer Opportunities and Benefits case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. New Audit Partner Identification Rules May Offer Opportunities and Benefits case study is a Harvard Business School (HBR) case study written by Colin D. Reid, Julie Furr Youngman. The New Audit Partner Identification Rules May Offer Opportunities and Benefits (referred as “Audit Accounting” from here on) case study provides evaluation & decision scenario in field of Finance & Accounting. It also touches upon business topics such as - Value proposition, Business law, Communication, Crisis communication.

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 New Audit Partner Identification Rules May Offer Opportunities and Benefits Case Study

From the WorldCom and Enron accounting debacles that triggered the demise of Arthur Andersen to Ernst & Young's 2013 and 2015 settlements claiming that its audits facilitated massive accounting fraud by financial services firm Lehman Brothers, large-scale financial scandals have led to increasing scrutiny of public auditors. Investors are justifiably eager to ascertain the quality of audits of public companies when making investment decisions. In the U.K., the reputation of the audit partner is recognized as a signal of audit quality, and as such, the names of the lead partner have been disclosed to the public since 2009. The U.S. standard of providing the auditing firm name without identifying the lead partner recently changed to match the U.K. and EU standard after much debate. As of May 2016, the Public Company Accounting Oversight Board has adopted-and the Securities and Exchange Commission has approved-new regulations that will require the public disclosure of the individual audit partner responsible for each public company audit, as well as the identification of any additional accounting firms that contribute to the audit. This article examines the new rules in light of disclosure requirements imposed on other professionals, as well as international auditor disclosure requirements. The accounting profession has generally opposed the new disclosures, but this article suggests opportunities and benefits for the profession as a result of the changes, including the opportunity for audit partners to develop individual reputations for quality and specialization. In addition, this article makes recommendations for business managers, owners, and investors for making the best use of the information the new disclosures will provide.

Case Authors : Colin D. Reid, Julie Furr Youngman

Topic : Finance & Accounting

Related Areas : Business law, Communication, Crisis communication

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Calculating Net Present Value (NPV) at 6% for New Audit Partner Identification Rules May Offer Opportunities and Benefits Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10013313)	-10013313	-	-
Year 1	3448402	-6564911	3448402	0.9434	3253209
Year 2	3961201	-2603710	7409603	0.89	3525455
Year 3	3945675	1341965	11355278	0.8396	3312865
Year 4	3242920	4584885	14598198	0.7921	2568696
TOTAL			14598198		12660225

The Net Present Value at 6% discount rate is 2646912

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. Payback Period
3. Internal Rate of Return
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 Audit Accounting 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. Audit Accounting 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 New Audit Partner Identification Rules May Offer Opportunities and Benefits

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 Audit Accounting 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 Audit Accounting 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	(10013313)	-10013313	-	-
Year 1	3448402	-6564911	3448402	0.8696	2998610
Year 2	3961201	-2603710	7409603	0.7561	2995237
Year 3	3945675	1341965	11355278	0.6575	2594345
Year 4	3242920	4584885	14598198	0.5718	1854150
TOTAL					10442343

The Net NPV after 4 years is 429030

(10442343 - 10013313 )

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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	(10013313)	-10013313	-	-
Year 1	3448402	-6564911	3448402	0.8333	2873668
Year 2	3961201	-2603710	7409603	0.6944	2750834
Year 3	3945675	1341965	11355278	0.5787	2283377
Year 4	3242920	4584885	14598198	0.4823	1563908
TOTAL					9471787

The Net NPV after 4 years is -541526

At 20% discount rate the NPV is negative (9471787 - 10013313 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Audit Accounting 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 Audit Accounting has a NPV value higher than Zero then finance managers at Audit Accounting 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 Audit Accounting, then the stock price of the Audit Accounting 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 Audit Accounting 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 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.

What can impact the cash flow of the project.

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 New Audit Partner Identification Rules May Offer Opportunities and Benefits

References & Further Readings

Colin D. Reid, Julie Furr Youngman (2018), "New Audit Partner Identification Rules May Offer Opportunities and Benefits Harvard Business Review Case Study. Published by HBR Publications.