Houston We Have A Problem: They Paid Themselves Bonuses! 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 Houston We Have A Problem: They Paid Themselves Bonuses! case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Houston We Have A Problem: They Paid Themselves Bonuses! case study is a Harvard Business School (HBR) case study written by Pascale Lapointe-Antunes, Deborah McPhee. The Houston We Have A Problem: They Paid Themselves Bonuses! (referred as “Amanda Duffy” from here on) case study provides evaluation & decision scenario in field of Finance & Accounting. It also touches upon business topics such as - Value proposition, Compensation, Ethics, Financial 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 Houston We Have A Problem: They Paid Themselves Bonuses! Case Study

It was June of 2006, and Amanda Walsh, interim CFO, was soundly criticizing herself for not seeing the bigger picture of what had gone on during the previous 18 months at Vanderville Plastics Company (VPC). Two prior years' financials were still in "draft" form with auditors' statements showing that the firm might not be a going concern. Peter Giroux, the CFO who hired her, had kept Amanda from having any interaction with the company vice presidents, the board, or the owners, maintained a tight grip on both the human resources and payroll operations, and refused to provide details when she questioned him about any aspect of the financial operations. Then, in January of 2006, close to a million dollars in bonuses were paid to senior management and employees, despite the company's precarious cash flow position. Not long after the bonus payment Peter resigned unexpectedly. Today's phone call from Ken Duffy, one of the owners, made all the pieces fit together. Duffy had called for clarification about the sudden decrease in the company's accrued liabilities. The call ended abruptly when Amanda told him that bonuses were paid for performance in the previous 2005 fiscal year. His shocked reaction on the phone made it clear that the owners had not authorized the bonus payments. Amanda started to think about the succession of events since she came to VPC to better understand what this all meant, what was likely to happen next, and what she should do. The case exposes students to the day-to-day life of a professional accountant employed in a small business. COSO considers opportunistic behavior from senior management to secure incentive compensation by using adjusting journal entries the most likely way for fraud to occur. Looking at the events surrounding the payout as they unfold through in the day-to-day life of Amanda should help students develop the professional judgment and skepticism required to better interpret the oral assertions made by management, assess the RMM resulting from fraud, and provide recommendations to improve a client organization's control environment and fraud risk management practices related to incentive compensation and management override of controls.

Case Authors : Pascale Lapointe-Antunes, Deborah McPhee

Topic : Finance & Accounting

Related Areas : Compensation, Ethics, Financial management

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Calculating Net Present Value (NPV) at 6% for Houston We Have A Problem: They Paid Themselves Bonuses! Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10018097)	-10018097	-	-
Year 1	3468030	-6550067	3468030	0.9434	3271726
Year 2	3966652	-2583415	7434682	0.89	3530306
Year 3	3943357	1359942	11378039	0.8396	3310919
Year 4	3230678	4590620	14608717	0.7921	2559000
TOTAL			14608717		12671951

The Net Present Value at 6% discount rate is 2653854

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. Profitability Index
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. Magnitude of both incoming and outgoing cash flows – Projects can be capital intensive, time intensive, or both. Amanda Duffy 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 Amanda Duffy 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 Houston We Have A Problem: They Paid Themselves Bonuses!

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 Amanda Duffy 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 Amanda Duffy 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	(10018097)	-10018097	-	-
Year 1	3468030	-6550067	3468030	0.8696	3015678
Year 2	3966652	-2583415	7434682	0.7561	2999359
Year 3	3943357	1359942	11378039	0.6575	2592821
Year 4	3230678	4590620	14608717	0.5718	1847151
TOTAL					10455009

The Net NPV after 4 years is 436912

(10455009 - 10018097 )

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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	(10018097)	-10018097	-	-
Year 1	3468030	-6550067	3468030	0.8333	2890025
Year 2	3966652	-2583415	7434682	0.6944	2754619
Year 3	3943357	1359942	11378039	0.5787	2282035
Year 4	3230678	4590620	14608717	0.4823	1558004
TOTAL					9484684

The Net NPV after 4 years is -533413

At 20% discount rate the NPV is negative (9484684 - 10018097 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Amanda Duffy 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 Amanda Duffy has a NPV value higher than Zero then finance managers at Amanda Duffy 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 Amanda Duffy, then the stock price of the Amanda Duffy 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 Amanda Duffy 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 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.

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.

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 Houston We Have A Problem: They Paid Themselves Bonuses!

References & Further Readings

Pascale Lapointe-Antunes, Deborah McPhee (2018), "Houston We Have A Problem: They Paid Themselves Bonuses! Harvard Business Review Case Study. Published by HBR Publications.