Comerica Incorporated: The Valuation Dilemma 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 Comerica Incorporated: The Valuation Dilemma case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Comerica Incorporated: The Valuation Dilemma case study is a Harvard Business School (HBR) case study written by Yiorgos Allayannis, Baijnath Ramraika. The Comerica Incorporated: The Valuation Dilemma (referred as “Bank Comerica” from here on) case study provides evaluation & decision scenario in field of Finance & Accounting. It also touches upon business topics such as - Value proposition, 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 Comerica Incorporated: The Valuation Dilemma Case Study

In early September 2008, in the midst of the subprime crisis, a manager with the student-run Darden Capital Management fund, wants to evaluate whether Comerica Incorporated, a regional bank based in Dallas, Texas, is a good candidate for inclusion in his portfolio. He needs to perform a valuation of the bank to assert whether the bank seems to be undervalued by the market or whether a further decline in value might be possible. He must account for all the factors that affect bank valuation, both as related to the bank itself as well as to the current market conditions. The case can be taught to: a) examine the valuation of a bank during turbulent times; b) understand the key accounting statements (balance sheet and income statement) for a bank and how they may differ from those for an industrial company; and c) understand the key value drivers of bank value (metrics for profitability, credit quality, liquidity, and capital).

Case Authors : Yiorgos Allayannis, Baijnath Ramraika

Topic : Finance & Accounting

Related Areas : Financial management

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Calculating Net Present Value (NPV) at 6% for Comerica Incorporated: The Valuation Dilemma Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10008933)	-10008933	-	-
Year 1	3445393	-6563540	3445393	0.9434	3250371
Year 2	3970122	-2593418	7415515	0.89	3533394
Year 3	3972191	1378773	11387706	0.8396	3335128
Year 4	3239508	4618281	14627214	0.7921	2565994
TOTAL			14627214		12684887

The Net Present Value at 6% discount rate is 2675954

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. Internal Rate of Return
2. Net Present Value
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. Timing of the expected cash flows – stockholders of Bank Comerica 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. Bank Comerica 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 Comerica Incorporated: The Valuation Dilemma

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 Bank Comerica 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 Bank Comerica 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	(10008933)	-10008933	-	-
Year 1	3445393	-6563540	3445393	0.8696	2995994
Year 2	3970122	-2593418	7415515	0.7561	3001983
Year 3	3972191	1378773	11387706	0.6575	2611780
Year 4	3239508	4618281	14627214	0.5718	1852199
TOTAL					10461956

The Net NPV after 4 years is 453023

(10461956 - 10008933 )

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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	(10008933)	-10008933	-	-
Year 1	3445393	-6563540	3445393	0.8333	2871161
Year 2	3970122	-2593418	7415515	0.6944	2757029
Year 3	3972191	1378773	11387706	0.5787	2298722
Year 4	3239508	4618281	14627214	0.4823	1562263
TOTAL					9489174

The Net NPV after 4 years is -519759

At 20% discount rate the NPV is negative (9489174 - 10008933 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Bank Comerica 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 Bank Comerica has a NPV value higher than Zero then finance managers at Bank Comerica 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 Bank Comerica, then the stock price of the Bank Comerica 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 Bank Comerica 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 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 will be a multi year spillover effect of various taxation regulations.

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 Comerica Incorporated: The Valuation Dilemma

References & Further Readings

Yiorgos Allayannis, Baijnath Ramraika (2018), "Comerica Incorporated: The Valuation Dilemma Harvard Business Review Case Study. Published by HBR Publications.