Ben S. Bernanke in 2005 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 Ben S. Bernanke in 2005 case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Ben S. Bernanke in 2005 case study is a Harvard Business School (HBR) case study written by Wei Li. The Ben S. Bernanke in 2005 (referred as “Bernanke Monetary” 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 markets, Global strategy, Policy.

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 Ben S. Bernanke in 2005 Case Study

This is a Darden case study.The case has been used in a first-year required course called Global Economies and Markets in a module on monetary policy. On October 24, 2005, President Bush nominated Ben S. Bernanke to be chairman of the board of governors of the Federal Reserve System for a term of four years along with a 14-year term on the board of governors. With the U.S. Senate confirmation widely anticipated, Bernanke was expected to take over stewardship of the U.S. monetary policy from Chairman Alan Greenspan when he retired in January 2006. While the U.S. economy was in good shape at the end of 2005, Bernanke had to prepare to deal with two challenges when charting a course for managing U.S. monetary policy. First, the sharp rise in energy prices that began in 2002 had the potential to bring back the specter of inflation and dampen desired consumer and business spending. Second, the housing boom could turn into a housing bust, throwing the mortgage industry into turmoil and weakening consumer business confidence. There was also the possibility that the housing bust could affect broader financial markets. Bernanke had to consider his options for dealing with contingencies in the not-so-distant future.

Case Authors : Wei Li

Topic : Finance & Accounting

Related Areas : Financial markets, Global strategy, Policy

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Calculating Net Present Value (NPV) at 6% for Ben S. Bernanke in 2005 Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10003436)	-10003436	-	-
Year 1	3464004	-6539432	3464004	0.9434	3267928
Year 2	3973661	-2565771	7437665	0.89	3536544
Year 3	3963116	1397345	11400781	0.8396	3327509
Year 4	3247429	4644774	14648210	0.7921	2572268
TOTAL			14648210		12704249

The Net Present Value at 6% discount rate is 2700813

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. Net Present Value
3. Internal Rate of Return
4. Payback Period

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 Bernanke Monetary 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. Bernanke Monetary 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 Ben S. Bernanke in 2005

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 Bernanke Monetary 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 Bernanke Monetary 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	(10003436)	-10003436	-	-
Year 1	3464004	-6539432	3464004	0.8696	3012177
Year 2	3973661	-2565771	7437665	0.7561	3004659
Year 3	3963116	1397345	11400781	0.6575	2605813
Year 4	3247429	4644774	14648210	0.5718	1856728
TOTAL					10479377

The Net NPV after 4 years is 475941

(10479377 - 10003436 )

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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	(10003436)	-10003436	-	-
Year 1	3464004	-6539432	3464004	0.8333	2886670
Year 2	3973661	-2565771	7437665	0.6944	2759487
Year 3	3963116	1397345	11400781	0.5787	2293470
Year 4	3247429	4644774	14648210	0.4823	1566083
TOTAL					9505709

The Net NPV after 4 years is -497727

At 20% discount rate the NPV is negative (9505709 - 10003436 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Bernanke Monetary 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 Bernanke Monetary has a NPV value higher than Zero then finance managers at Bernanke Monetary 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 Bernanke Monetary, then the stock price of the Bernanke Monetary 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 Bernanke Monetary 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 can impact the cash flow of 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.

Understanding of risks involved in 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 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 Ben S. Bernanke in 2005

References & Further Readings

Wei Li (2018), "Ben S. Bernanke in 2005 Harvard Business Review Case Study. Published by HBR Publications.