Predicting Earnings Manipulation by Indian Firms Using Machine Learning Algorithms 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 Predicting Earnings Manipulation by Indian Firms Using Machine Learning Algorithms case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Predicting Earnings Manipulation by Indian Firms Using Machine Learning Algorithms case study is a Harvard Business School (HBR) case study written by Dinesh Kumar Unnikrishnan, Tousif Ahmed Inayath Syed, Suresh Ganeshan. The Predicting Earnings Manipulation by Indian Firms Using Machine Learning Algorithms (referred as “Mca Manipulations” from here on) case study provides evaluation & decision scenario in field of Finance & Accounting. It also touches upon business topics such as - Value proposition, Analytics, Ethics, Regulation.

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 Predicting Earnings Manipulation by Indian Firms Using Machine Learning Algorithms Case Study

MCA Technology Solutions Private Limited was established in 2015 in Bangalore with an objective to integrate analytics and technology with business. MCA Technology Solutions helped its clients in areas such as customer intelligence, forecasting, optimization, risk assessment, web analytics, and text mining and cloud solutions. Risk assessment vertical at MCA technology solutions focused on problems such as fraud detection and credit scoring. Sachin Kumar, Director at MCA Technology Solutions, Bangalore was approached by one his clients, a commercial bank, to assist them in detecting earnings manipulators among the bank's customers. The bank provided business loans to small and medium enterprises and the value of loan ranged from INR 10 million to 500 million. The bank suspected that its customers may be involved in earnings manipulations to increase their chance of securing a loan. Saurabh Rishi, the chief data scientist at MCA Technologies was assigned the task of developing a use case for predicting earnings manipulations. He was aware of models such as Benford's law and Beneish model used for predicting earnings manipulations; however, he was not sure of its performance, especially in the Indian context. Saurabh decided to develop his own model for predicting earnings manipulations using data downloaded from the Prowess database maintained by the Centre of Monitoring Indian Economy (CMIE). Daniel received information related to earning manipulators from Securities Exchange Board of India (SEBI) and the Lexis Nexis database. Data on more than 1200 companies was collected to develop the model. MCA Technology believed that machine learning algorithms may give better accuracy compared to other traditional models such as Beneish model used for predicting earnings manipulation.

Case Authors : Dinesh Kumar Unnikrishnan, Tousif Ahmed Inayath Syed, Suresh Ganeshan

Topic : Finance & Accounting

Related Areas : Analytics, Ethics, Regulation

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Calculating Net Present Value (NPV) at 6% for Predicting Earnings Manipulation by Indian Firms Using Machine Learning Algorithms Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10025500)	-10025500	-	-
Year 1	3445373	-6580127	3445373	0.9434	3250352
Year 2	3960334	-2619793	7405707	0.89	3524683
Year 3	3975159	1355366	11380866	0.8396	3337620
Year 4	3240540	4595906	14621406	0.7921	2566811
TOTAL			14621406		12679466

The Net Present Value at 6% discount rate is 2653966

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. Payback Period
3. Profitability Index
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. Mca Manipulations 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 Mca Manipulations 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 Predicting Earnings Manipulation by Indian Firms Using Machine Learning Algorithms

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 Mca Manipulations 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 Mca Manipulations 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	(10025500)	-10025500	-	-
Year 1	3445373	-6580127	3445373	0.8696	2995977
Year 2	3960334	-2619793	7405707	0.7561	2994581
Year 3	3975159	1355366	11380866	0.6575	2613732
Year 4	3240540	4595906	14621406	0.5718	1852789
TOTAL					10457079

The Net NPV after 4 years is 431579

(10457079 - 10025500 )

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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	(10025500)	-10025500	-	-
Year 1	3445373	-6580127	3445373	0.8333	2871144
Year 2	3960334	-2619793	7405707	0.6944	2750232
Year 3	3975159	1355366	11380866	0.5787	2300439
Year 4	3240540	4595906	14621406	0.4823	1562760
TOTAL					9484576

The Net NPV after 4 years is -540924

At 20% discount rate the NPV is negative (9484576 - 10025500 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Mca Manipulations 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 Mca Manipulations has a NPV value higher than Zero then finance managers at Mca Manipulations 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 Mca Manipulations, then the stock price of the Mca Manipulations 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 Mca Manipulations 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.

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 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 Predicting Earnings Manipulation by Indian Firms Using Machine Learning Algorithms

References & Further Readings

Dinesh Kumar Unnikrishnan, Tousif Ahmed Inayath Syed, Suresh Ganeshan (2018), "Predicting Earnings Manipulation by Indian Firms Using Machine Learning Algorithms Harvard Business Review Case Study. Published by HBR Publications.