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Investment Technology Group 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 Investment Technology Group case study


At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Investment Technology Group case study is a Harvard Business School (HBR) case study written by Clayton Rose, David Lane. The Investment Technology Group (referred as “Itg Itg's” from here on) case study provides evaluation & decision scenario in field of Finance & Accounting. It also touches upon business topics such as - Value proposition, Marketing, Recession.

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






Case Description of Investment Technology Group Case Study


ITG CEO Robert Gasser wondered if the financial crisis had permanently affected the firm's business model. A leader in trade analytics and execution for institutional equity investors, ITG had grown since its establishment in 1987 in step with the dramatic rise in equity trading volumes. During 2009, however, investors curbed their equities trading, depressing ITG's heavily commission-based revenues, and earnings plunged by 63%, resulting in ITG's first unprofitable quarter since 1988. Gasser was convinced that ITG's challenges were not simply a function of shrinking trading volumes; 2009's downturn revealed limits of client willingness to pay for the value ITG delivered, and the infrastructure ITG had constructed to support clients with customized software tools and technical support had grown well beyond sustainable levels. With his management team, Gasser had developed a two part response to the challenge: a reduction in staff and a focus on clients that most valued what ITG offered. While significant cost savings goals would be realized in part through employee layoffs, he wondered about ITG's ability to deal with these changes. Adjusting its customer portfolio meant that ITG would be pulling back products from some clients while reaching out to others in new ways, and he was unsure how clients would respond.


Case Authors : Clayton Rose, David Lane

Topic : Finance & Accounting

Related Areas : Marketing, Recession




Calculating Net Present Value (NPV) at 6% for Investment Technology Group Case Study


Years              Cash Flow     Net Cash Flow     Cumulative    
Cash Flow
Discount Rate
@ 6 %
Discounted
Cash Flows
Year 0 (10021699) -10021699 - -
Year 1 3453414 -6568285 3453414 0.9434 3257938
Year 2 3960651 -2607634 7414065 0.89 3524965
Year 3 3969255 1361621 11383320 0.8396 3332663
Year 4 3226863 4588484 14610183 0.7921 2555978
TOTAL 14610183 12671544




The Net Present Value at 6% discount rate is 2649845

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.




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. Magnitude of both incoming and outgoing cash flows – Projects can be capital intensive, time intensive, or both. Itg Itg's 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 Itg Itg's have higher preference for cash returns over 4-5 years rather than 10-15 years given the nature of the volatility in the industry.






Formula and Steps to Calculate Net Present Value (NPV) of Investment Technology Group

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 Itg Itg's 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 Itg Itg's 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 (10021699) -10021699 - -
Year 1 3453414 -6568285 3453414 0.8696 3002969
Year 2 3960651 -2607634 7414065 0.7561 2994821
Year 3 3969255 1361621 11383320 0.6575 2609850
Year 4 3226863 4588484 14610183 0.5718 1844969
TOTAL 10452609


The Net NPV after 4 years is 430910

(10452609 - 10021699 )








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 (10021699) -10021699 - -
Year 1 3453414 -6568285 3453414 0.8333 2877845
Year 2 3960651 -2607634 7414065 0.6944 2750452
Year 3 3969255 1361621 11383320 0.5787 2297023
Year 4 3226863 4588484 14610183 0.4823 1556165
TOTAL 9481484


The Net NPV after 4 years is -540215

At 20% discount rate the NPV is negative (9481484 - 10021699 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Itg Itg's 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 Itg Itg's has a NPV value higher than Zero then finance managers at Itg Itg's 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 Itg Itg's, then the stock price of the Itg Itg's 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 Itg Itg's 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 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.

What are the key aspects of the projects that need to be monitored, refined, and retuned for continuous delivery of projected cash flows.

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.






Negotiation Strategy of Investment Technology Group

References & Further Readings

Clayton Rose, David Lane (2018), "Investment Technology Group Harvard Business Review Case Study. Published by HBR Publications.


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