Introduction to Net Present Value (NPV) - What is Net Present Value (NPV) ? How it impacts financial decisions regarding project management?
At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Goldman Sachs and Its Reputation case study is a Harvard Business School (HBR) case study written by David P. Baron. The Goldman Sachs and Its Reputation (referred as “Goldman Securities” 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, 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.
Goldman Sachs was a bank, but it did not take deposits, issue credit cards, make mortgage loans, or interact with consumers. For most of its history Goldman was organized as a partnership and operated as an investment bank engaging in underwriting new securities to raise funds for corporations and public agencies, advising clients as in mergers and acquisitions, and managing assets for clients. It began to engage in securities trading and risk arbitrage in the 1950s, when it developed its philosophy of being "long-term greedy," which the bank understood as focusing on long-term profitability rather than short-term performance. Goldman went public in 1999, forecasting that its investment banking business would continue to provide most of its revenue and profits. Soon, however, its proprietary trading and trading on behalf of clients began to dominate both its revenue and profit streams. The leadership of the firm also shifted from investment bankers to traders, such as Henry Paulson and CEO Lloyd C. Blankfein. Goldman was a major player in the events leading to the financial crisis and was a major participant in the CDO market. As with most financial institutions Goldman was heavily criticized for its role in the crisis. The disclosure that Goldman had allowed an investor to select securities for inclusion in a CDO that the investor intended to short caused an uproar, particularly because the purchasers were not informed of the investor's role. The media covered the issue extensively, Congress held hearings, the SEC filed a lawsuit against Goldman, private investors filed lawsuits, and some issuers of securities shunned the company. Goldman's reputation was damaged. The company faced the decision of how to rebuild its reputation as it addressed new regulations on banks as a result of Dodd-Frank and Federal Reserve actions.
| Years | Cash Flow | Net Cash Flow | Cumulative Cash Flow |
Discount Rate @ 6 % |
Discounted Cash Flows |
|---|---|---|---|---|---|
| Year 0 | (10005478) | -10005478 | - | - | |
| Year 1 | 3460838 | -6544640 | 3460838 | 0.9434 | 3264942 |
| Year 2 | 3980297 | -2564343 | 7441135 | 0.89 | 3542450 |
| Year 3 | 3945647 | 1381304 | 11386782 | 0.8396 | 3312841 |
| Year 4 | 3247502 | 4628806 | 14634284 | 0.7921 | 2572326 |
| TOTAL | 14634284 | 12692559 |
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 -
Capital Budgeting Approaches
There are four types of capital budgeting techniques that are widely used in the corporate world –
1. Payback Period
2. Internal Rate of Return
3. Net Present Value
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 Goldman Securities 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. Goldman Securities shareholders have preference for diversified projects investment rather than prospective high income from a single capital intensive project.
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
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 Goldman Securities 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 Goldman Securities 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.
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 | (10005478) | -10005478 | - | - | |
| Year 1 | 3460838 | -6544640 | 3460838 | 0.8696 | 3009424 |
| Year 2 | 3980297 | -2564343 | 7441135 | 0.7561 | 3009676 |
| Year 3 | 3945647 | 1381304 | 11386782 | 0.6575 | 2594327 |
| Year 4 | 3247502 | 4628806 | 14634284 | 0.5718 | 1856770 |
| TOTAL | 10470197 |
(10470197 - 10005478 )
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 | (10005478) | -10005478 | - | - | |
| Year 1 | 3460838 | -6544640 | 3460838 | 0.8333 | 2884032 |
| Year 2 | 3980297 | -2564343 | 7441135 | 0.6944 | 2764095 |
| Year 3 | 3945647 | 1381304 | 11386782 | 0.5787 | 2283361 |
| Year 4 | 3247502 | 4628806 | 14634284 | 0.4823 | 1566118 |
| TOTAL | 9497605 |
At 20% discount rate the NPV is negative (9497605 - 10005478 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Goldman Securities to discount cash flow at lower discount rates such as 15%.
Simplest Approach – If the investment project of Goldman Securities has a NPV value higher than Zero then finance managers at Goldman Securities 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 Goldman Securities, then the stock price of the Goldman Securities 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.
Project selection is often a far more complex decision than just choosing it based on the NPV number. Finance managers at Goldman Securities 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 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.
What are the key aspects of the projects that need to be monitored, refined, and retuned for continuous delivery of projected cash flows.
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.
David P. Baron (2018), "Goldman Sachs and Its Reputation Harvard Business Review Case Study. Published by HBR Publications.
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