Donaldson, Lufkin & Jenrette, 1995 Abridged V. 1.3 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 Donaldson, Lufkin & Jenrette, 1995 Abridged V. 1.3 case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Donaldson, Lufkin & Jenrette, 1995 Abridged V. 1.3 case study is a Harvard Business School (HBR) case study written by Robert F. Bruner, Douglas Fordyce. The Donaldson, Lufkin & Jenrette, 1995 Abridged V. 1.3 (referred as “Dlj Donaldson” 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, Financial markets, Pricing, Risk 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 Donaldson, Lufkin & Jenrette, 1995 Abridged V. 1.3 Case Study

This case explains the plan of the Equitable Companies to sell a 20 percent interest in Donaldson, Lufkin & Jenrette (DLJ) via an equity carve-out in an initial public offering (IPO), and presents students the task of pricing DLJ's shares in the IPO. The company approached the pricing task using the method of comparable multiples. The case gives ample information on valuation multiples of peer firms. A key point of assessment is to choose which industry segment DLJ competes in so that an appropriate multiple may be chosen. The case also describes the equity-underwriting process in detail. It presents a rich range of industry information, affording an opportunity to discuss forces of change in the investment-banking industry. The teaching note explains how the case may be used to explore the trade-off between maximizing the offering price and supporting the trading of shares in the aftermarket. This case is an abridgement of the A (F-1145) and B (F-1146) cases, which may be taught alone or together. Taught together, they would ordinarily require two class periods. The instructor may cover the general subject matter of the A and B cases by using this abridged version.

Case Authors : Robert F. Bruner, Douglas Fordyce

Topic : Finance & Accounting

Related Areas : Financial management, Financial markets, Pricing, Risk management

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Calculating Net Present Value (NPV) at 6% for Donaldson, Lufkin & Jenrette, 1995 Abridged V. 1.3 Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10020703)	-10020703	-	-
Year 1	3449181	-6571522	3449181	0.9434	3253944
Year 2	3954920	-2616602	7404101	0.89	3519865
Year 3	3959399	1342797	11363500	0.8396	3324388
Year 4	3240277	4583074	14603777	0.7921	2566603
TOTAL			14603777		12664800

The Net Present Value at 6% discount rate is 2644097

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

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. Dlj Donaldson 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 Dlj Donaldson 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 Donaldson, Lufkin & Jenrette, 1995 Abridged V. 1.3

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 Dlj Donaldson 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 Dlj Donaldson 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	(10020703)	-10020703	-	-
Year 1	3449181	-6571522	3449181	0.8696	2999288
Year 2	3954920	-2616602	7404101	0.7561	2990488
Year 3	3959399	1342797	11363500	0.6575	2603369
Year 4	3240277	4583074	14603777	0.5718	1852639
TOTAL					10445784

The Net NPV after 4 years is 425081

(10445784 - 10020703 )

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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	(10020703)	-10020703	-	-
Year 1	3449181	-6571522	3449181	0.8333	2874318
Year 2	3954920	-2616602	7404101	0.6944	2746472
Year 3	3959399	1342797	11363500	0.5787	2291319
Year 4	3240277	4583074	14603777	0.4823	1562634
TOTAL					9474742

The Net NPV after 4 years is -545961

At 20% discount rate the NPV is negative (9474742 - 10020703 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Dlj Donaldson 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 Dlj Donaldson has a NPV value higher than Zero then finance managers at Dlj Donaldson 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 Dlj Donaldson, then the stock price of the Dlj Donaldson 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 Dlj Donaldson 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.

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 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 Donaldson, Lufkin & Jenrette, 1995 Abridged V. 1.3

References & Further Readings

Robert F. Bruner, Douglas Fordyce (2018), "Donaldson, Lufkin & Jenrette, 1995 Abridged V. 1.3 Harvard Business Review Case Study. Published by HBR Publications.