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Aiding or Abetting? The World Bank and the 1997 Judicial Reform Project 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 Aiding or Abetting? The World Bank and the 1997 Judicial Reform Project case study


At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Aiding or Abetting? The World Bank and the 1997 Judicial Reform Project case study is a Harvard Business School (HBR) case study written by Kirsten Lundberg, Philip Heymann. The Aiding or Abetting? The World Bank and the 1997 Judicial Reform Project (referred as “Judicial Loan” from here on) case study provides evaluation & decision scenario in field of Global Business. It also touches upon business topics such as - Value proposition, Ethics, Government, International business, Leadership, Operations management, Project management, Strategic planning.

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 Aiding or Abetting? The World Bank and the 1997 Judicial Reform Project Case Study


When the World Bank signed an agreement with the government of Peru in December, 1997 to provide a $22.5 million loan to help reform the country's antiquated and corrupt judicial system, the Bank knew it faced risks. Peru's President Alberto Fujimori was under fire and observers considered it possible that, rather than exhibiting real commitment to reform, the government may have been seeking the loan chiefly to lend a veneer of legitimacy to measures that in reality reduced judicial independence and concentrated more power in the executive. On balance, however, Bank officials who had to make the decision on whether to proceed with the agreement believed it offered a rare opportunity to address a variety of longstanding ills-including limited access to the justice system, a crumbling infrastructure, and inadequate training of judges and prosecutors. But just three months after the agreement had been signed, Peru's Congress-dominated by members loyal to the President-passed a measure which led Bank officials to question the good faith of the government. The new law limited the powers of one of the pillars of the loan agreement-the National Council of Magistrates, an independent entity mandated to , ratify and remove judges and prosecutors. The Council's members resigned en masse and, in response, the Bank postponed the effective date of the judicial reform loan by six months-halting any disbursement of funds. But in the days following the announcement, Peru's government put increasing pressure on the Bank to change its mind-and finally summoned the Bank's country director for Peru to a personal meeting with President Fujimori. The country director would have to decide whether to stick with the loan postponement-and, more broadly, take stock of what was really going on in Peru. Would the loan help a government sincerely embarked on reform? Or might it simply abet a government bent on subverting the judiciary to further its own political goals? HKS Case Number 1779.0


Case Authors : Kirsten Lundberg, Philip Heymann

Topic : Global Business

Related Areas : Ethics, Government, International business, Leadership, Operations management, Project management, Strategic planning




Calculating Net Present Value (NPV) at 6% for Aiding or Abetting? The World Bank and the 1997 Judicial Reform Project Case Study


Years              Cash Flow     Net Cash Flow     Cumulative    
Cash Flow
Discount Rate
@ 6 %
Discounted
Cash Flows
Year 0 (10010533) -10010533 - -
Year 1 3445832 -6564701 3445832 0.9434 3250785
Year 2 3973956 -2590745 7419788 0.89 3536807
Year 3 3946032 1355287 11365820 0.8396 3313165
Year 4 3246811 4602098 14612631 0.7921 2571778
TOTAL 14612631 12672535


The Net Present Value at 6% discount rate is 2662002

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. Payback Period
2. Internal Rate of Return
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. Timing of the expected cash flows – stockholders of Judicial Loan 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. Judicial Loan shareholders have preference for diversified projects investment rather than prospective high income from a single capital intensive project.




Formula and Steps to Calculate Net Present Value (NPV) of Aiding or Abetting? The World Bank and the 1997 Judicial Reform 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

Why Global Business 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 Judicial Loan 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 Judicial Loan 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 (10010533) -10010533 - -
Year 1 3445832 -6564701 3445832 0.8696 2996376
Year 2 3973956 -2590745 7419788 0.7561 3004882
Year 3 3946032 1355287 11365820 0.6575 2594580
Year 4 3246811 4602098 14612631 0.5718 1856375
TOTAL 10452212


The Net NPV after 4 years is 441679

(10452212 - 10010533 )






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 (10010533) -10010533 - -
Year 1 3445832 -6564701 3445832 0.8333 2871527
Year 2 3973956 -2590745 7419788 0.6944 2759692
Year 3 3946032 1355287 11365820 0.5787 2283583
Year 4 3246811 4602098 14612631 0.4823 1565785
TOTAL 9480586


The Net NPV after 4 years is -529947

At 20% discount rate the NPV is negative (9480586 - 10010533 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Judicial Loan 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 Judicial Loan has a NPV value higher than Zero then finance managers at Judicial Loan 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 Judicial Loan, then the stock price of the Judicial Loan 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 Judicial Loan 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.

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 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.




References & Further Readings

Kirsten Lundberg, Philip Heymann (2018), "Aiding or Abetting? The World Bank and the 1997 Judicial Reform Project Harvard Business Review Case Study. Published by HBR Publications.