The Fall of Banco Espirito Santo: Holy Spirit or Devil in Disguise? 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 The Fall of Banco Espirito Santo: Holy Spirit or Devil in Disguise? case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. The Fall of Banco Espirito Santo: Holy Spirit or Devil in Disguise? case study is a Harvard Business School (HBR) case study written by James Shein, Jason P. Hawbecker. The The Fall of Banco Espirito Santo: Holy Spirit or Devil in Disguise? (referred as “Santo Espa­rito” from here on) case study provides evaluation & decision scenario in field of Global Business. It also touches upon business topics such as - Value proposition, Competitive strategy, Crisis management, Entrepreneurial finance, Ethics, Financial management, Public relations, 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

---

Case Description of The Fall of Banco Espirito Santo: Holy Spirit or Devil in Disguise? Case Study

In 2014, after nearly 150 years as one of Portugal's most wealthy and powerful families, the EspA­rito Santo family completely lost control of its empire, which included Banco EspA­rito Santo, Portugal's largest bank by market capitalization and second-largest private-sector bank in terms of assets, along with stakes in numerous financial, non-financial, privately held, and publicly traded companies. During the European financial crisis of 2010 to 2014, many of the family's companies required capital investment. To avoid family equity dilution, the family's patriarch, Ricardo EspA­rito Santo Silva Salgado, engaged in a creative money-go-round structure whereby Banco EspA­rito Santo would legally raise short-term commercial paper with high interest rates and sell them to third parties that were partially owned by the EspA­rito Santo family. These third parties then would sell that paper back to the bank's retail clients as safe investments similar to Portuguese deposits. The plan failed, and the house of cards that was the EspA­rito Santo empire collapsed. Students will consider whether Salgado and the board of Banco EspA­rito Santo acted appropriately or if they failed their fiduciary duties to the non-family shareholders of the bank.

Case Authors : James Shein, Jason P. Hawbecker

Topic : Global Business

Related Areas : Competitive strategy, Crisis management, Entrepreneurial finance, Ethics, Financial management, Public relations, Risk management

---

Calculating Net Present Value (NPV) at 6% for The Fall of Banco Espirito Santo: Holy Spirit or Devil in Disguise? Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10016743)	-10016743	-	-
Year 1	3471720	-6545023	3471720	0.9434	3275208
Year 2	3982920	-2562103	7454640	0.89	3544785
Year 3	3967663	1405560	11422303	0.8396	3331326
Year 4	3233789	4639349	14656092	0.7921	2561464
TOTAL			14656092		12712782

The Net Present Value at 6% discount rate is 2696039

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. Profitability Index
3. Internal Rate of Return
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. Santo Espa­rito 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 Santo Espa­rito 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 The Fall of Banco Espirito Santo: Holy Spirit or Devil in Disguise?

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 Santo Espa­rito 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 Santo Espa­rito 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	(10016743)	-10016743	-	-
Year 1	3471720	-6545023	3471720	0.8696	3018887
Year 2	3982920	-2562103	7454640	0.7561	3011660
Year 3	3967663	1405560	11422303	0.6575	2608803
Year 4	3233789	4639349	14656092	0.5718	1848929
TOTAL					10488279

The Net NPV after 4 years is 471536

(10488279 - 10016743 )

---

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	(10016743)	-10016743	-	-
Year 1	3471720	-6545023	3471720	0.8333	2893100
Year 2	3982920	-2562103	7454640	0.6944	2765917
Year 3	3967663	1405560	11422303	0.5787	2296101
Year 4	3233789	4639349	14656092	0.4823	1559505
TOTAL					9514623

The Net NPV after 4 years is -502120

At 20% discount rate the NPV is negative (9514623 - 10016743 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Santo Espa­rito 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 Santo Espa­rito has a NPV value higher than Zero then finance managers at Santo Espa­rito 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 Santo Espa­rito, then the stock price of the Santo Espa­rito 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 Santo Espa­rito 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 key aspects of the projects that need to be monitored, refined, and retuned for continuous delivery of projected cash flows.

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 will be a multi year spillover effect of various taxation regulations.

Understanding of risks involved in the project.

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 The Fall of Banco Espirito Santo: Holy Spirit or Devil in Disguise?

References & Further Readings

James Shein, Jason P. Hawbecker (2018), "The Fall of Banco Espirito Santo: Holy Spirit or Devil in Disguise? Harvard Business Review Case Study. Published by HBR Publications.