CME 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 CME Group case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. CME Group case study is a Harvard Business School (HBR) case study written by Forest Reinhardt, James Weber. The CME Group (referred as “Cme Participants” from here on) case study provides evaluation & decision scenario in field of Global Business. It also touches upon business topics such as - Value proposition, Government, International business, Risk management, Sustainability.

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 CME Group Case Study

The case describes CME Group, the world's largest commodities exchange, futures and options on futures contracts, history, regulation, and the strategic choices the company faced. CME Group was formed from the oldest and most well-known exchanges in the world. Traders on the exchange bought and sold contracts in order to hedge risk or speculate on future price trends. In recent decades trading had undergone significant growth. From its roots in agricultural commodities, with trading typically occurring in face-to-face transactions in pits on exchange floors, CME introduced new hedging products in metals, energy, and finance, and electronic trading, which brought new market participants. Some of these new participants, such as pension funds, were significantly larger and had different strategic agendas than the traditional agricultural related participants. The case raises the question of whether increased speculation was helping or hurting the exchange or its participants. In addition, the financial crisis of 2007 and 2008 was driving new regulation in the industry which brought new challenges and opportunities to CME.

Case Authors : Forest Reinhardt, James Weber

Topic : Global Business

Related Areas : Government, International business, Risk management, Sustainability

---

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

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10013406)	-10013406	-	-
Year 1	3448557	-6564849	3448557	0.9434	3253356
Year 2	3958598	-2606251	7407155	0.89	3523138
Year 3	3968526	1362275	11375681	0.8396	3332051
Year 4	3236934	4599209	14612615	0.7921	2563955
TOTAL			14612615		12672500

The Net Present Value at 6% discount rate is 2659094

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. Cme Participants 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 Cme Participants 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 CME 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 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 Cme Participants 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 Cme Participants 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	(10013406)	-10013406	-	-
Year 1	3448557	-6564849	3448557	0.8696	2998745
Year 2	3958598	-2606251	7407155	0.7561	2993269
Year 3	3968526	1362275	11375681	0.6575	2609370
Year 4	3236934	4599209	14612615	0.5718	1850728
TOTAL					10452112

The Net NPV after 4 years is 438706

(10452112 - 10013406 )

---

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	(10013406)	-10013406	-	-
Year 1	3448557	-6564849	3448557	0.8333	2873798
Year 2	3958598	-2606251	7407155	0.6944	2749026
Year 3	3968526	1362275	11375681	0.5787	2296601
Year 4	3236934	4599209	14612615	0.4823	1561021
TOTAL					9480446

The Net NPV after 4 years is -532960

At 20% discount rate the NPV is negative (9480446 - 10013406 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Cme Participants 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 Cme Participants has a NPV value higher than Zero then finance managers at Cme Participants 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 Cme Participants, then the stock price of the Cme Participants 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 Cme Participants 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 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.

What can impact the cash flow of the project.

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 CME Group

References & Further Readings

Forest Reinhardt, James Weber (2018), "CME Group Harvard Business Review Case Study. Published by HBR Publications.