Risk Management at Wellfleet Bank: Deciding about "Megadeals" 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 Risk Management at Wellfleet Bank: Deciding about "Megadeals" case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Risk Management at Wellfleet Bank: Deciding about "Megadeals" case study is a Harvard Business School (HBR) case study written by Anette Mikes. The Risk Management at Wellfleet Bank: Deciding about "Megadeals" (referred as “Risk Credit” 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, International business, 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 Risk Management at Wellfleet Bank: Deciding about "Megadeals" Case Study

This case introduces risk management in the context of corporate lending, one of the bread-and-butter functions of commercial banks. It evokes the cultural tension between the risk function and the business line, which in this organization reverberated long after the decisive votes were cast at the group credit committee. The case further motivates debate on calculative cultures, and the role of model-based risk assessments in decision-making, and underlines the role of judgment in risk decisions. Modeling and judgment carry different weight in different types of risk decisions. While risk models can be relied upon as the key decision-makers in a retail banking environment (e.g. credit card applications), in the case of large credit decisions, their reliability is, generally, low. This is because the key features of the proposals at hand cannot all be condensed into risk metrics; as in these proposals, several "qualitative" issues arise that the decision-maker needs to judge in tandem with the quantitative metrics. The exercise also highlights that model-based risk metrics are themselves judgmental (they reflect the assumptions of the modeler) and that their use must be as much an art as a science. The story has got a temporal dimension: one proposal was current in mid-2006, the other in late 2008, two very different credit environments.

Case Authors : Anette Mikes

Topic : Finance & Accounting

Related Areas : Financial management, International business, Risk management

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Calculating Net Present Value (NPV) at 6% for Risk Management at Wellfleet Bank: Deciding about "Megadeals" Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10008450)	-10008450	-	-
Year 1	3449269	-6559181	3449269	0.9434	3254027
Year 2	3968587	-2590594	7417856	0.89	3532028
Year 3	3942692	1352098	11360548	0.8396	3310360
Year 4	3222522	4574620	14583070	0.7921	2552539
TOTAL			14583070		12648955

The Net Present Value at 6% discount rate is 2640505

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. Timing of the expected cash flows – stockholders of Risk Credit 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. Risk Credit shareholders have preference for diversified projects investment rather than prospective high income from a single capital intensive project.

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Formula and Steps to Calculate Net Present Value (NPV) of Risk Management at Wellfleet Bank: Deciding about "Megadeals"

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 Risk Credit 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 Risk Credit 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	(10008450)	-10008450	-	-
Year 1	3449269	-6559181	3449269	0.8696	2999364
Year 2	3968587	-2590594	7417856	0.7561	3000822
Year 3	3942692	1352098	11360548	0.6575	2592384
Year 4	3222522	4574620	14583070	0.5718	1842487
TOTAL					10435058

The Net NPV after 4 years is 426608

(10435058 - 10008450 )

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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	(10008450)	-10008450	-	-
Year 1	3449269	-6559181	3449269	0.8333	2874391
Year 2	3968587	-2590594	7417856	0.6944	2755963
Year 3	3942692	1352098	11360548	0.5787	2281650
Year 4	3222522	4574620	14583070	0.4823	1554071
TOTAL					9466076

The Net NPV after 4 years is -542374

At 20% discount rate the NPV is negative (9466076 - 10008450 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Risk Credit 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 Risk Credit has a NPV value higher than Zero then finance managers at Risk Credit 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 Risk Credit, then the stock price of the Risk Credit 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 Risk Credit 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 will be a multi year spillover effect of various taxation regulations.

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 can impact the cash flow of 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.

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Negotiation Strategy of Risk Management at Wellfleet Bank: Deciding about "Megadeals"

References & Further Readings

Anette Mikes (2018), "Risk Management at Wellfleet Bank: Deciding about "Megadeals" Harvard Business Review Case Study. Published by HBR Publications.