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Seeing Profitability Through a Banking Lens 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 Seeing Profitability Through a Banking Lens case study


At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Seeing Profitability Through a Banking Lens case study is a Harvard Business School (HBR) case study written by Francesc Prior, Javier Santoma. The Seeing Profitability Through a Banking Lens (referred as “Banks Banking” 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.

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 Seeing Profitability Through a Banking Lens Case Study


The two things that emerging markets lack - access to finance and the extension of credit - are the two basic factors considered as key drivers of economic growth. Yet, for banks, the lack of access to financial services and money transfer facilities in these markets represents a huge business opportunity, especially among low-income segments and small and medium-sized enterprises (SMEs). This article examines three promising new business models: upscaling, whereby existing local non-bank institutions become banks; downscaling, whereby the infrastructure of traditional banks is adapted to serve new segments; and greenfield banking, which involves creating completely new microfinance institutions. All require a willingness to adapt to a very different type of customer, as well as taking an innovative, proactive approach to the challenges of risk assessment and efficiency. For companies in other sectors looking to expand into emerging markets, these three business models can serve as a guide. Using lessons derived from the banking sector, the authors urge all companies to see the profitability of emerging markets through new eyes: study their social diversity in depth; forge local alliances; and use new technology to make up for structural shortcomings and inefficiencies.


Case Authors : Francesc Prior, Javier Santoma

Topic : Finance & Accounting

Related Areas : Financial management




Calculating Net Present Value (NPV) at 6% for Seeing Profitability Through a Banking Lens Case Study


Years              Cash Flow     Net Cash Flow     Cumulative    
Cash Flow
Discount Rate
@ 6 %
Discounted
Cash Flows
Year 0 (10010214) -10010214 - -
Year 1 3455464 -6554750 3455464 0.9434 3259872
Year 2 3955039 -2599711 7410503 0.89 3519971
Year 3 3971766 1372055 11382269 0.8396 3334771
Year 4 3244658 4616713 14626927 0.7921 2570073
TOTAL 14626927 12684687


The Net Present Value at 6% discount rate is 2674473

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

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 Banks Banking 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. Banks Banking 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 Seeing Profitability Through a Banking Lens

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 Banks Banking 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 Banks Banking 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 (10010214) -10010214 - -
Year 1 3455464 -6554750 3455464 0.8696 3004751
Year 2 3955039 -2599711 7410503 0.7561 2990578
Year 3 3971766 1372055 11382269 0.6575 2611501
Year 4 3244658 4616713 14626927 0.5718 1855144
TOTAL 10461973


The Net NPV after 4 years is 451759

(10461973 - 10010214 )






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 (10010214) -10010214 - -
Year 1 3455464 -6554750 3455464 0.8333 2879553
Year 2 3955039 -2599711 7410503 0.6944 2746555
Year 3 3971766 1372055 11382269 0.5787 2298476
Year 4 3244658 4616713 14626927 0.4823 1564746
TOTAL 9489330


The Net NPV after 4 years is -520884

At 20% discount rate the NPV is negative (9489330 - 10010214 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Banks Banking 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 Banks Banking has a NPV value higher than Zero then finance managers at Banks Banking 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 Banks Banking, then the stock price of the Banks Banking 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 Banks Banking 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 will be a multi year spillover effect of various taxation regulations.

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.




References & Further Readings

Francesc Prior, Javier Santoma (2018), "Seeing Profitability Through a Banking Lens Harvard Business Review Case Study. Published by HBR Publications.