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The Volcker Rule: Financial Crisis, Bailouts, and the Need for Financial Regulation 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 Volcker Rule: Financial Crisis, Bailouts, and the Need for Financial Regulation case study


At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. The Volcker Rule: Financial Crisis, Bailouts, and the Need for Financial Regulation case study is a Harvard Business School (HBR) case study written by Dylan Minor, Nicola Persico. The The Volcker Rule: Financial Crisis, Bailouts, and the Need for Financial Regulation (referred as “Bailouts Volcker” from here on) case study provides evaluation & decision scenario in field of Innovation & Entrepreneurship. It also touches upon business topics such as - Value proposition, Policy, Recession.

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 Volcker Rule: Financial Crisis, Bailouts, and the Need for Financial Regulation Case Study


In response to the potential collapse of large financial institutions in 2007, the U.S. government committed trillions of dollars to loans, asset purchases, guarantees, direct spending to provide fiscal stimulus, expansionary monetary policy, and bailouts of various private financial institutions. The bailouts were especially controversial because public money was used to protect private financial institutions and their wealthy executives while ordinary citizens received no such protection. One outcome of the government's response was the proposal to enact into law the Volcker rule, which prohibited banks from engaging in proprietary trading, or trading for their own-not their clients'-benefit. Proprietary trading was believed to generate up to 10 percent of total trading revenues, which would have exceeded $5.9 billion in 2010 for the six largest American banks alone. If the Volcker rule were to become law, government agencies, including the Federal Reserve, the Securities and Exchange Commission, the FDIC, and the Office of the Comptroller of the Currency, would write the detailed regulations that would implement the law. These agencies employed civil servants but were run by political appointees with technical backgrounds. After issuing a notice of proposed rulemaking the agencies would solicit comments from the public, which would help shape the regulations. Executives of large banks needed to decide how to respond to this potential change in their business environment.


Case Authors : Dylan Minor, Nicola Persico

Topic : Innovation & Entrepreneurship

Related Areas : Policy, Recession




Calculating Net Present Value (NPV) at 6% for The Volcker Rule: Financial Crisis, Bailouts, and the Need for Financial Regulation Case Study


Years              Cash Flow     Net Cash Flow     Cumulative    
Cash Flow
Discount Rate
@ 6 %
Discounted
Cash Flows
Year 0 (10005176) -10005176 - -
Year 1 3470536 -6534640 3470536 0.9434 3274091
Year 2 3963390 -2571250 7433926 0.89 3527403
Year 3 3963073 1391823 11396999 0.8396 3327473
Year 4 3236993 4628816 14633992 0.7921 2564002
TOTAL 14633992 12692968


The Net Present Value at 6% discount rate is 2687792

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. 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 Bailouts Volcker 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. Bailouts Volcker 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 The Volcker Rule: Financial Crisis, Bailouts, and the Need for Financial Regulation

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 Innovation & Entrepreneurship 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 Bailouts Volcker 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 Bailouts Volcker 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 (10005176) -10005176 - -
Year 1 3470536 -6534640 3470536 0.8696 3017857
Year 2 3963390 -2571250 7433926 0.7561 2996892
Year 3 3963073 1391823 11396999 0.6575 2605785
Year 4 3236993 4628816 14633992 0.5718 1850761
TOTAL 10471296


The Net NPV after 4 years is 466120

(10471296 - 10005176 )






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 (10005176) -10005176 - -
Year 1 3470536 -6534640 3470536 0.8333 2892113
Year 2 3963390 -2571250 7433926 0.6944 2752354
Year 3 3963073 1391823 11396999 0.5787 2293445
Year 4 3236993 4628816 14633992 0.4823 1561050
TOTAL 9498962


The Net NPV after 4 years is -506214

At 20% discount rate the NPV is negative (9498962 - 10005176 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Bailouts Volcker 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 Bailouts Volcker has a NPV value higher than Zero then finance managers at Bailouts Volcker 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 Bailouts Volcker, then the stock price of the Bailouts Volcker 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 Bailouts Volcker 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 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.

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.

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.




References & Further Readings

Dylan Minor, Nicola Persico (2018), "The Volcker Rule: Financial Crisis, Bailouts, and the Need for Financial Regulation Harvard Business Review Case Study. Published by HBR Publications.