Bank Leu's Prima Cat Bond Fund 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 Bank Leu's Prima Cat Bond Fund case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Bank Leu's Prima Cat Bond Fund case study is a Harvard Business School (HBR) case study written by George Chacko, Vincent Dessain, Anders Sjoman, Adam Plotkin. The Bank Leu's Prima Cat Bond Fund (referred as “Cat Leu's” 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, Financial markets, 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 Bank Leu's Prima Cat Bond Fund Case Study

In 2001, Bank Leu, a Swiss private bank, is considering creating the world's first public fund for catastrophe bonds. Cat bonds are securities whose payments depend on the probability of a catastrophe occurring, such as an earthquake or hurricane. Cat bonds are traditionally issued by large insurance or reinsurance companies. This case outlines the traditional reinsurance market and securitization efforts that have taken place in the past and focuses on Bank Leu's decision as a buy-side participant in the cat bond market.

Case Authors : George Chacko, Vincent Dessain, Anders Sjoman, Adam Plotkin

Topic : Finance & Accounting

Related Areas : Financial management, Financial markets, Risk management

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Calculating Net Present Value (NPV) at 6% for Bank Leu's Prima Cat Bond Fund Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10002752)	-10002752	-	-
Year 1	3453375	-6549377	3453375	0.9434	3257901
Year 2	3961711	-2587666	7415086	0.89	3525909
Year 3	3953769	1366103	11368855	0.8396	3319661
Year 4	3223550	4589653	14592405	0.7921	2553354
TOTAL			14592405		12656824

The Net Present Value at 6% discount rate is 2654072

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. Internal Rate of Return
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. Magnitude of both incoming and outgoing cash flows – Projects can be capital intensive, time intensive, or both. Cat Leu's 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 Cat Leu's have higher preference for cash returns over 4-5 years rather than 10-15 years given the nature of the volatility in the industry.

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Formula and Steps to Calculate Net Present Value (NPV) of Bank Leu's Prima Cat Bond Fund

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 Cat Leu's 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 Cat Leu's 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	(10002752)	-10002752	-	-
Year 1	3453375	-6549377	3453375	0.8696	3002935
Year 2	3961711	-2587666	7415086	0.7561	2995623
Year 3	3953769	1366103	11368855	0.6575	2599667
Year 4	3223550	4589653	14592405	0.5718	1843075
TOTAL					10441300

The Net NPV after 4 years is 438548

(10441300 - 10002752 )

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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	(10002752)	-10002752	-	-
Year 1	3453375	-6549377	3453375	0.8333	2877813
Year 2	3961711	-2587666	7415086	0.6944	2751188
Year 3	3953769	1366103	11368855	0.5787	2288061
Year 4	3223550	4589653	14592405	0.4823	1554567
TOTAL					9471628

The Net NPV after 4 years is -531124

At 20% discount rate the NPV is negative (9471628 - 10002752 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Cat Leu's 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 Cat Leu's has a NPV value higher than Zero then finance managers at Cat Leu's 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 Cat Leu's, then the stock price of the Cat Leu's 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 Cat Leu's 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 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.

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.

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 Bank Leu's Prima Cat Bond Fund

References & Further Readings

George Chacko, Vincent Dessain, Anders Sjoman, Adam Plotkin (2018), "Bank Leu's Prima Cat Bond Fund Harvard Business Review Case Study. Published by HBR Publications.