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Forging the New Salomon, Spanish Version 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 Forging the New Salomon, Spanish Version case study


At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Forging the New Salomon, Spanish Version case study is a Harvard Business School (HBR) case study written by Lynn Sharp Paine, Michael A. Santoro. The Forging the New Salomon, Spanish Version (referred as “Salomon Deryck” from here on) case study provides evaluation & decision scenario in field of Leadership & Managing People. It also touches upon business topics such as - Value proposition, Ethics, Leadership, Regulation.

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 Forging the New Salomon, Spanish Version Case Study


Describes Salomon Brothers' recovery from the August 1991 Treasury auction scandal. Details the impact of the firm's disclosure of bidding improprieties and describes how the new management team, led by Warren Buffett and Deryck Maughan, guided the company through the ensuing crisis. The impact of the crisis is followed through the end of 1992.


Case Authors : Lynn Sharp Paine, Michael A. Santoro

Topic : Leadership & Managing People

Related Areas : Ethics, Leadership, Regulation




Calculating Net Present Value (NPV) at 6% for Forging the New Salomon, Spanish Version Case Study


Years              Cash Flow     Net Cash Flow     Cumulative    
Cash Flow
Discount Rate
@ 6 %
Discounted
Cash Flows
Year 0 (10019533) -10019533 - -
Year 1 3452729 -6566804 3452729 0.9434 3257292
Year 2 3970806 -2595998 7423535 0.89 3534003
Year 3 3971687 1375689 11395222 0.8396 3334705
Year 4 3239957 4615646 14635179 0.7921 2566349
TOTAL 14635179 12692349


The Net Present Value at 6% discount rate is 2672816

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

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. Salomon Deryck 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 Salomon Deryck 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 Forging the New Salomon, Spanish Version

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 Leadership & Managing People 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 Salomon Deryck 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 Salomon Deryck 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 (10019533) -10019533 - -
Year 1 3452729 -6566804 3452729 0.8696 3002373
Year 2 3970806 -2595998 7423535 0.7561 3002500
Year 3 3971687 1375689 11395222 0.6575 2611449
Year 4 3239957 4615646 14635179 0.5718 1852456
TOTAL 10468777


The Net NPV after 4 years is 449244

(10468777 - 10019533 )






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 (10019533) -10019533 - -
Year 1 3452729 -6566804 3452729 0.8333 2877274
Year 2 3970806 -2595998 7423535 0.6944 2757504
Year 3 3971687 1375689 11395222 0.5787 2298430
Year 4 3239957 4615646 14635179 0.4823 1562479
TOTAL 9495688


The Net NPV after 4 years is -523845

At 20% discount rate the NPV is negative (9495688 - 10019533 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Salomon Deryck 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 Salomon Deryck has a NPV value higher than Zero then finance managers at Salomon Deryck 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 Salomon Deryck, then the stock price of the Salomon Deryck 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 Salomon Deryck 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 –

Understanding of risks involved in the project.

What are the key aspects of the projects that need to be monitored, refined, and retuned for continuous delivery of projected cash flows.

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 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

Lynn Sharp Paine, Michael A. Santoro (2018), "Forging the New Salomon, Spanish Version Harvard Business Review Case Study. Published by HBR Publications.