INDUSTRIAL AND COMMERCIAL BANK OF CHINA: GOVERNANCE LESSONS FROM EAST TO WEST 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 INDUSTRIAL AND COMMERCIAL BANK OF CHINA: GOVERNANCE LESSONS FROM EAST TO WEST case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. INDUSTRIAL AND COMMERCIAL BANK OF CHINA: GOVERNANCE LESSONS FROM EAST TO WEST case study is a Harvard Business School (HBR) case study written by Didier Cossin, Hongze Abraham Lu. The INDUSTRIAL AND COMMERCIAL BANK OF CHINA: GOVERNANCE LESSONS FROM EAST TO WEST (referred as “Governance Icbc” 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, Emerging markets, Government.

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 INDUSTRIAL AND COMMERCIAL BANK OF CHINA: GOVERNANCE LESSONS FROM EAST TO WEST Case Study

(A short version of this case is also available: IMD-1-0335 Industrial and Commercial Bank of China: The Governance Model.) In June 1999, ICBC - the largest commercial bank in China - was technically bankrupt, with a nonperforming loan ratio of 47.59%. But, thanks to the united efforts of the government, the management team and its employees, the bank rose from the ashes through a transformation in its governance structure. After the third quarter of 2007, ICBC had continued to be ranked as the largest bank in the world by market capitalization, customers' deposits and profitability.This case was developed to record corporate governance reform at ICBC within the context of China's banking reform. It describes the evolution of governance in China, the challenges faced by leaders at all levels, the choices made and the results of these hard decisions. The challenges and discussion are relevant to Western companies in terms of understanding the corporate governance structure adopted by large Chinese enterprises. The success of the bank and its unique governance structure bring much inspiration from East to West. Learning objectives: Participants can explore the different issues behind ICBC's governance reform. At undergraduate level in a political economy program, students can discuss the strategies involved in transforming from a centrally planned economy to a free market economy and the systematic design required to make any reform work. In MBA programs, participants can discuss issues related to corporate restructuring, governance structure, IPOs, as well as competitive strategy. At executive and board level, participants can focus on the banking governance structure and the pros and cons of the ICBC system. By the end of the class discussion, participants should have gained an insight into working with large Chinese companies. They should be able to grasp the problems arising from conflicts of interest among shareholders, directors, supervisors, the management team, strategic investors, the communist party and regulators. They should also understand the inner workings of these stakeholders, in particular the incentives of each stakeholder group, which differ greatly from those in the West. Participants will realize how corporate governance could be managed differently and how complex it could become. The discussions offer participants the opportunity to reflect on governance practices in the West and borrow elements that could be useful.

Case Authors : Didier Cossin, Hongze Abraham Lu

Topic : Leadership & Managing People

Related Areas : Emerging markets, Government

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Calculating Net Present Value (NPV) at 6% for INDUSTRIAL AND COMMERCIAL BANK OF CHINA: GOVERNANCE LESSONS FROM EAST TO WEST Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10002179)	-10002179	-	-
Year 1	3454963	-6547216	3454963	0.9434	3259399
Year 2	3957166	-2590050	7412129	0.89	3521864
Year 3	3945759	1355709	11357888	0.8396	3312935
Year 4	3229997	4585706	14587885	0.7921	2558460
TOTAL			14587885		12652658

The Net Present Value at 6% discount rate is 2650479

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. 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 Governance Icbc 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. Governance Icbc 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 INDUSTRIAL AND COMMERCIAL BANK OF CHINA: GOVERNANCE LESSONS FROM EAST TO WEST

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 Governance Icbc 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 Governance Icbc 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	(10002179)	-10002179	-	-
Year 1	3454963	-6547216	3454963	0.8696	3004316
Year 2	3957166	-2590050	7412129	0.7561	2992186
Year 3	3945759	1355709	11357888	0.6575	2594401
Year 4	3229997	4585706	14587885	0.5718	1846761
TOTAL					10437664

The Net NPV after 4 years is 435485

(10437664 - 10002179 )

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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	(10002179)	-10002179	-	-
Year 1	3454963	-6547216	3454963	0.8333	2879136
Year 2	3957166	-2590050	7412129	0.6944	2748032
Year 3	3945759	1355709	11357888	0.5787	2283425
Year 4	3229997	4585706	14587885	0.4823	1557676
TOTAL					9468269

The Net NPV after 4 years is -533910

At 20% discount rate the NPV is negative (9468269 - 10002179 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Governance Icbc 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 Governance Icbc has a NPV value higher than Zero then finance managers at Governance Icbc 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 Governance Icbc, then the stock price of the Governance Icbc 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 Governance Icbc 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 can impact the cash flow of the project.

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 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.

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Negotiation Strategy of INDUSTRIAL AND COMMERCIAL BANK OF CHINA: GOVERNANCE LESSONS FROM EAST TO WEST

References & Further Readings

Didier Cossin, Hongze Abraham Lu (2018), "INDUSTRIAL AND COMMERCIAL BANK OF CHINA: GOVERNANCE LESSONS FROM EAST TO WEST Harvard Business Review Case Study. Published by HBR Publications.