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Introduction to Net Present Value (NPV) - What is Net Present Value (NPV) ? How it impacts financial decisions regarding project management?

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Structured Credit Index Products and Default Correlation case study is a Harvard Business School (HBR) case study written by Darrell Duffie, Erin Yurday. The Structured Credit Index Products and Default Correlation (referred as “Trac Tranched” 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 markets, Product development, 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.

In mid-2003, Morgan Stanley and JPMorgan launched a number of structured credit products that had exposure to correlations in the credit risks of the firms underlying the TRAC-X index: tranched TRAC-X NA, tranched TRAC-X Europe, and options on both TRAC-X NA and TRAC-X Europe. The values of these TRAC-X derivatives were determined by some key parameters: the probabilities of default of each of the firms covered in the index, the recovery rates of the underlying corporate debt instruments in the event of default, and credit risk correlations among the underlying firms (plus, the value of TRAC-X options was also influenced by the volatility of CDS premiums). Tranched TRAC-X and other tranched products were often quoted in the market at prices that were expressed through an implied correlation parameter. Among the issues facing Morgan Stanley's Lewis O'Donald was the implication of the "implied correlation" quotations on the tranched products. Taken at face value, the quotations available in the market seemed to indicate that different tranches on the same underlying index of firms were trading at different implied default correlations. The market prices of the different tranches implied different default correlations for the same set of underlying firms--meaning that credit protection for the same set of underlying firms could be bought or sold at prices that assumed that the defaults of the underlying firms were correlated differently from the viewpoint of different tranches. This correlation skew across the different TRAC-X tranches represented a form of pricing discrepancy.

Years | Cash Flow | Net Cash Flow | Cumulative Cash Flow |
Discount Rate @ 6 % |
Discounted Cash Flows |
---|---|---|---|---|---|

Year 0 | (10016879) | -10016879 | - | - | |

Year 1 | 3447003 | -6569876 | 3447003 | 0.9434 | 3251890 |

Year 2 | 3960922 | -2608954 | 7407925 | 0.89 | 3525206 |

Year 3 | 3959649 | 1350695 | 11367574 | 0.8396 | 3324598 |

Year 4 | 3247632 | 4598327 | 14615206 | 0.7921 | 2572429 |

TOTAL | 14615206 | 12674122 |

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 -

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

There are four types of capital budgeting techniques that are widely used in the corporate world –

1. Profitability Index

2. Payback Period

3. Internal Rate of Return

4. Net Present Value

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. Trac Tranched 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 Trac Tranched have higher preference for cash returns over 4-5 years rather than 10-15 years given the nature of the volatility in the industry.

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

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 Trac Tranched 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 Trac Tranched 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.

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 | (10016879) | -10016879 | - | - | |

Year 1 | 3447003 | -6569876 | 3447003 | 0.8696 | 2997394 |

Year 2 | 3960922 | -2608954 | 7407925 | 0.7561 | 2995026 |

Year 3 | 3959649 | 1350695 | 11367574 | 0.6575 | 2603533 |

Year 4 | 3247632 | 4598327 | 14615206 | 0.5718 | 1856844 |

TOTAL | 10452798 |

(10452798 - 10016879 )

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 | (10016879) | -10016879 | - | - | |

Year 1 | 3447003 | -6569876 | 3447003 | 0.8333 | 2872503 |

Year 2 | 3960922 | -2608954 | 7407925 | 0.6944 | 2750640 |

Year 3 | 3959649 | 1350695 | 11367574 | 0.5787 | 2291464 |

Year 4 | 3247632 | 4598327 | 14615206 | 0.4823 | 1566181 |

TOTAL | 9480787 |

At 20% discount rate the NPV is negative (9480787 - 10016879 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Trac Tranched to discount cash flow at lower discount rates such as 15%.

Simplest Approach – If the investment project of Trac Tranched has a NPV value higher than Zero then finance managers at Trac Tranched 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 Trac Tranched, then the stock price of the Trac Tranched 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.

Project selection is often a far more complex decision than just choosing it based on the NPV number. Finance managers at Trac Tranched 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.

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.

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.

** Darrell Duffie, Erin Yurday (2018)**, "Structured Credit Index Products and Default Correlation Harvard Business Review Case Study. Published by HBR Publications.

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