Banking on Change: Aligning Culture and Compensation at Morgan Stanley 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 Banking on Change: Aligning Culture and Compensation at Morgan Stanley case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Banking on Change: Aligning Culture and Compensation at Morgan Stanley case study is a Harvard Business School (HBR) case study written by Malcolm S. Salter. The Banking on Change: Aligning Culture and Compensation at Morgan Stanley (referred as “Culture Stanley” 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, Technology.

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 Banking on Change: Aligning Culture and Compensation at Morgan Stanley Case Study

This case study was prepared as part of a research project on Culture, Conduct, and Governance in Financial Firms. The objective of this project is to compare and contrast the efforts of U.S. and European banks to induce changes in organization culture in the aftermath of the 2008 financial crisis. Since this crisis, wide ranging regulations aimed at improving risk management and bankers' ethics have been promulgated in the United States and in Europe, and more rules are currently under discussion. Academics, regulators, and public officials have proposed many of these measures. At the same time, banks have been implementing their own company-tailored culture change programs. This project and the Morgan Stanley case in particular describes these change programs and banks' experience with them so far-with particular attention being paid to how banks are using compensation and other incentives to change and reinforce organization culture and conduct. One of the central questions of this case is whether or not the voluntary efforts of Morgan Stanley to strengthen their conduct and culture will prove to be "effective" or "adequate" according to bank regulators and the general public. This case lends itself to analysis and discussion in a variety of related graduate-level courses dealing with the management of financial institutions, financial regulation, corporate governance, organization behavior, and corporate accountability and ethics.

Case Authors : Malcolm S. Salter

Topic : Leadership & Managing People

Related Areas : Ethics, Technology

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Calculating Net Present Value (NPV) at 6% for Banking on Change: Aligning Culture and Compensation at Morgan Stanley Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10002694)	-10002694	-	-
Year 1	3451711	-6550983	3451711	0.9434	3256331
Year 2	3957291	-2593692	7409002	0.89	3521975
Year 3	3966776	1373084	11375778	0.8396	3330582
Year 4	3228193	4601277	14603971	0.7921	2557031
TOTAL			14603971		12665919

The Net Present Value at 6% discount rate is 2663225

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. Profitability Index
2. Net Present Value
3. Internal Rate of Return
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 Culture Stanley 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. Culture Stanley 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 Banking on Change: Aligning Culture and Compensation at Morgan Stanley

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 Culture Stanley 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 Culture Stanley 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	(10002694)	-10002694	-	-
Year 1	3451711	-6550983	3451711	0.8696	3001488
Year 2	3957291	-2593692	7409002	0.7561	2992281
Year 3	3966776	1373084	11375778	0.6575	2608220
Year 4	3228193	4601277	14603971	0.5718	1845730
TOTAL					10447718

The Net NPV after 4 years is 445024

(10447718 - 10002694 )

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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	(10002694)	-10002694	-	-
Year 1	3451711	-6550983	3451711	0.8333	2876426
Year 2	3957291	-2593692	7409002	0.6944	2748119
Year 3	3966776	1373084	11375778	0.5787	2295588
Year 4	3228193	4601277	14603971	0.4823	1556806
TOTAL					9476939

The Net NPV after 4 years is -525755

At 20% discount rate the NPV is negative (9476939 - 10002694 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Culture Stanley 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 Culture Stanley has a NPV value higher than Zero then finance managers at Culture Stanley 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 Culture Stanley, then the stock price of the Culture Stanley 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 Culture Stanley 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 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 will be a multi year spillover effect of various taxation regulations.

What can impact the cash flow of the project.

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.

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 Banking on Change: Aligning Culture and Compensation at Morgan Stanley

References & Further Readings

Malcolm S. Salter (2018), "Banking on Change: Aligning Culture and Compensation at Morgan Stanley Harvard Business Review Case Study. Published by HBR Publications.