Lessons Learned? Brooksley Born & the OTC Derivatives Market (A) 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 Lessons Learned? Brooksley Born & the OTC Derivatives Market (A) case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Lessons Learned? Brooksley Born & the OTC Derivatives Market (A) case study is a Harvard Business School (HBR) case study written by Clayton Rose, David Lane. The Lessons Learned? Brooksley Born & the OTC Derivatives Market (A) (referred as “Otc Born” from here on) case study provides evaluation & decision scenario in field of Finance & Accounting. It also touches upon business topics such as - Value proposition, Government, Recession.

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 Lessons Learned? Brooksley Born & the OTC Derivatives Market (A) Case Study

On May 7, 1998, the U.S. Commodity Futures Trading Commission, chaired by Brooksley Born, issued a "Concept Release," inviting public comment on the relevance and appropriateness of existing regulation of the over-the-counter (OTC) derivatives market, a market with a notional value of $29 trillion dollars. The CFTC Concept Release, often a precursor to regulatory proposals, sought analysis of "the benefits and burdens of any potential regulatory modifications in light of current market realities." The Release was not welcomed by other regulators or by the Clinton administration. Just hours after it was published, U.S. Treasury Secretary Robert Rubin, Federal Reserve Board Chairman Alan Greenspan, and Securities and Exchange Commission Chairman Arthur Levitt announced their "grave concerns" about it in an unusual joint press release that minced no words. This case explores the battle between Born, on the one hand, and a large number of policymakers, regulators, legislators and industry representatives, on the other, over whether and how greater regulatory oversight should be applied to the OTC derivative market. Born was defeated in her efforts; OTC derivatives played a central role in the 2008-09 financial crisis.

Case Authors : Clayton Rose, David Lane

Topic : Finance & Accounting

Related Areas : Government, Recession

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Calculating Net Present Value (NPV) at 6% for Lessons Learned? Brooksley Born & the OTC Derivatives Market (A) Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10012139)	-10012139	-	-
Year 1	3447872	-6564267	3447872	0.9434	3252709
Year 2	3953531	-2610736	7401403	0.89	3518629
Year 3	3945937	1335201	11347340	0.8396	3313085
Year 4	3241275	4576476	14588615	0.7921	2567393
TOTAL			14588615		12651816

The Net Present Value at 6% discount rate is 2639677

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. Payback Period
2. Profitability Index
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. Timing of the expected cash flows – stockholders of Otc Born 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. Otc Born 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 Lessons Learned? Brooksley Born & the OTC Derivatives Market (A)

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 Otc Born 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 Otc Born 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	(10012139)	-10012139	-	-
Year 1	3447872	-6564267	3447872	0.8696	2998150
Year 2	3953531	-2610736	7401403	0.7561	2989437
Year 3	3945937	1335201	11347340	0.6575	2594518
Year 4	3241275	4576476	14588615	0.5718	1853210
TOTAL					10435314

The Net NPV after 4 years is 423175

(10435314 - 10012139 )

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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	(10012139)	-10012139	-	-
Year 1	3447872	-6564267	3447872	0.8333	2873227
Year 2	3953531	-2610736	7401403	0.6944	2745508
Year 3	3945937	1335201	11347340	0.5787	2283528
Year 4	3241275	4576476	14588615	0.4823	1563115
TOTAL					9465378

The Net NPV after 4 years is -546761

At 20% discount rate the NPV is negative (9465378 - 10012139 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Otc Born 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 Otc Born has a NPV value higher than Zero then finance managers at Otc Born 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 Otc Born, then the stock price of the Otc Born 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 Otc Born 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.

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 Lessons Learned? Brooksley Born & the OTC Derivatives Market (A)

References & Further Readings

Clayton Rose, David Lane (2018), "Lessons Learned? Brooksley Born & the OTC Derivatives Market (A) Harvard Business Review Case Study. Published by HBR Publications.