Lecture 8 Net Present Value and Calculating the Best Alternative

What CEOs do for a living CEO Business 1 Business 2 Opportunity 1 Opportunity 2

Investment Alternatives The object is to take capital earned, borrowed or from investors and allocate it in a fashion that earns the highest return for the shareholders of the company. There needs to be an appropriate balance of long and short term returns. More complex and as simple as a matter of dollars and cents. Question: What are some investment alternatives for a company?

What are typical investment alternatives... Invest in –product line a or product line b –Advertising –Information Systems –A new factory –Buy-back companies stock –Acquisition –Employee bonus or salary raise –Hire more HR personnel –etc.,etc. The Criteria is: Which investment(s) gives the highest return?

Question How do you calculate which gives the highest return?

Principal of Equivalence The state of being equal in value –amount –discount assumptions –Time transactions occur All investments must be normalized to give equivalence so comparisons can be made

Net Present Value of an Investment Holds for all investments Takes into account inflation, cost of capital, corporate expectations of return Reduces all times to a common point

Calculation of Net Present Value Where k is the expected rate of return A sub t is the cash flow in the period t Choose the programs whose NPV is highest consistent with strategy, risk, resource, etc.

Calculation of Payback Period Where r = discount rate is the cash flow in period t

Preparing an economic feasibility study Compare product Returns on Investment example: Sample business plan pro forma Dollars Time (Years)

What should the discount rate be? For a start-up For a growth company For a mature company For an Aerospace company

To calculate NPV, first assume a cash flow Time (Years) Cash Flow

Calculation of NPV and Payback Period of an investment

Calculation of Internal Rate of Return (IRR) for a project Calculate a discount rate (k) that reduces the NPV of a project to zero

Calculation of Internal Rate of Return IRR) of an investment IRR=24.3%

Net Present Value What are the Problems with this analysis methodology? Fudge earnings Macroeconomic effects inflation crash war Competition Disruptive tech Personnel change

What’s wrong with this picture? Predictions are very difficult- especially when they involve the future. –Extrinsic Markets change Competitors change Macro-economic conditions change –Intrinsic The analyses are based on flawed assumptions –Program delays –Manufacturing snafus –Technologies not ready –Externalities (out of your control) –Many other reasons Then why does everybody do it?

Advantages of a quantitative methodology Screen out the losers Sensitivity analysis Target Common language

Sensitivity Analysis Reduce (Increase) Price Change Product Development Time Consider competitive response

Some thoughts on how to increase profits P=SP-C 1. Increase Selling Price Increase Customer Value Put extra features in product which require little marginal cost Provide extra service Target less competitive segment of the market Get to market before competition Price at the maximum the customer is willing to pay Price models should reflect customer value- not cost (except in government contracts if you wish to avoid jail Note in English gardening magazine: Even though seed sales are at an all time high, the price is not expected to come down

Why? Some thoughts on how to increase profits P=SP-C 2. Decrease Selling Price Undermine competetion Increase sales volume Change business model Build base

Do it right the first time Don’t commit to detailed design until you have customers specs firm then don’t change Build a manufacturable product. Bring manufacturing in early Don’t overload with features that the customer doesn’t want that are costly to develop Manage tightly to schedule with appropriate risk and risk reduction plans Use rigid phase exit criteria All of these consistent with Fast C/T Some thoughts on how to increase profits P=SP-C 3. Decrease Product Development (NRE) and Manufacturing (RE) costs

Effect on product price in being first to market? Effect on total revenue of turning out products faster? Effect on Cost? Some thoughts on how to increase profits P=SP-C 4. Decrease Cycle Time for product Development

Assume the decision is made to invest in developing new products How do you make the decision on which new product to invest in? What are the criteria for this decision- making process? How do we maximize profit? –in the long range –in the short range

Portfolio Analysis Reward (NPV) Risk Game Changers Kill Bread and Butter Pearls

D C B A Reward (NPV) Risk Kill Game Changers Bread and Butter Pearls A Portfolio of 6 programs G F Note: area = program cost

How do you allocate? Not by NPV and Payback Period alone But... Portfolio Balance (long/short) Strategically Important vs Tactically Important Product Families and Platforms Future Sales Model Available Resource –People and Dollars Customers demands

Data for Rank ordered List

Rank Ordered by discounting returns by probability of success

Some references Economist Quarterly Using markets – ory_id= http:// ory_id= Methodologies – sting.html