Lecture 8 Net Present Value and Calculating the Best Alternative

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Lecture 8 Net Present Value and Calculating the
Best Alternative
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What CEOs do for a living
Opportunity 1
Opportunity 2
CEO
Business 1
Business 2
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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?
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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?
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Question

• How do you calculate which gives the highest
  return?

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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

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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

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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.
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Calculation of Payback Period
Where r discount rate is the cash flow in
period t
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Preparing an economic feasibility study

• Compare product Returns on Investment
• example Sample business plan pro forma
• Dollars
• Time
• (Years)

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What should the discount rate be?

• For a start-up
• For a growth company
• For a mature company
• For an Aerospace company

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To calculate NPV, first assume a cash flow
Cash Flow
Time (Years)
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Calculation of NPV and Payback Period of an
investment
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Calculation of Internal Rate of Return (IRR) for
a project

• Calculate a discount rate (k) that reduces the
  NPV of a project to zero

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Calculation of Internal Rate of Return IRR) of an
investment
IRR24.3
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Net Present Value

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

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Whats 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?

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

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

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Some thoughts on how to increase
profitsPSP-C1. 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
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Some thoughts on how to increase
profitsPSP-C2. Decrease Selling Price

• Why?

Undermine competetion Increase sales
volume Change business model Build base
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Some thoughts on how to increase
profitsPSP-C3. Decrease Product Development
(NRE) and Manufacturing (RE) costs

• Do it right the first time
• Dont commit to detailed design until you have
  customers specs firm
• then dont change
• Build a manufacturable product. Bring
  manufacturing in early
• Dont overload with features that the customer
  doesnt 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
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Some thoughts on how to increase
profitsPSP-C4. Decrease Cycle Time for product
Development

• Effect on product price in being first to market?
• Effect on total revenue of turning out products
  faster?
• Effect on Cost?

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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

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

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Data for Rank ordered List
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Rank Ordered by discounting returns by
probability of success
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Some references

• Economist Quarterly
• Using markets
• http//www.economist.com/displaystory.cfm?story_id
  5244000
• Methodologies
• http//www.class.uh.edu/MediaFutures/forecasting.h
  tml