Making Finance Relevant

1
Making Finance Relevant

• Creating Shareholder Value Through Corporate
  Finance ReengineeringFinegan Company LLC

2
What Reengineering Does Not Mean

• Reengineering does not mean cost-cutting.
• It does not mean improving technology to do the
  same tasks faster.
• It does not mean TQM.
• It does not mean continuous improvement.

3
What Reengineering Does Mean

• the fundamental rethinking and radical redesign
  of business processes to achieve dramatic
  improvements in critical, contemporary measures
  of performance M. Hammer, Reengineering the
  Corporation
• Closely allied with
• Identifying and exploiting core competencies.
• Eliminating hand-offs and bureaucracy.
• Empowering employees to make their own decisions.
• Identifying the unmet, often unarticulated needs
  of customers.
• Starting with a blank sheet of paper.

4
Why Reengineering Degenerates Into Cost-Cutting

• The finance functions seem too diverse for
  comprehensive, radical improvement.
• Its nearly impossible to measure the value
  created by any particular finance function.

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To ReengineerFocus on the Process, Not the Task

• Problem The classical tools (or tasks) of
  finance are too slow, disconnected, and one-sided
  to be of practical value to line managers and
  stockholders.
• Consequence The entire strategic planning
  process is discredited.

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Technology is the Essential Enabler

• Classical Finance Reengineered Finance
• Developed to explain ? Developed to
  monitorinvestor behavior and assist
  corporate(Shoe-horned into evaluating
  behaviorcorporate behavior)
• Mathematically based ? Simulation-based
  (Inherently simplistic) (Comprehensive,
  potentially realistic)
• One set of answers per ? Multiple
  answersassumption set per assumption
  set(Inherently reactive) (Responsive and
  proactive)

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The Proper Objectives ofFinance Reengineering

• Improved quality and consistency of business plan
  assumptions.
• Improved relevance and clarity to line managers.
• Sustained relevance throughout the year.
• Better contingency planning.

8
Dont Get Distracted

• Reengineering is not about cost-cutting. Its
  about making planning and reporting processes
  facilitate better business decisions. Finance
  processes must be as flexible, responsive and
  just-in-time as the business processes they
  assist.
• For many companies, devoting adequate attention
  to uncertainty would create far more value, at
  the margin, than devoting further financial
  resources to projecting, prescribing and policing
  expected returns.

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Classic Signs of Disfunction The
Decentralization Paradox
Vision
Reality

• Decentralization and empowerment lead to
  inconsistent assumptions, benchmarks and
  objectives.

• Decentralization and empowerment lead to improved
  responsiveness, coordination, feedback and
  accuracy.

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Classic Signs of Disfunction The Project
Selection Paradox
Vision
Reality

• Capital costs differ wildly between projectseven
  within business units.
• Line managers forced to forgo projects which, on
  paper, promise profitable IRRs.

• Uniform cost of capital for each business unit.
• Projects selected on basis of rank IRR or EVA.

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Classic Signs of Disfunction The Efficiency
Paradox
Vision
Reality

• Managers encouraged to pursue marginal product
  line extensions and efficiency gains, instead of
  identifying new opportunities.

• Managers encouraged to pursue all value-enhancing
  opportunities, whether from efficiency
  improvements, downsizing or growth.

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Defects of the Traditional Financial Planning
Process

• Can't tell whether the Base Case is the mean,
  mode, median ormore likelyan arbitrary product
  of negotiation.
• Can't tell whether the Worst Case represents a
  0.01 probability or a 25 probability.
• Provides no guidance six months out about how to
  get back on plan if off.

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Implications

• Capital budgeting is distorted by ignoring
  asymmetries in the distribution of value drivers.

14
Implications

• Valuation efforts are compromised by confusing
  goals with expectations, modes with means.

15
Implications

• Incentive payments are rendered arbitrary by not
  reflecting difficulty of attainment.

16
Implications

• Financing decisions are distorted by not gauging
  downside risk accurately, and by not evaluating
  the fatness of tails.

17
Implications

• Communications between the corporate office and
  the field are frustrated by not being sensitive
  to macroeconomic factors beyond the control of
  management.

The relationship between weather and resort
attendance means . . .
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Implications

• Communications between the corporate office and
  the field are frustrated by not being sensitive
  to macroeconomic factors beyond the control of
  management.

Its easy to confuse bad luck with bad management
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The Reengineering ApproachFocus on the Model,
Not Point Estimates

• Express forecasts of value drivers as verifiable
  ranges, not point estimates.
• Focus attention on how those value drivers
  inter-relate in the face of uncertainty.
• Manage business decisions and expectations on the
  basis of how aggregate performance measures
  cluster, given variability in the underlying
  value drivers.
• Make strategic planning proactive and
  contingency aware, and thus useful to guiding
  investment decisionsnot just policing them.

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The Six Steps of Corporate Finance Reengineering

• Assign meaningful (if possible, verifiable)
  patterns to the key ingredients or value
  drivers of a forward plan.

Identify Value Drivers
Quantify Relationships Build a better model
Identify Sources of Exposure

• Posit relationships (again often verifiable)
  between those value drivers

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The Six Steps of Corporate Finance Reengineering

• Re-compile management's forward plan many, many
  times, allowing the plan's value drivers to vary
  randomly.

Run Lots of Simulations
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The Six Steps of Corporate Finance Reengineering

• Derive distributions for important aggregate
  measures.

Re-examine the Aggregates
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The Six Steps of Corporate Finance Reengineering

• Base expectations, financing decisions and
  rewards on patterns in those aggregate measures.

Re-evaluate Expectations
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The Six Steps of Corporate Finance Reengineering

• Use subset analysis to guide performance 6-to-18
  months later.

PlanContingencies
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The Six Steps of Corporate Finance Reengineering
Plan Contingencies
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Summary of theReengineering Process

• Corporate finance reengineering tackles
  uncertainty by concentrating attention on those
  components of performance where randomness can be
  measured historically, and where it is thus
  easier to generate consensus among line managers
  as to bounds.
• The alternative approach is to assign weights to
  arbitrary best and worst scenarios. Although
  quicker, the approach does not distill from
  historically verifiable relationships those
  factors over which management has influence, and
  is thus more prone to error. It is often
  impossible to explain the chosen weights to line
  management, appearing instead to be a black box
  rationalization.

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Benefits of Reengineering

• Improves the quality and consistency of business
  plans and financial reporting.
• Makes finance understandable by shedding the
  black box, one answer approach to financial
  modeling.
• Requires little or no statistical training.
• Makes fair calibration of bonus plans possible.
• Filters out the impact of macroeconomic factors
  beyond managements control.
• Extends the planning process relevance.

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Implications for Incentives

• Measure management's contribution to share value,
  not the economy's.
• The exercise price of employee stock options
  should be indexed against the stock price
  performance of competitors.
• Cash bonuses should be based on discretionary
  EVA, not total EVA.
• Base expectations on verifiable levels of
  difficulty.
• Price options fairly.
• Calibrate bonus plans fairly (a linear award
  schedule is presumptive evidence of unfairness).
• Revise goals and expectations to meet economic
  conditions at the time.

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Other Areas of Application

• Annual planning and budgeting
• Performance measurement and appraisal
• Interim planning and target-setting
• Capital budgeting and formation
• Treasury planning
• Stock option pricing
• Financial communication
• Executive incentive compensation
• Acquisition pricing and planning

In each of these areas, the framework for
value-based planning is established. What is
needed now are explicit ways to measure,
communicate and address uncertainty in a world
where chaos has become the norm.