Closing the Business Case Prof. John-Paul Clarke 16.886 Air Transportation Systems Architecting April 21, 2004 The top 5 investor questions ? How much will I need to invest? ? How much will I get back? ? When will I get my money back? ? How much is this going to cost me? ? How are you handling risk & uncertainty? Investment criteria ? Net present value ?Payback ? Discounted payback ? Average return on book value ? Internal rate of return Net present value (NPV) ? Measure of present value of various cash flows in different periods in the future ? Cash flow in any given period discounted by the value of a dollar today at that point in the future – “Time is money” – A dollar tomorrow is worth less today since if properly invested, a dollar today would be worth more tomorrow ? Rate at which future cash flows are discounted is determined by the “discount rate” or “hurdle rate” – Discount rate is equal to the amount of interest the investor could earn in a single time period (usually a year) if he/she were to invest in a “safer” investment Calculating NPV ? Forecast the cash flows of the project over Its economic life – Treat investments as negative cash flow ? Determine the appropriate opportunity cost of capital ? Use opportunity cost of capital to discount the future cash flow of the project ? Sum the discounted cash flows to get the net present value (NPV) NPV =C 0 + C 1 1+r + C 2 1+r () 2 +K + C T 1+r () T NPV example Period Discount Factor Cash Flow Present Value 0 1 -150,000 -150,000 1 0.935 -100,000 -93,500 2 0.873 +300000 +261,000 Discount rate = 7% NPV = $18,400 Points to keep in mind about NPV ? Assumes only one course of action: – Reasonable assumption if conditions are stable – No room for managerial flexibility ? Choice of the discount rate is difficult: – Typically, use a combination of equilibrium models (like CAPM) and “expert judgment” – Should always perform sensitivity analysis on discount rate! Payback ? Investment decision based on “time it takes to recover investment” ? No discounting of cash flows ? Gives equal weight to cash flows before cut-off date & no weight to cash flows after cut-off date ? Cannot distinguish between projects with different NPV ? Difficult to decide on appropriate cut-off date Payback example Project C 0 C 1 C 2 C 3 NPV @ 10% Payback A -2,000 +1,000 +1,000 +5,000 3,492 2 B -2,000 0 +2000 +5,000 3,409 2 C -2,000 +1,000 +1,000 +100,000 74,867 2 Discounted payback ? Payback criterion modified to account for the time value of money – Cash flows before cut-off date are discounted ? Surmounts objection that equal weight is given to all flows before cut-off date ? Cash flows after cut-off date still not given any weight Average return on book value ? Investment decision based on book rate of return of project relative to book rate of return of entire firm (or some external yardstick) ? Book rate of return given by dividing the average forecasted profits (after depreciation & taxes) by the average book value of the investment ? Average return on book value depends on accounting income (different from cash flow) ? Decision of yardstick is arbitrary Internal rate of return (IRR) ? Investment criterion is “rate of return must be greater than the opportunity cost of capital” ? Internal rate of return is equal to the discount rate for which the NPV is equal to zero ? IRR solution is not unique – Multiple rates of return for same project ? IRR doesn’t always correlate with NPV – NPV does not always decrease as discount rate increases NPV =C 0 + C 1 1+IRR + C 2 1+IRR () 2 +K + C T 1+IRR () T = 0 IRR example Dealing with risk & uncertainty ? Artificially high hurdle rate ? Bracketing (upper & lower bounds) ? Probabilistic analysis ? Decision tree analysis Artificially high hurdle rate ? Simplistic ? Doesn’t fully capture range of possibilities ? Not well suited for products with relatively small margins such as aircraft ? Better suited for products with relatively large margins or projects that require small capital outlays Bracketing ? Better that using a high hurdle rate ? Gives indication of variability in financial performance ? Highly unlikely that all the factors or issues will be all good or all bad at the same time ? Can over estimate “best” and “worst” case outcomes ? Best used for analysis with few factors Probabilistic analysis ? Essentially a Monte-Carlo simulation of NPV ? Repetitive NPV analyses using input values selected from probability distributions ? Can become very complex for products with many components & factors ? Requires many assumptions & good understanding of development & manufacturing/production processes Decision tree analysis ? NPV calculation that incorporates different future scenarios based on the likely hood of that scenario occurring ? Cash flow for any given year is the weighted sum of the cash flows for each scenario that could occur in that year ? Weightings are equal to the probability that a specific scenario will occur Decision tree example Period Option Prob. Cash Flow PV Prob. * PV 0 Both 100% -150,000 -150,000 -150,000 1 A 50% +50,000 +46,750 +23,375 B 50% +100000 +93,500 +46,750 2 A 50% +50,000 +43,650 +22,825 B 50% +200,000 +174,600 +87,300 Discount rate = 7% NPV = $30,250 Decision tree analysis ? Widely used technique to determine value of investments under uncertainty ? Main steps: – Determine possible states of nature – Determine probability of reaching each state (use conditional probabilities) – Determine NPV for each end state (use constant discount rate) Decision tree High NPV1 Low NPV2 High High NPV3 Low NPV4 Low Alt. 1 High NPV5 Low NPV6 High High NPV7 Low NPV8 Low Alt. 2 Best Alternative Decision node Chance node p 1 p 2 p 3 p 4 p 6 p 5 p 7 p 8 p 9 p 10 p 11 p 12 Solving the tree ? Move along the tree from end to the front ? NPV for any state (except for end states) is the weighted sum of the NPV of following state ? Weightings are the probabilities of reaching such states Points about decision analysis ? Difficult to apply when multiple sources of uncertainty are present ? Does not resolve problem of choice of discount rate Possible analysis approaches ? Bottom-up analysis ? Top-down analysis Bottom-up analysis ? Determine costs and timing (profile of expenditure versus time) for each phase of cargo system development and production based on heuristics or first principles analysis ? Determine market penetration (profile of cargo system revenue versus time) based on heuristics or first principles analysis ? Determine uncertainty in all values ? Determine NPV and variability in NPV Top-down analysis ? Determine market penetration (profile of cargo system revenue versus time) based on heuristics or first principles analysis ? Scale existing profile of expenditure versus time for development and production of a closely related system ? Determine costs for which NPV equals zero ? Determine uncertainty in market penetration ? Determine uncertainty in costs Managing risk ? Hedge investment – Buy portfolio that is not correlated with the market for the product you are developing ? Limit impact of factors outside your control – Insure against detrimental actions or inaction of partners, or catastrophic events ? Change the playing field – Influence market to either make it more stable overall or more favorable to your product Managing risk ? Build in flexibility – Create ability to respond to changes in product requirements space and market ? Plan staged development and introduction – Develop strategy to evaluate product utility and market situation before full investment is made Summary ? Investment criteria –NPV ? Risk & uncertainty – Bracketing (if there are only a few key factors) – Probabilistic analysis (if details of processes available) – Decision tree analysis (is there are clear investment options) ? Analysis approaches – Bottom-up analysis (if details of processes available) – Top-down analysis (if details of processes not available) ? Manage your risks