Managing the Investment Process

1. Managing the Investment Process Henry C. Co Technology and Operations Management, California Polytechnic and State University

2. Assessing Financial Attractiveness of Investments Security Recompense Predictability Option Value

3. Security • How safe is my money? • How soon will I be able to get it back? • Risk • Payback period: see page 259. Managing the Investment Process (Henry C. Co)

4. Measures of Recompense • (Average annual profit after tax)/(Average beginning of year investment book value) • (Average annual net cash flow)/(Initial Investment) • Annual cash flow – Cost of the capital investment • The NPV • The IRR Managing the Investment Process (Henry C. Co)

5. Measures of Predictability • Different projects carry different hurdle rates • Adjusting for effect of inflation Managing the Investment Process (Henry C. Co)

6. Option Value • Many investments generate returns other than financial (see p. 270-271) • Valuable information • Open up new opportunities • Cultivate expertise in new technologies • Foster new capabilities • Provide access to new markets • Option value = value of the future opportunities that that would be available only if the investment was made. • In finance, the “call option” allows the holder to buy an asset at the “strike price” within a specified period of time Managing the Investment Process (Henry C. Co)

7. New Technology: Costs and Requirements

8. Capital for initial and ongoing investments. • Enhanced labor skills - direct and in-direct (supervisory). • Material inputs - higher quality, improved availability. • System reliability and precision • Process equipment • Supplier lead times • Market demand forecasts • Integration • Function • Software and database communications Managing the Investment Process (Henry C. Co)

9. CIM Performance Benefits

10. Productivity Improvement - direct and indirect labor • Flexibility - reduced design lead times, production cycle times, setup times, run times. • Quality - lower rework and scrap, improved product conformance. • Cost reductions - material, WIP • Customer Service - reduced order delivery lead-time, improved finished product availability, reduced order backlog • Product Design - greater variety & customization, fewer engineering changes Managing the Investment Process (Henry C. Co)

11. Justification Approaches

12. Financial • Many benefits not quantifiable or arbitrarily assigned zero. • Doing nothing may have a negative PV due to competitor actions. • Hurdle rates often set too high. • Systematic biases. • Strategic • Strategic impact may be more important than rate of return • Risk and diversification should be considered at firm level • long term, competitive impact is key. Managing the Investment Process (Henry C. Co)

13. Decision Trees

15. Understanding Productivity Trends

16. Manufacturing sector labor productivity growth exceeds that of service sector. • Output of both sectors continues to grow. Managing the Investment Process (Henry C. Co)

17. Employment levels in manufacturing have been flat, while service sector employment growth matches output. Managing the Investment Process (Henry C. Co)

18. Summary • Financial Justification Necessary • Do it right! • Understand your numbers. • Consider operational performance metrics. • Implementation • Develop automation (operational) and IS strategy as part of competitive corporate strategy. • Build on intellectual assets of the firm • Invest in human capital • Organizational biases must be removed - may require a cultural shift. Managing the Investment Process (Henry C. Co)

19. Elements of an explicit implementation plan. • Objectives • Cross-functional teams • Identify & prioritize needs • System design critical • Training & retraining • Monitor, analyze, improve Managing the Investment Process (Henry C. Co)

20. Getting the Numbers Right Getting the Numbers Right by David W. Mullins, Jr. The Cost of Capital Measuring Alternatives Piecemeal Investment

21. Cost of Capital • DCF usually fails to work right when companies set arbitrarily high hurdle rates for evaluating new investment projects. Managing the Investment Process (Henry C. Co)

22. Weighted average of the current cost of equity and debt at the mix of capital financing typical in the industry. • Real (after-inflation) return from investments in common stocks at about 8.5% per year. Managing the Investment Process (Henry C. Co)

23. All cash are expressed in 1977 dollars • The company used a 20% discount rate. This assumption of a 20% cost of capital most likely arose from a prior assumption of a real cost of capital of about 10% and an expected inflation rate of 10% per year. • If inflation would average 10%, the company should also have raised the assumed selling price and the unit costs of labor, material, and overhead by their expected price increases over the life of the project. Managing the Investment Process (Henry C. Co)

24. Measuring Alternatives (Table B in previous slide) • Cash flows from alternative 1 assume a constant level of sales during the next ten years; • Cash flows from alternative 5 show a somewhat higher level of sales based on a small increase in market share. • The company should rest its decision on a correct reading of what is likely to happen to cash flows when it rejects a new technology investment. • If competitors adopt new technology, market share may decline and profits erode over time. Managing the Investment Process (Henry C. Co)

25. Piecemeal Investment • Each year, a company or a division may undertake a series of small improvements in its production process—to alleviate bottlenecks, to add capacity where needed, or to introduce islands of automation based on immediate and easily quantified labor savings. • Each of these projects, taken by itself, may have a positive net present value. By investing on a piecemeal basis, however, the company or division will never get the full benefit of completely redesigning and rebuilding its plant. Managing the Investment Process (Henry C. Co)

26. Must CIM Be justified by faith alone? Kaplan, R.S. (1986), "Must CIM be justified by faith alone?", Harvard Business Review, Vol. 34 pp.87-95. Kaplan is Arthur Lowes Dickinson Professor of Accounting at the Harvard Business School and a professor of industrial administration at Carnegie-Mellon University, where for six years he was dean of the business school.

27. Yamazaki Machinery Co. invested $18m in FMS • Machines reduced from 68 to 18 • Employees from 215 to 12 • Floor space from 103,000 sq. ft to 30,000 sq. ft • Average processing time from 35 days to 1.5 • Impressive? Not really. • After two years ... • $3.9 million came from a one time cut in inventory • Even if the project continues to save $1.5 millions/year for 20 years, it will not be able to go over the hurdle rate of 15%. Managing the Investment Process (Henry C. Co)

28. ‘Strategic Faith’ • “Let's be more practical, DCF (discounted cash flow analysis) is not the only gospel. Many managers have become too absorbed with DCF to the extent that practical strategic directional considerations have been overlooked.” • “Beyond all else, capital investment represents an act of faith, a belief that the future will be as promising as the present, together with a commitment to making the future happen.” • Fact: • A dollar received in the future is worth less than receiving one dollar today • We can not reject the logic of the time value of money. Managing the Investment Process (Henry C. Co)

29. Technical Issues • The DCF approach most often goes wrong when companies set arbitrarily high hurdle rates for evaluating new investment projects. Real cost of capital is about 8%. • Companies underinvested in CIM and other new process technologies because they fail to evaluate properly all the relevant alternatives. • New investments against a status quo alternative of making no new investments—an alternative that usually assumes a continuation of current market share, selling price, and costs. • Status quo rarely lasts. Business as usual does not continue undisturbed. Managing the Investment Process (Henry C. Co)

30. What Is Right With DCF? • Some Technical Issues • Hurdle rate too high • What if your competitors' hurdle rate is lower? • Does your hurdle rate reflect your actual opportunity cost of capital (the return available in the capital markets for investments of the same risk)? • Kaplan estimated the real cost of capital ~ 8% !!! • Bad assumptions • When measuring new investment versus the status quo alternative, assume that the status quo exists -- continuation of market share, selling price, and costs. • “If you need a machine and don't buy it, you pay for it without getting it”...Henry Ford • Bias toward incremental investment • Capital approval process; different levels of authorization depending on the size of the request Managing the Investment Process (Henry C. Co)

31. Justification Guidelines • Determine how the new technology relates to the firm’s long-term strategic goals and objectives, and ensure that the technology and the firm’s strategy are aligned. • List all the costs and benefits (both tangible and intangible) associated with the new technology. • Quantify as many of the costs and benefits as possible. • Perform an NPV analysis of the project, using the costs and benefits quantified in Step 3. Carefully consider what discount rates and status quo assumptions should be used. Estimate the value of both incremental projects and the whole project. Managing the Investment Process (Henry C. Co)

32. If the NPV is positive, accept the project. If the NPV analysis is negative, do not scrap the project (yet). Top management must now decide whether the intangible benefits associated with the new technology warrant the acquisition. Move to step 6. • Estimate the value of all the intangible (remaining) costs and benefits. Managing the Investment Process (Henry C. Co)