Lecture 8 – “ATH Microtechnologies & Project Valuation and ROI - I” Steve Montgomery
Introduction To The Business Environment • What to do when someone’s not telling you what to do • Topics covered: • Course introduction and Overview of corporate structure (1 session) • Fundamentals of business strategy (2 sessions) • Introduction to Marketing (2 sessions) • Overview of Accounting and Finance (2 sessions) • Project Valuation and ROI (2 sessions) • Course review & strategy illustration (1 session)
Accounting/Finance • Accounting: Two types • Bookkeeping and managerial • Bookkeeping: Your company’s overall financial health • Balance sheets income statements and how to read them • Managerial: Measurable metrics that drive decision making • What incentives are you creating, and can you measure the right things? • Finance: The art and science of cash management • Cash is King • Treat it like it’s yours • Time = money • End goal: • Understanding your business, how you reach customers, and your firm’s business condition allow you to pick smart projects and sell them to management
Project Valuation and ROI • The project decision: Is this project a good use of company resources? • How can we tell? What should we measure? • What are we not doing by starting this project? • Techniques for estimating Return on Investment • End goal: • Understanding your business, how you reach customers, your firm’s business condition and the potential impact your of your work allow you to pick smart projects and sell them to management
Lecture 8: Project Valuation and ROI I • ATH Microtechnologies Case • Finance and the time value of money • Present/future value problems
Growth Profit Control ATH Microtechnologies • Founding Period: • Scepter’s bid: • $90M initial payment • $30M if new product approved by FDA • $35M if independent study proved product superiority • Up to $120M in cash for sales/profit goals • What are some features of this payment system? • Is there anything missing here?
ATH Microtechnologies, cont. • Did the earn out structure focus on the right performance goals? • Were there adequate controls in place? • What are some good metrics to measure ATH’s performance by?
ATH Microtechnologies, cont. • Growth Phase: • Autonomy granted to ATH (why?) • Goal: Get market share through new product development and marketing • Were bonuses linked to market share growth? • First earn out paid as FDA approved product, but European tech proved superior in test, so no second phase earn out Growth Profit Control
ATH Microtechnologies, cont. • How did they do during the growth period? • Did they achieve their strategic objectives?
ATH Microtechnologies, cont. • Push to profitability: • 20% bonus and trip for two to Hawaii if we’re profitable! • What’s not to like? • Would you design an incentive program this way? Growth Profit Control
ATH Microtechnologies, cont. • Was ATH successful in becoming profitable? • How did they do it? • What effects did this have on the rest of the business?
ATH Microtechnologies, cont. • Refocus on Process • Issued vision statement • Restructured bonus program • Launched education initiative
ATH Microtechnologies, cont. • How did they do? • Were the issues contained at this point? • Final earn out paid at this point Growth Profit Control
ATH Microtechnologies, cont. • New Management: • Declining sales • Founders left the company • New European tech eating at business + other competitors entering market • New spending focused on new product development and tech leadership • Newest products withdrawn from market; corners cut to make deadlines Growth Profit Control
ATH Microtechnologies, cont. • How well is ATH positioned for the future?
ATH Summary • People respond to incentives: • You get what you measure! • Consequently, measures need to be balanced: Reward one thing, get one thing • Strategy is everything! • In this case, did ATH focus on the short or the long term? • It’s difficult to balance short vs. long term goals, but: • Design incentives that try to do both • How could that have been done here? • Keep tension in the system between growth, profit and control • If one is sacrificed completely, negative consequences can appear later!
Time…Is Money • The key to understanding financing decisions is to note that the value of money decreases over time • Two factors contribute: • Inflation. It takes more dollars to buy something tomorrow that it does today • Opportunity cost. By doing x instead of y, you lost out on potential revenue. • How do we assign a value to these things?
Future Value: • Future value: Example • You take $100 and buy a CD paying 4% annual interest rate: • ValueYear 1 = $100(1+4%) = $104.00 • ValueYear 2 = $104(1+4%) = $108.16 • Therefore, your $100 has a future value of $108.16 after 2 years.
Future Value, cont. • CFj = Cash flow value at some jth compounding period • j = The jth compounding period • F0 = The initial investment • i = The interest rate (Also called the discount rate) • Note that this is the value of some single investment at some future date • The factor (1+i)j is called the “Future Value interest factor” • Sometimes tabulated • Handy to use in spreadsheets when doing discounted cash flow analysis
Using Future Value to Derive Present Value • Sometimes it’s desirable to know what the present value of a future payment will be • Drives decision making: If you know what something is worth in today’s dollars, is this a good investment or not? • The value of money isn’t static: • Inflation degrades its value • Other opportunities that weren’t pursued should be thought of as costs
Using Future Value to Derive Present Value, cont. • Revisit the equation • Recast slightly: • Note that the “initial investment” is the same as the value of that investment today, or is also the “Present Value” –Becomes– Where PV = “Present Value”
Using Future Value to Derive Present Value, cont. • Solving for present value: • Same formula, we’re just thinking about it differently. • The factor 1/(1+i)j is called the “Present Value interest factor” (PVIF) • Sometimes tabulated • Handy to use in spreadsheets when doing discounted cash flow analysis
Present Value Example: • A friend of yours owes you $1,000. He can’t pay you back today, but promises that he will pay you back one year from now. • Suppose that inflation is 3%. What is the present value of the $1,000 payment (that happens 1 year from now)? (You lost $30 on that deal)
Present Value Example, cont.: • A friend of yours owes you $1,000. He can’t pay you back today, but promises that he will pay you back one year from now. • Suppose you could have invested some money at 7% interest. How much would you have had to set aside this year to get $1000 next year? (This time your friend cost you ~$65)
What About A Series Of Cash Flows? • Suppose you invest $4,000 a year in an IRA, and that you expect the IRA to earn 5.5% on average for the next 20 years. • How much will you have 20 years from now? • This is a sum of future years’ problem: Add the future value of each of the next 20 years together:
CF1 CF2 CF3 CF4 CF5 CFn Period 0 (Today) Period 1 Period 2 Period 3 Period 4 Period 5 Period n Visualizing Cash Flows • Sometimes it’s helpful to consider a picture: • Each of these cash flows is listed in their value at that particular time period. We then use discounting (more on this in a minute) to relate them all back to today.
Present Value of a Stream Of Cash Flows: • Note that CFn = PV(1+k)n • Cash flow (or future value) at some year (or compounding period) equals the initial investment adjusted by the interest rate and number of periods) k = interest rate n = number of periods
Present Value of a Stream Of Cash Flows, cont. • Considering inflation, the value of a dollar degrades over time • Example: What’s the value of $1 ten years from now in today’s dollars? (Assume inflation rate of 3%) • Ans: • Note that there’s no summation here, since there’s only 1 cash flow in this case (or think of it as a series of zero cash flows)
Present Value of a Stream Of Cash Flows, cont. • What if we have multiple cash flows? • Example: Ichiro Suzuki signs an endorsement deal with Mizuno paying him $2M/year for the next 4 years (payment starts 1 year from now). What’s the present value of this contract? (Assume inflation is 3%) • In other words, inflation knocks ~$565k off the value of his contract.
CF1 CF2 CF3 CF4 CF5 CFn *PVIF1 *PVIF2 *PVIF3 *PVIF4 *PVIF5 *PVIFn Period 0 (Today) Period 1 Period 2 Period 3 Period 4 Period 5 Period n PV, CF1 PV, CF2 PV, CF3 PV, CF4 PV, CF5 PV, CFn Period 0 (Today) Period 1 Period 2 Period 3 Period 4 Period 5 Period n Visualizing Cash Flows, again • To visualize what happens when we perform the discounting, multiply each CF by the PVIF of that period and see…
PV, cont. • A good way to format this on spreadsheets is the following: • What if Ichiro took this class and wanted $8M in today’s dollars? How would we figure out what his payments should be?
Back to Ichiro • Notice the power of inflation – to get $8M in today’s dollars, he needs to be paid $618k more over the course of 4 years • Why do the payments get bigger further out in time?
A Bond Example • You want to invest in something, yet you’re leery of the stock market. How about buying bonds? • A bond is a promissory note from an entity obligating the payee to pay out interest over the life of the bond, and refund the principal at some later date • Corporate bonds • Municipal bonds (tax-free!)
A Bond Example, cont. • Bonds are present value problems: You get the interest (Called coupon payments) + the amount of the bond (Called the face value) back when the bond expires • Bonds are issued in lots of $1000 (Face) with some pre-determined interest rate (Coupon) • Typically paid annually or semi-annually • Let’s buy a bond and figure out how much our investment is worth
Bond Example, cont. • Suppose you want to buy a bond for $1000 face value and a coupon rate of 10% The market interest rate is 12% (The market expects to earn a 12% return on this bond). • Bond makes payments annually • Say there are 10 years to maturity, or 10 compounding periods • What is this bond worth today?
Bond Example, cont. • First, how much is each interest payment? • Each payment = (10%)(1000)= $100 • Next step is to find the present value of each of the interest payments, then add those up: • Next, find the present value of $1000 at a rate of 12% in 10 years ($321.97) • The sum is the price of the bond: $287.48 + $565.02 = $887.
Bonds, cont. • When a bond is first issued, you can pay the face value and realize payments at the coupon rate • But, the market will value/devalue bonds just like stocks! This affects the math • Also, there’s the matter of getting in on a bond at the beginning of its term or somewhere in the middle • Let’s go buy a real bond
Bond Example, Cont. • Emerson Electric: • 5% coupon, semi-annual • $1000 face • ~10 payments remaining of (5%)($1000)/2 = $25. • What’s the price of this bond?
Bond Example, cont. • The market’s expected rate of return is called the “Yield To Maturity” (2.456% in this case) • So the interest rate to use is (2.456/2)%: • The actual price of this bond is $1120.31 – why the difference?
Lump Sum or Monthly Payments? • You being a hot commodity thanks to some class you took at UW has landed you a new job. Upon leaving your old company, you have the option to take your retirement plan savings as either: • Lump sum of $50,000 now • 18 monthly payments of $3,000 (for a total of $54k) • In either case, you can invest your money at 6%/year (0.5%/month) *Example adapted from J. Karpoff, UW
Take The Monthly Payments • With the monthly payments, at this interest rate you came our ahead by $1,518.30. • What would change this situation?
Present/Future Value Problem Summary: • PV/FV techniques are useful for a variety of different calculations – • Investment decisions • Retirement savings • Bond buying • …and much more • They’re also useful for evaluating projects. The only thing we do differently is change the discount rate and the cash flows