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Managing the Investment Process

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Title: 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.

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

5
Measures of Predictability
  • Different projects carry different hurdle rates
  • Adjusting for effect of inflation

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

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

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

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.

13
Decision Trees
14
(No Transcript)
15
Understanding Productivity Trends
16
  • Manufacturing sector labor productivity growth
    exceeds that of service sector.
  • Output of both sectors continues to grow.

17
  • Employment levels in manufacturing have been
    flat, while service sector employment growth
    matches output.

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.

19
  • Elements of an explicit implementation plan.
  • Objectives
  • Cross-functional teams
  • Identify prioritize needs
  • System design critical
  • Training retraining
  • Monitor, analyze, improve

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.

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.

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.

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.

25
Piecemeal Investment
  • Each year, a company or a division may undertake
    a series of small improvements in its production
    processto 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.

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.

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.

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 investmentsan 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.

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

31
Justification Guidelines
  • Determine how the new technology relates to the
    firms long-term strategic goals and objectives,
    and ensure that the technology and the firms
    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.

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.
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