Managing the Investment Process

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Managing the Investment Process

• Henry C. Co
• Technology and Operations Management,
• California Polytechnic and State University

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Assessing Financial Attractiveness of Investments

• Security
• Recompense
• Predictability
• Option Value

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Security

• How safe is my money?
• How soon will I be able to get it back?
• Risk
• Payback period see page 259.

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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

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Measures of Predictability

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

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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

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New Technology Costs and Requirements
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• 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

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CIM Performance Benefits
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• 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

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Justification Approaches
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• 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.

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Decision Trees
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Understanding Productivity Trends
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• Manufacturing sector labor productivity growth
  exceeds that of service sector.
• Output of both sectors continues to grow.

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

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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.

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

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Getting the Numbers Right

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

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Cost of Capital

• DCF usually fails to work right when companies
  set arbitrarily high hurdle rates for evaluating
  new investment projects.

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• 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.

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• 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.

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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.

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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.

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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.

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• 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.

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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.

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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.

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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

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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.

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• 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.