Lecture 8 ATH Microtechnologies & Project Valuation and ROI - I

Steve Montgomery

Introduction To The Business Environment

What to do when someones 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)

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Accounting/Finance
Accounting: Two types Bookkeeping and managerial
Bookkeeping: Your companys 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 its yours Time = money
End goal: Understanding your business, how you reach customers, and your firms business condition allow you to pick smart projects and sell them to management 4/5/2012

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 firms business condition and the potential impact your of your work allow you to pick smart projects 4/5/2012 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

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ATH Microtechnologies
Founding Period: Scepters 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

Growth

What are some features of this payment system? Is there anything missing here?
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Profit

Control

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 ATHs performance by?

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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?

Growth

First earn out paid as FDA

approved product, but European tech proved superior in test, so no second phase earn out

Profit

Control

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ATH Microtechnologies, cont.

How did they do during the growth period? Did they achieve their strategic objectives?
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ATH Microtechnologies, cont.

Push to profitability:

20% bonus and trip

for two to Hawaii if were profitable!
Whats not to like?

Growth

Would you design an

incentive program this way?

Profit

Control

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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?

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ATH Microtechnologies, cont.

Refocus on Process

Issued vision
statement Restructured bonus program Launched education initiative

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ATH Microtechnologies, cont.

How did they do? Were the issues contained at this point? Final earn out paid at this point
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Growth

Profit

Control

ATH Microtechnologies, cont.

New Management: Declining sales Founders left the company New European tech eating at

Growth

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

Profit

Control

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ATH Microtechnologies, cont.

How well is ATH positioned for the future?

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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? Its 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!

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TimeIs 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?

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Time Is Money, cont.

Effect Of Compounding Interest Over Time
$20.00 $18.00 $16.00 $14.00
Value j Value j 1 1 i or

With Rate 1 With Rate 2 With Rate 3

10%

Value, [$]

$12.00 $10.00 $8.00 $6.00

Value j ,n Value0 1 i

5% $4.00 3% $2.00 $0 5 10 15 20 25 Compounding Period 30 35

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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.

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Future Value, cont.

CFj F0 1 i

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

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Using Future Value to Derive Present Value

Sometimes its desirable to know what the present value of a future payment will be Drives decision making: If you know what something is worth in todays dollars, is this a good investment or not? The value of money isnt static:

Inflation degrades its value Other opportunities that werent pursued should be
thought of as costs

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Using Future Value to Derive Present Value, cont.

Revisit the equation Recast slightly:

CFj F0 1 i
Becomes

Note that the initial investment is the same as the value of that investment today, or is also the Present Value

CFj PV 1 i

Where PV = Present Value

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Using Future Value to Derive Present Value, cont.

Solving for present value:

PV

1 i

CFj

Same formula, were 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

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Present Value Example:

A friend of yours owes you $1,000. He cant 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)?

PV
PV

1 i

CFj

$1000 $970 .87 1 1 0.03

(You lost $30 on that deal)

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Present Value Example, cont.:

A friend of yours owes you $1,000. He cant 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?

PV

1 i

CFj

$1000 PV $934 .58 1 1 0.07

(This time your friend cost you ~$65)

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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:
CF20 $40001 0.055 $40001 0.055
20 19

$40001 0.055
18
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Stream Of Cash Flows, cont.

Calculations for Application #1: Personal savings Number of years of annual savings = Expected annual rate of return = Years from now 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 Amount invested 4000 4000 4000 4000 4000 4000 4000 4000 4000 4000 4000 4000 4000 4000 4000 4000 4000 4000 4000 4000 20 5.50%

FVIF Future value 2.9178 11671.03 2.7656 11062.59 2.6215 10485.87 2.4848 9939.21 2.3553 9421.05 2.2325 8929.91 2.1161 8464.37 2.0058 8023.10 1.9012 7604.83 1.8021 7208.37 1.7081 6832.58 1.6191 6476.38 1.5347 6138.75 1.4547 5818.72 1.3788 5515.37 1.3070 5227.84 1.2388 4955.30 1.1742 4696.97 1.1130 4452.10 1.0550 4220.00 147144.30

Sum of all invested amounts =

Source: J. Karpoff, UW.

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Visualizing Cash Flows

Sometimes its helpful to consider a picture:
CF1 CF2 CF3 CF4 CF5 CFn

Period 0 (Today)

Period 1

Period 2

Period 3

Period 4

Period 5

Period n

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.
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Present Value of a Stream Of Cash Flows:

Note that CFn = PV(1+k)n
k = interest rate n = number of periods

Cash flow (or future value) at some year (or

compounding period) equals the initial investment adjusted by the interest rate and number of periods)

CF0 PV 1 i CF1 PV 1 i

CF2 PV 1 i

2 n 0 2 n

CFn PV 1 i
n

CF0 CF1 CF2 ... CFn PV 1 i PV 1 i PV 1 i ... PV 1 i CFn PV 1 k Divide both sides by 1 i
n n 0 n 0 n n

CFn (Total) PV n 1 n 0 i

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Present Value of a Stream Of Cash Flows, cont.

Considering inflation, the value of a dollar degrades over time Example: Whats the value of $1 ten years from now in todays

dollars? (Assume inflation rate of 3%) Ans:

n

CFn CF10 $1 PV $0.74 n 10 10 1 k 1 0.03 1 n 0 k

Note that theres no summation here, since theres only 1 cash flow in this case (or think of it as a series of zero cash flows)
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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). Whats the present value of this contract? (Assume inflation is 3%)

CFn CF0 CF3 CF1 CF2 CF4 PV n 0 1 2 3 4 1 k 1 k 1 k 1 k 1 k 1 n 0 k 0 $2,000,000 $2,000,000 $2,000,000 $2,000,000 $7.434M 0 1 2 3 4 1 3% 1 3% 1 3% 1 3% 1 3%

In other words, inflation knocks ~$565k off the value of his contract.
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Visualizing Cash Flows, again

CF1 *PVIF1 CF2 *PVIF2 CF3 *PVIF3 CF4 *PVIF4 CF5 *PVIF5 CFn *PVIFn

Period 0 (Today)

Period 1

Period 2

Period 3

Period 4

Period 5

Period n

To visualize what happens when we perform the discounting, multiply each CF by the PVIF of that period and see
PV, CF1 PV, CF2 PV, CF3 PV, CF4 PV, CF5

PV, CFn

Period 0 (Today)
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Period 1

Period 2

Period 3

Period 4

Period 5

Period n

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PV, cont.
A good way to format this on spreadsheets is the following:
Ichiro and Spresheet-friendly formatting: Interest rate: 3% Year Payout PVIF PV, each pay: $ 0 1 2 3 4 0 $ 2,000,000 $ 2,000,000 $ 2,000,000 $ 2,000,000 * * * * * 1 0.970873786 0.942595909 0.915141659 0.888487048 $ 1,941,747.57 $ 1,885,191.82 $ 1,830,283.32 $ 1,776,974.10

Total value: (sum of PV's): $ 7,434,196.81

What if Ichiro took this class and wanted $8M in todays dollars? How would we figure out what his payments should be?
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Back to Ichiro
What if Ichiro wanted $8M in today's dollars? Interest rate 3% Year 0 1 2 3 4 TOTAL New payout $ $ $ $ $ 2,060,000 2,121,800 2,185,454 2,251,018 8,618,272 PVIF 1 0.970874 0.942596 0.915142 0.888487 PV $ $ 2,000,000.00 $ 2,000,000.00 $ 2,000,000.00 $ 2,000,000.00 $ 8,000,000.00 Total PV $ 618,272 Difference

Notice the power of inflation to get $8M in todays dollars, he needs to be paid $618k more over the course of 4 years Why do the payments get bigger further out in time?
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A Bond Example
You want to invest in something, yet youre 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!)

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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

Lets buy a bond and figure out how much our investment is worth

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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?

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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:
CFn CF0 CF3 CF1 CF2 CF4 1 k n 1 k 0 1 k 1 1 k 2 1 k 3 1 k 4 n 0 0 $100 $100 $100 $100 $565.02 0 1 2 3 4 1 12% 1 12% 1 12% 1 12% 1 12% PV
n

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.

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Bond Example, cont.

Bond Example Interest rate Compounding Period 0 1 2 3 4 5 6 7 8 9 10 12.00% Interest Payment $0.00 $100.00 $100.00 $100.00 $100.00 $100.00 $100.00 $100.00 $100.00 $100.00 $100.00 Principal 0 0 0 0 0 0 0 0 0 0 1000 PVIF 1 0.892857143 0.797193878 0.711780248 0.635518078 0.567426856 0.506631121 0.452349215 0.403883228 0.360610025 0.321973237 CF $0.00 $89.29 $79.72 $71.18 $63.55 $56.74 $50.66 $45.23 $40.39 $36.06 $354.17

5.650223028

$887.00 Total

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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, theres the matter of getting in on a bond at the beginning of its term or somewhere in the middle

Lets go buy a real bond

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Bond Example, Cont.

Emerson Electric: 5% coupon, semi-annual $1000 face ~10 payments remaining of (5%)($1000)/2 = $25. Whats the price of this bond?
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Bond Example, cont.

The markets 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)%:
Bond Example Interest rate Compounding Period 0 1 2 3 4 5 6 7 8 9 10 1.228% Interest Payment $0.00 $25.00 $25.00 $25.00 $25.00 $25.00 $25.00 $25.00 $25.00 $25.00 $25.00

Principal 0 0 0 0 0 0 0 0 0 0 $1,000

PVIF 1 0.987868969 0.9758851 0.964046608 0.952351728 0.94079872 0.929385862 0.918111453 0.906973815 0.895971287 0.885102232

CF $0.00 $24.70 $24.40 $24.10 $23.81 $23.52 $23.23 $22.95 $22.67 $22.40 $907.23 $1,119.01 Total

The actual price of this bond is $1120.31 why the difference?

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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

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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?
New Job Example Interest rate Compounding Period 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 0.500% Monthly Payment $0.00 $3,000.00 $3,000.00 $3,000.00 $3,000.00 $3,000.00 $3,000.00 $3,000.00 $3,000.00 $3,000.00 $3,000.00 $3,000.00 $3,000.00 $3,000.00 $3,000.00 $3,000.00 $3,000.00 $3,000.00 $3,000.00 PVIF 1 0.995024876 0.990074503 0.985148759 0.980247522 0.975370668 0.970518078 0.96568963 0.960885204 0.95610468 0.951347941 0.946614866 0.94190534 0.937219243 0.932556461 0.927916877 0.923300375 0.918706841 0.91413616 CF $0.00 $2,985.07 $2,970.22 $2,955.45 $2,940.74 $2,926.11 $2,911.55 $2,897.07 $2,882.66 $2,868.31 $2,854.04 $2,839.84 $2,825.72 $2,811.66 $2,797.67 $2,783.75 $2,769.90 $2,756.12 $2,742.41 $51,518.30 Total

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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

Theyre also useful for evaluating projects. The only thing we do differently is change the discount rate and the cash flows

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