Capital budgeting and innovation Flashcards
Capital budgeting techniques
- Payback method
2. NPV method
Payback method
Decision rule: Profitable investment if the payback time < cut-off point decided by the company
+ Easy to understand
+ Early years can be calculated with more certainty
+ Works for add-on investments
- Theoretically incorrect (time value of money and discounting)
- Don’t care about cash flows after cut-off point
- Not suited for long term projects or innovation investments
Innovation investments: Long term and more uncertain. How to be dealt with?
- Sensitivity analysis: change one parameter at a time, view of materiality
- Scenario analysis: change all parameters, best/worst case
Critique of traditional capital budgeting methods
- Innovation investments discriminated due to short-term financial demands
- The NPV method is an “innovation killer”, companies systematically discriminate innovation investments
- Innovation killer component: “cost” of business as usual
The DCF Trap
When comparing cash flows from innovation against the default scenario of doing nothing, assuming incorrectly that the present health of the company will persist indefinitely if the investment is not made. The comparison should be between discounted cash flows and the more likely scenario of a decline in performance in the absence of innovation investment.
Decline in market share? Loss in revenues? Effect on profit?
How to take innovation into account?
- Put numbers on the innovation killer component and include that in the investment decision
- Make a qualitative judgement and include an ‘innovation dimension’ in your executive summary
- Earmark money - different investment budgets
Extended executive summary
Part 1: Business case and financial data
- Financial data presented in a pedagogical way and a short description of the business case
Part 2: Strategic fit
- The investment is discussed in relation to 3-5 strategic areas. INNOVATION one of these areas. Also discussion of consequences if investment is NOT done
Part 3: Recommendation
- Recommendation which clearly states the bases for the decision to facilitate follow-up
The process of making an investment decision
- Important and measurable economic consequences
- The financial calculations using capital budgeting methods
- Can we quantify strategy and innovation in the calculations? - Is the investment economically profitable?
- > Investment decision-making
Other aspects
- Uncertainty
- Innovation
Investment management
Academic literature has historically given less focused on investment management
Benefits
- Follow-up: do we proceed according to plan?
- Learning: how can we improve our investments?
- Legitimacy: show shareholders that we conduct capital budgeting in a professional way
Case: Investment management in “Manufacturing”
What can “manufacturing” do?
- NPV vs financial accounting. Need to think through short term vs long term (incentives)
- Implement extended executive summary
- Some sort of follow-up, golden rule: random testing (can’t follow up everything)
- Separate budgets to safeguard innovation
