Lecture 6: Capital Budgeting, Innovation & Sustainability

Question 1

What are the six basic elements of capital budgeting?

Answer 1

1. Economic life (given in this course)
2. Cost of capital (given in this course)
3. Main investment (→ define year 0)
4. Positive cash flows
5. Negative cash flows
6. Salvage value

Question 2

What is the payback method and why is it not optimal?

Answer 2

How long does it take before you get the invested capital back?

Accumulate cash flows and see when we sign switches (no discounting).

Decision rule: Profitable investment if the payback time is shorter than the cut-off point decided by the company.

• Cut-off point is arbitrary.
• Systematically discriminates innovation and sustainability oriented investments (innovation killer)

Question 3

What is the net present value method?

Answer 3

How much is an investment worth if all cash flows (out and in) are discounted back to the same date? (absolute metric)

Decision rule: Profitable investment if the NPV is positive.

Question 4

What are additional issues we should know how to handle from previous courses?

Answer 4

• Pre-tax vs. after-tax
• Working capital
• Gains/losses on sale of old equipment

Question 5

What are the two general ways of examining uncertainty?

Answer 5

1. Sensitivity analysis.
   Change one parameter at a time. A variable’s impact can depend on both the timing of the cash flows, and the size of the cash flows.
   → can identify key variables to focus forecasting efforts on (hence this analysis may be emphasized).
2. Scenario analysis.
   Change all parameters at once (best case, normal case, worst case scenarios).

Question 6

Are sensitivity/scenario analysis enough to account for different variables?

Answer 6

No.

• Innovation and sustainability oriented investments are discriminated due to short-term financial demands.
• The NPV method is an innovation/sustainability killer; companies systematically discriminate these investments.

Need to adjust the method

Question 7

What do we assume are the cash flows for the innovation killer component?

Answer 7

Profit = cash flows

Question 8

What is the idea of the innovation killer component?

Answer 8

To put a number on the actual cost of business as usual (of not investing in innovation and sustainability).

Question 9

What are the 4 alternatives for how to take innovation and sustainability into account?

Answer 9

1. Put numbers on the innovation killer component and include that in the investment decision.
2. Make a qualitative judgment and include “innovation and sustainability dimensions” in your executive summary.
3. Different investment budgets, e.g.: 50% new development projects, 25% improvement projects, 25% basic innovation.
4. Discovery-driven planning.

Question 10

What are the 3 parts of the extended executive summary?

Answer 10

1: Financial data presented in a pedagogical way and a short description of the business case.

2: Strategic fit where the investment is discussed in relation to 3-5 strategic areas. Also discussion of consequences if investment is NOT done.

3: Recommendation which clearly states the bases for the decision to facilitate follow-up

Question 11

What is the process of making an investment decision?

Answer 11

1. Important and measurable economic consequences
   - Financial calculations using capital budgeting methods
   - Can we quantify innovation and sustainability in the calculations (innovation killer component)?
   → Is the investment economically profitable
2. Other aspects of the investment
   - Uncertainty (visualize)
   - Innovation & Sustainability (Extend the executive summary, use portfolios with different budgets, and/or use discovery-driven planning).

→ INVESTMENT DECISION-MAKING

Question 12

What are three financial analysis tools that may go against successful innovation?

Answer 12

1. The use of DCF and NPV to evaluate investment opportunities. Underestimate real returns and benefits of proceeding with investments in innovation.
2. How fixed and sunk costs are considered when evaluating future investments. Unfair advantage on challengers and shackles incumbent firms that attempt to respond to an attack.
3. Emphasis on EPS as primary driver of share price and hence of shareholder value creation. Diverts resources away from investments whose payoffs lie beyond the immediate horizon.

Not bad tools, but their common application can create a systematic bias against innovation.

Question 13

What is the rationale of the innovation killer component?

Answer 13

Can’t assume the base case of not investing in the innovation (do nothing) remains. The present health of the company will likely not persist indefinitely into the future if the investment is not made. Competitors’ sustaining and disruptive investments over time result in price and margin pressure, technology changes, market share losses, sales volume decreases, and a declining stock price.

Question 14

What is stage-gate innovation?

Answer 14

Three stages to find the viable ideas.

1. Feasibility.
2. Development.
3. Launch.

Between each stage, there is a gate; review meetings at which accomplishments are reported. Passage to next stage, return to past stage, or kill the project.

Question 15

What is discovery-driven planning?

Answer 15

Reverses the sequence of steps in the stage-gate process.

1. Find the minimally acceptable revenue/income/CF statement to receive funding.
2. What set of assumptions must prove true for these numbers to materialise?
3. Based on assumptions list, rank issues to find deal killers and assumptions to test. (reverse income statement).

If critical assumptions proves not to be valid, the project team must revise its strategy until all assumptions are plausible.

Good: we don’t just single out the innovation killer component; everything is under assessment

Question 16

What is capital budgeting?

Answer 16

The process of making long-run planning decisions for investments in projects

Question 17

What are the stages of capital budgeting?

Answer 17

1. Identify projects. Potential capital investments that agree with the organization’s strategy.
2. Obtain information. From all parts of the value chain to evaluate alternative projects.
3. Make predictions. Forecast all potential cash flows attributable to the alternative projects.
4. Make decisions by choosing among alternatives. Determine which investment yields the greatest benefit and the least cost to the organization.
5. Implement the decision, evaluate performance, and learn.

Question 18

What are the three typical categories of cash flows in a capital investment project?

Answer 18

1. Net initial investment in the project (acquisition of assets and any associated additions to working capital, minus the after-tax cash flow from the disposal of existing assets).
2. After-tax cash flow from operations (including income tax cash savings from annual depreciation deductions).
3. After-tax cash flows from terminal disposal of an asset and recovery of working capital.

Question 19

Does Kalle recommend to deduct the innovation killer component from business-as-usual, or to add it to the investment option?

Answer 19

Add it! In reality we often have fewer innovation investments than everything going on in business-as-usual. Hence it is easier to single these out and adjustments on them instead of adjusting every incremental investment.

However, positive with deduct: can see if it becomes negative (if positive unadjusted NPV is needed to support this component)