innovation

MOR 559 – Strategic RenewalMOR 559 – Strategic Renewal

University of Southern CaliforniaUniversity of Southern California

©2000, Michael A. Mische©2000, Michael A. Mische

INNOVATIONINNOVATION

Supplement B:Supplement B:

Investment Selection & Investment Merit Investment Selection & Investment Merit ScoreScore




Investment Decision-MakingInvestment Decision-Making

DESCRIPTION

The decision-making process involves an evaluation of each major investment opportunity or concept for new products, acquisitions, technologies and business processes using multiple criteria.

The criteria used in the process represent a combination of quantitative and qualitative data:

• Quantitative data includes ROI, NPV and EVA calculations, estimates as to revenues, selling prices, earnings, cash flows, costs, gross margins and EBIT.

• Qualitative data includes assessments such as strategic fit, competitor reactions and positioning, product longevity, business, technical and regulatory risk.

The weightings assigned to each criteria are adjustable based on the type of project, its investment requirements and priorities.

The overall investment making and project review processes are supported by a number of activities, including the product development process.

DESCRIPTION

The decision-making process involves an evaluation of each major investment opportunity or concept for new products, acquisitions, technologies and business processes using multiple criteria.

The criteria used in the process represent a combination of quantitative and qualitative data:

• Quantitative data includes ROI, NPV and EVA calculations, estimates as to revenues, selling prices, earnings, cash flows, costs, gross margins and EBIT.

• Qualitative data includes assessments such as strategic fit, competitor reactions and positioning, product longevity, business, technical and regulatory risk.

The weightings assigned to each criteria are adjustable based on the type of project, its investment requirements and priorities.

The overall investment making and project review processes are supported by a number of activities, including the product development process.

KEY DECISION CRITERIA

The investment merit of a project is determined based on a number of factors, including but not limited to:

• Financial return generated

• Market value created

• Business, technological and regulatory risks

• Technology involved or required

• Markets created or market share gained

• Strategic value

• Operational need

• Infrastructure need

• Patent value

KEY DECISION CRITERIA

The investment merit of a project is determined based on a number of factors, including but not limited to:

• Financial return generated

• Market value created

• Business, technological and regulatory risks

• Technology involved or required

• Markets created or market share gained

• Strategic value

• Operational need

• Infrastructure need

• Patent value




Decision-Making Prerequisites & Information Decision-Making Prerequisites & Information RequirementsRequirements

INVESTMENT DECISION-MAKING

The process uses an objective method for evaluating an investment and its impact on the overall capital portfolio of the company.

Projects are considered for investment merit only after :

• They have been subjected to multiple-level review processes, screens and filters

• Financial returns have been calculated

• Business plans have been completed and reviewed

• Executive sponsor has been assigned to the project

• Rigorous reviews by appropriate operational, financial, regulatory and business specialists have been performed

INVESTMENT DECISION-MAKING

The process uses an objective method for evaluating an investment and its impact on the overall capital portfolio of the company.

Projects are considered for investment merit only after :

• They have been subjected to multiple-level review processes, screens and filters

• Financial returns have been calculated

• Business plans have been completed and reviewed

• Executive sponsor has been assigned to the project

• Rigorous reviews by appropriate operational, financial, regulatory and business specialists have been performed

SOURCES OF INFORMATION• Financial data and ROI, NPV

or EVA are calculated by the project sponsor and confirmed by the SMG and the finance group

• Strategic data, risk assessments and technology reviews are developed by the project sponsors

• A business case is completed and linked to the product development process, as appropriate

• A discussion of the investment merits and implications of the project

• An assessment of the project’s impact on the P&L

• A comparison of financial performance benchmarks

SOURCES OF INFORMATION• Financial data and ROI, NPV

or EVA are calculated by the project sponsor and confirmed by the SMG and the finance group

• Strategic data, risk assessments and technology reviews are developed by the project sponsors

• A business case is completed and linked to the product development process, as appropriate

• A discussion of the investment merits and implications of the project

• An assessment of the project’s impact on the P&L

• A comparison of financial performance benchmarks




Investment Scoring Process… Using the IMSInvestment Scoring Process… Using the IMS

INVESTMENT SCORING

Investment decisions and changes to the project portfolio and priorities are based on a relative score that an investment earns through its assessment process.

In general, investments (projects) that generate a higher (or the highest) investment merit score (IMS) will receive the greatest level of attention and consideration. However, there will be situations when investments will be made, while obtaining lower IMS ratings:

• Physical infrastructure needs

• Certain IT investments

• Certain investments mandated by regulatory, legal and other relevant guidelines

INVESTMENT SCORING

Investment decisions and changes to the project portfolio and priorities are based on a relative score that an investment earns through its assessment process.

In general, investments (projects) that generate a higher (or the highest) investment merit score (IMS) will receive the greatest level of attention and consideration. However, there will be situations when investments will be made, while obtaining lower IMS ratings:

• Physical infrastructure needs

• Certain IT investments

• Certain investments mandated by regulatory, legal and other relevant guidelines

BENEFITS OF IMS

• The IMS is a method that helps to reduce subjectivity and bias from the investment decision-making process.

• Formal application and continuous use of the IMS allows for evaluation and comparison investments more objectively.

• Evaluating investments against one another provides the company with the ability to optimize its investments and re-direct investments to their highest and best uses.

• The IMS establishes the baseline for the project that can be reviewed and audited against.

BENEFITS OF IMS

• The IMS is a method that helps to reduce subjectivity and bias from the investment decision-making process.

• Formal application and continuous use of the IMS allows for evaluation and comparison investments more objectively.

• Evaluating investments against one another provides the company with the ability to optimize its investments and re-direct investments to their highest and best uses.

• The IMS establishes the baseline for the project that can be reviewed and audited against.




IMS… Calculating the Investment ScoreIMS… Calculating the Investment Score

DEFIN

ITIO

ND

EFIN

ITIO

N

Represents the financial contribution of the project to revenues, earnings and shareholder value

Represents the business and strategic assessment of of project and its relative risk

Estimates the impact of the project on the overall capital budget and sources of funds

Represents the project’s merit score

DES

CR

IPTIO

ND

ES

CR

IPTIO

N

Highest weighting factorBased on the financial analysis performed on the projectSee special section for using EVA

Second highest weighting factorBased on the risk-return relationshipBased on 10 differentiating weighting factors

Third weighting factorsBased on the funding sources and requirements of the project

Considers the overall numeric value of the project

SO

UR

CE

SO

UR

CE

Calculated by the project sponsor and confirmed by finance

Calculated by ELT/SMG based on a comprehensive assessment

Calculated by ELT/SMG based on a review of portfolio and capital plans

Calculated/confirmed by the IPC and sponsor

Project’s ROI, Project’s ROI, NPV or EVANPV or EVA


Project’s Project’s Strategic Risk Strategic Risk

Scale Scale


Scale Scale

Project’s Project’s Portfolio Portfolio

Effect ScoreEffect Score



Investment Merit Score

Investment Merit Score0.5 0.3 0.2X X =




IMS… A 4-Step CalculationIMS… A 4-Step Calculation

STEP 1:STEP 1: Calculate the project’s NPV, ROI or EVACalculate the project’s NPV, ROI or EVA

STEP 2:STEP 2: Calculate the project’s strategic risk scoreCalculate the project’s strategic risk score

STEP 3:STEP 3: Calculate the project’s portfolio effectCalculate the project’s portfolio effect

STEP 4:STEP 4: Calculate the project’s IMS = Weigh and Total Calculate the project’s IMS = Weigh and Total Steps 1-3Steps 1-3

RESULT:RESULT:

Once calculated, rank the project’s IMS score Once calculated, rank the project’s IMS score against other projects.against other projects.

RESULT:RESULT:

Once calculated, rank the project’s IMS score Once calculated, rank the project’s IMS score against other projects.against other projects.




STEP 1: Calculate the Project’s Financial ContributionSTEP 1: Calculate the Project’s Financial Contribution




Scale Scale


Scale Scale





Investment Investment Merit ScoreMerit ScoreInvestment Investment Merit ScoreMerit Score0.5 0.3 0.2X X =




Step 1… Key Questions: FinancialStep 1… Key Questions: Financial

What is the estimated impact of the product or process on generating sales and revenues?

What is the estimated impact of the product or process on costs?

What is the estimated impact of the product or process on profits?

To what extent are the product’s prices likely to decline?

What is the likelihood of significant price degradation over the forthcoming 5-year period?

What is the anticipated growth rate sales in terms of units and dollars?

To what extent does the product/process increase EPS?




Step 1… Calculating the Project’s Financial ScoreStep 1… Calculating the Project’s Financial Score

GUIDELINES

1. For EVA, use the dollars or value created over a given period

2. Use NPV or ROI in favor of IRR

GUIDELINES

1. For EVA, use the dollars or value created over a given period

2. Use NPV or ROI in favor of IRR

PROCESS STEPS

STEP DESCRIPTION

1. Calculate the project’s ROI, NPV or EVA

2. Confirm calculation with other responsible units/parties

3. Calculate weighted score

PROCESS STEPS

STEP DESCRIPTION

1. Calculate the project’s ROI, NPV or EVA

2. Confirm calculation with other responsible units/parties

3. Calculate weighted score

Project A 0.5 * 38% = 0.19

Project B 0.5 * 32% = 0.16

Project C 0.5 * 26% = 0.13




Step 1: Calculating the Project’s ROI, NPV or EVA Step 1: Calculating the Project’s ROI, NPV or EVA

VALUATION APPROACHES & CONSIDERATIONS

Often, companies use both ROI and NPV as indicators of financial contributions and financial viability. However, these are traditional, internally focused measurements that do not consider the impact of the investment on shareholder value.

• Subject to accounting method manipulation

• ROE is sensitive to leverage

• IRR assumes that rates are continuous

• High ROI does not correlate with increases in market value in dollar terms

• High ROI does not necessarily correlate with higher EPS or PE ratios

VALUATION APPROACHES & CONSIDERATIONS

Often, companies use both ROI and NPV as indicators of financial contributions and financial viability. However, these are traditional, internally focused measurements that do not consider the impact of the investment on shareholder value.

• Subject to accounting method manipulation

• ROE is sensitive to leverage

• IRR assumes that rates are continuous

• High ROI does not correlate with increases in market value in dollar terms

• High ROI does not necessarily correlate with higher EPS or PE ratios

SOME PLUSES & MINUSESTraditional measurements are adequate for most projects and investments:

• IT investments• Infrastructure investments• Some acquisitions

• Products• IPRs

• Some R&DIn other situations, more sophisticated valuation practices must be applied:

• Major product initiative• Major line extension• New processes• Acquisition of technologies• Company acquisitions

SOME PLUSES & MINUSESTraditional measurements are adequate for most projects and investments:

• IT investments• Infrastructure investments• Some acquisitions

• Products• IPRs

• Some R&DIn other situations, more sophisticated valuation practices must be applied:

• Major product initiative• Major line extension• New processes• Acquisition of technologies• Company acquisitions

THE ISSUE

The key indicator for investments is not only the percentage return, but mainly the dollars generated and market value created.

THE ISSUE

The key indicator for investments is not only the percentage return, but mainly the dollars generated and market value created.




Step 1: Calculating the Project’s ROI, NPV or EVA, Step 1: Calculating the Project’s ROI, NPV or EVA, cont’d.cont’d.

BENEFITS OF EVA

• EVA has some desirable attributes:

• Directly linked to shareholder value

• Simple and easy to understand

• Based upon objective data that is not easily manipulated

• EVA is a measure of dollar surplus value, not the percentage difference in returns.

• EVA is the closest in both theory and construct to the NPV of a project in capital budgeting, as opposed to the IRR.

• The value of a firm, in DCF terms, can be written in terms of the EVA of projects in place and the present value of the EVA of future projects.

• EVA is the best single-period measure of realized value creation; EVA ties directly to the governing objective of shareholder value creation.

BENEFITS OF EVA

• EVA has some desirable attributes:

• Directly linked to shareholder value

• Simple and easy to understand

• Based upon objective data that is not easily manipulated

• EVA is a measure of dollar surplus value, not the percentage difference in returns.

• EVA is the closest in both theory and construct to the NPV of a project in capital budgeting, as opposed to the IRR.

• The value of a firm, in DCF terms, can be written in terms of the EVA of projects in place and the present value of the EVA of future projects.

• EVA is the best single-period measure of realized value creation; EVA ties directly to the governing objective of shareholder value creation.

Empirical studies (Credit Suisse) indicate that EVA shows the greatest correlation to changes in market value added (MVA).

Where:

ROC is the “true” cash flow return on capital earned on the investment, or:

ROC = (NOPAT)/(BV of Equity + BV of Debt)

NOPAT is not operating profit after taxes

COC is the weighted cost of capital

Used to finance the project, or:

COC = COE (MVE/Tot. Cap.) + COD (TVD/Tot. Cap.)

COE… cost of equity

MVE… market value of equity

COD… cost of debt

TVD… total value of debt

Tot. Cap… sum of total equity and total debt

CI is the amount of capital invested in the project.

EVA = (ROC - COC) (CI)EVA = (ROC - COC) (CI)EVA = (ROC - COC) (CI)EVA = (ROC - COC) (CI)




STEP 2: Calculate the Project’s Strategic Risk ScoreSTEP 2: Calculate the Project’s Strategic Risk Score




Scale Scale


Scale Scale









Step 2… Key Questions: Strategic RiskStep 2… Key Questions: Strategic RiskREGULATORY/LEGAL/OTHER:

To what extent does the product require significant regulatory, legal or other compliance, review and testing?What are the estimated levels of such efforts?

TECHNOLOGY:To what extent does this technology displace existing technology?To what extent does the company currently possess the technology necessary to manufacture this product?To what extent does the proposed concept or product provide an existing platform?To what extent does the company possess the adequate skills and competencies to manufacture and service the product/process?What is the overall level of risk of the technology as related to emerging technologies and their potential for obsolescence?To what extent is the current environment favorable to the concept, design and operation of the product?

MARKET:At what rate are the markets growing?To what extent are the markets driven by, or sensitive to, changes in the reimbursement processes?To what extent does this product demonstrate or provide cost savings relative to the best product/price in the market?To what degree can the product be sold into or across multiple areas and market segments?To what extent does this product/process change the dynamics of the marketplace?What is the potential that the product/process infringes upon the patent or intellectual property rights of another company?




Step 2… Calculating the Project’s Strategic ScoreStep 2… Calculating the Project’s Strategic Score

GUIDELINES

1. Use a developed Project Investment template

2. Use the the calculated risk/reward ratio as an input for Strategic Score

GUIDELINES

1. Use a developed Project Investment template

2. Use the the calculated risk/reward ratio as an input for Strategic Score

PROCESS

STEP DESCRIPTION

1. Determine the project’s risk level (market, R&D, regulatory, economic, other) on a scale of 0-10

2. Assign a corresponding weighting to each risk category (on a scale 0.-2.0)

3. Determine the reward level (strategic offensive/defensive, key technology, market access, other) on a scale of 0-10

4. Assign a corresponding weighting to each reward category (on a scale 0.-2.0)

PROCESS

STEP DESCRIPTION

1. Determine the project’s risk level (market, R&D, regulatory, economic, other) on a scale of 0-10

2. Assign a corresponding weighting to each risk category (on a scale 0.-2.0)

3. Determine the reward level (strategic offensive/defensive, key technology, market access, other) on a scale of 0-10

4. Assign a corresponding weighting to each reward category (on a scale 0.-2.0)

Project A 0.3 * 0.8 = 0.24

Project B 0.3 * 1.5 = 0.45

Project C 0.5 * 1.2 = 0.36




STEP 3: Calculate the Project’s Effect on the PortfolioSTEP 3: Calculate the Project’s Effect on the Portfolio




Scale Scale


Scale Scale









Step 3: Calculating the Project’s Effect on the PortfolioStep 3: Calculating the Project’s Effect on the Portfolio

KEY QUESTIONSKEY QUESTIONS

Do the existing budget or any available funds support this project?Do the existing budget or any available funds support this project?

If funds do not exist, where will they come from:If funds do not exist, where will they come from:

Self-fundingSelf-funding

Shifting prioritiesShifting priorities

Changing budgets of existing projectsChanging budgets of existing projects

To what extent will this project improve overall portfolio To what extent will this project improve overall portfolio performance?performance?

How will this project impact the overall aging of the portfolio?How will this project impact the overall aging of the portfolio?

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