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University of Southern California INNOVATION Supplement B: Investment Selection & Investment Merit Score ©2000, Michael A. Mische MOR 559 – Strategic Renewal University of Southern California Investment Decision-Making DESCRIPTION KEY DECISION CRITERIA 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 investment merit of a project is determined based on a number of factors, including but not limited to: 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. ©2000, Michael A. Mische • 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 MOR 559 – Strategic Renewal University of Southern California Decision-Making Prerequisites & Information Requirements 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 multiplelevel 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 ©2000, Michael A. Mische 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 MOR 559 – Strategic Renewal University of Southern California Investment Scoring Process… Using the IMS INVESTMENT SCORING BENEFITS OF IMS Investment decisions and changes to the project portfolio and priorities are based on a relative score that an investment earns through its assessment process. • 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 redirect investments to their highest and best uses. • The IMS establishes the baseline for the project that can be reviewed and audited against. 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 ©2000, Michael A. Mische MOR 559 – Strategic Renewal University of Southern California IMS… Calculating the Investment Score Project’s ROI, 0.5 NPV or EVA Project’s Strategic Risk X 0.3 Scale DEFINITION Represents the financial contribution of the project to revenues, earnings and shareholder value DESCRIPTION Highest weighting factor Based on the financial analysis performed on the project See special section for using EVA SOURCE Calculated by the project sponsor and confirmed by finance ©2000, Michael A. Mische X 0.2 Represents the business and strategic assessment of of project and its relative risk Second highest weighting factor Based on the riskreturn relationship Based on 10 differentiating weighting factors Calculated by ELT/SMG based on a comprehensive assessment Project’s Portfolio Effect Score Estimates the impact of the project on the overall capital budget and sources of funds Third weighting factors Based on the funding sources and requirements of the project Calculated by ELT/SMG based on a review of portfolio and capital plans = Investment Merit Score Represents the project’s merit score Considers the overall numeric value of the project Calculated/confirmed by the IPC and sponsor MOR 559 – Strategic Renewal University of Southern California IMS… A 4-Step Calculation STEP 1: Calculate the project’s NPV, ROI or EVA STEP 2: Calculate the project’s strategic risk score STEP 3: Calculate the project’s portfolio effect STEP 4: Calculate the project’s IMS = Weigh and Total Steps 1-3 RESULT: Once calculated, rank the project’s IMS score against other projects. ©2000, Michael A. Mische MOR 559 – Strategic Renewal University of Southern California STEP 1: Calculate the Project’s Financial Contribution Project’s ROI, 0.5 NPV or EVA ©2000, Michael A. Mische Project’s X 0.3 Strategic Risk Scale X 0.2 Project’s Portfolio Effect Score = Investment Merit Score MOR 559 – Strategic Renewal University of Southern California Step 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? ©2000, Michael A. Mische MOR 559 – Strategic Renewal University of Southern California Step 1… Calculating the Project’s Financial Score PROCESS STEPS GUIDELINES STEP DESCRIPTION 1. 1. Calculate the project’s ROI, NPV or EVA For EVA, use the dollars or value created over a given period 2. Use NPV or ROI in favor of IRR 2. Confirm calculation with other responsible units/parties 3. Calculate weighted score ©2000, Michael A. Mische Project A 0.5 * 38% = 0.19 Project B 0.5 * 32% = 0.16 Project C 0.5 * 26% = 0.13 MOR 559 – Strategic Renewal University of Southern California 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 SOME PLUSES & MINUSES Traditional measurements are adequate for most projects and investments: • IT investments • Infrastructure investments • Some acquisitions • Products • IPRs • Some R&D In 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. ©2000, Michael A. Mische MOR 559 – Strategic Renewal University of Southern California Step 1: Calculating the Project’s ROI, NPV or EVA, cont’d. Empirical studies (Credit Suisse) indicate that EVA shows the greatest correlation to changes in market value added (MVA). BENEFITS OF EVA • EVA = (ROC - COC) (CI) Where: ROC is the “true” cash flow return on capital earned on the investment, or: CI is the amount of capital invested in the project. ©2000, Michael A. Mische • Based upon objective data that is not easily manipulated • 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. MVE… market value of equity Tot. Cap… sum of total equity and total debt Simple and easy to understand EVA is the closest in both theory and construct to the NPV of a project in capital budgeting, as opposed to the IRR. COE… cost of equity TVD… total value of debt • • Used to finance the project, or: COD… cost of debt Directly linked to shareholder value EVA is a measure of dollar surplus value, not the percentage difference in returns. COC is the weighted cost of capital COC = COE (MVE/Tot. Cap.) + COD (TVD/Tot. Cap.) • • ROC = (NOPAT)/(BV of Equity + BV of Debt) NOPAT is not operating profit after taxes EVA has some desirable attributes: MOR 559 – Strategic Renewal University of Southern California STEP 2: Calculate the Project’s Strategic Risk Score Project’s ROI, 0.5 NPV or EVA ©2000, Michael A. Mische Project’s X 0.3 Strategic Risk Scale X 0.2 Project’s Portfolio Effect Score = Investment Merit Score MOR 559 – Strategic Renewal University of Southern California Step 2… Key Questions: Strategic Risk REGULATORY/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? ©2000, Michael A. Mische MOR 559 – Strategic Renewal University of Southern California Step 2… Calculating the Project’s Strategic Score PROCESS GUIDELINES STEP DESCRIPTION 1. Determine the project’s risk level (market, R&D, regulatory, economic, other) on a scale of 0-10 Assign a corresponding weighting to each risk category (on a scale 0.-2.0) Determine the reward level (strategic offensive/defensive, key technology, market access, other) on a scale of 0-10 Assign a corresponding weighting to each reward category (on a scale 0.-2.0) 2. 3. 4. ©2000, Michael A. Mische Project A 0.3 * 0.8 = 0.24 Project B 0.3 * 1.5 = 0.45 Project C 0.5 * 1.2 = 0.36 1. Use a developed Project Investment template 2. Use the the calculated risk/reward ratio as an input for Strategic Score MOR 559 – Strategic Renewal University of Southern California STEP 3: Calculate the Project’s Effect on the Portfolio Project’s ROI, 0.5 NPV or EVA ©2000, Michael A. Mische Project’s X 0.3 Strategic Risk Scale X 0.2 Project’s Portfolio Effect Score = Investment Merit Score MOR 559 – Strategic Renewal University of Southern California Step 3: Calculating the Project’s Effect on the Portfolio KEY QUESTIONS Do the existing budget or any available funds support this project? If funds do not exist, where will they come from: Self-funding Shifting priorities Changing budgets of existing projects To what extent will this project improve overall portfolio performance? How will this project impact the overall aging of the portfolio? ©2000, Michael A. Mische MOR 559 – Strategic Renewal