Sell Your Project; continued |
GOOD ENOUGH ISN'T ALWAYS GOOD ENOUGH If the project makes money, we've won our case, right? Wrong. Making money is easy. Making enough money is the trick. How much is enough? There are several answers to that question, and you'll need to adapt to your specific situation. Many companies have a "minimum attractive rate of return" (MARR) or "hurdle rate" which all projects must meet or exceed. This is an interest rate or return on investment that they will require before a project is considered viable. Where does your company get the funds that it will invest in your project? If it borrows them from a bank, it will pay the bank interest. If your project doesn't make enough money to pay back the interest, and make more money besides, it will not fly. In this case, your hurdle rate will be at least equal to the cost of borrowing money. Alternately, your company may have cash reserves, being handled by some investment firm. If these cash reserves are currently bringing in a 12% annual return, your project had better return more than 12%, or they will not be enthusiastic about allocating cash to it. However, in rare instances, it is possible that strategic or intangible factors will outweigh this hurdle rate, such as expanding into new markets or seeking new long-term strategic capabilities. But don't count on that. Frequently, the actual hurdle rate is dynamically changing above these minimum values, based on the competing projects from other engineers with ideas almost as good as your own. Even if the cost of money is only 12%, and your project will return 20%, there is a finite amount of cash to go around. If other projects on the list of candidates all return 30%, odds are yours will not get the green light. So, we've got to do more than just show that our project is profitable. We need to show how profitable it is. To do this, we need a slight twist on our analysis. In the formulas and lookup tables discussed above, we had to use an interest rate. What rate did we use? Actually, we didn't say. A common technique is to use the prevailing interest rate that you expect to govern most financial transactions during the time period of your project. This could be a composite of the current inflation rate and the going rate on loans your company takes out. But there are other options. To show that we can beat a hurdle rate, we use the corporate hurdle rate as our interest rate in our formulas or tables. If our project present value comes out positive, it shows that we have beaten the hurdle rate. So far so good; we've shown that we can beat the benchmark, but we still haven't show precisely how good the project is. A slightly more involved approach is to find the break even interest rate. That is, the interest rate that would make our CBA show a present value of exactly zero, so that all incomes and expenses, adjusted for time, cancel out. The interest rate that makes this happen is the overall rate of return of the project. Unfortunately, this requires an iterative solution (or a computer approach), but it tells us much more and gives us better ammunition to defend our project. As a simple example, consider a project that costs us $1000 to start up, and pays us $500 per year for five years. Is this a good project? Assume we have a corporate hurdle rate of 10%. Using our AV to PV formula, we can convert our AV into a PV by calculating PV = $500[((1 + 0.10)5 - 1) / (0.10(1 + 0.10)5)] = $500(3.791) = $1895.50 Now, the total present value = positive flow - negative flow = $1895.50 - $1000 = $895.50 Since the total present value is positive ($895.50), we know that we have beaten the 10% hurdle rate. But to find the actual project rate of return, we must find the interest rate that makes this equation balance, or sum to zero. Clearly, the conversion factor must be equal to 2.00 for the Present Value of the payback to equal the initial costs of $1000. We can see, either from our tables or by trying a few values in the formula, that the conversion factor has dropped from 3.791 to 2.035 when interest rate climbs to 40%, so we can say that our project's rate of return is slightly better than 40%. HANDLING UNCERTAINTIES Unfortunately, most of the numbers that we use in our analyses are not precisely known. In some cases, we can get pretty good estimates, but not always. This is particularly true in projecting revenues. So what do we do? There are a variety of approaches to select from, depending on the purpose of your analysis. All of these approaches derive from our main goal of proving that our project is profitable and better than competing projects. One approach is to use a worst-case estimate. By worst case, I mean a value so poor that the people reviewing your analysis will concede that reality will probably be better. This takes a bit of psychology to implement. You might firmly believe that your new production line will bring in revenues of $2 million per year, but your comptroller has doubts. He might be willing to concede that it will bring in $1 million per year or better, so use his number; in that way, he won't disagree with your conclusions. Of course, if your analysis shows that you aren't profitable at only $1 million per year, you'll need to find some other way to convince him. Another approach is the break-even analysis. Run your analysis for various values of the unknown number until it just barely looks good enough. Then you can argue that, as long as the true value is better than the assumed value, your project will be a good one. If the break even value is low enough. this might be an easy case to make. For example, you might have no idea what your revenues will be, but you know that projects with a rate of return over 25% often get funded. Find the revenue stream that gives you exactly 25% return. Let's say it turns out to be $1.5 million per year. Now your pitch is, all we need is revenues of $1.5 million per year to make at least 25%. If your audience finds it easy to believe in the $1.5 million, they will accept your pitch. The what-if analysis is another way you might choose to go. For the unknown value, make four or five guesses, and run your analysis each way. Put the results into a table, showing what your rate of return (or present value, or whatever you choose) would be for each possible value of revenue, labor costs, or whatever the unknown number was. In this way, the reviewers of the analysis can make their own decisions about what is likely to happen. Hopefully, if your project is a good one, they will receive a favorable impression of the probable outcomes. What about inflation? This is certainly an unknown, especially over a long term project, say 20 years or more. Fortunately, in many cases, we can simply ignore it. Costs will go up over time in the face of inflation, but so will revenues. In many situations, they will approximately cancel out. This is especially true when our costs are heavily weighted toward the early years of the project and the incomes are weighted toward the later years; in those scenarios, ignoring inflation gives us a conservative estimate of profitability. Annual cost streams, such as mortgage payments, remain constant in terms of dollar values, but decrease over time with respect to value, so again we are in a conservative estimate situation. The only time ignoring inflation will get you into trouble is when you make your revenues up front and have payments spread out into the future. Fortunately, those situations are rare in the engineering world, and mostly plague financiers. Handling this situation is not difficult, but is beyond the scope of our discussion here. The bottom line on handling uncertainty is to remember that your goal is to argue convincingly that your project is a winner; if you use conservative estimates that nobody could disagree with and your analysis still shows a profit, you've made your point. THE SOFTER STUFF Those numeric quantities discussed above weren't too hard to come by; at the very least we can get some arguable estimates. However, other issues can be much fuzzier. First and foremost, is there business out there for you to go after in the first place? You'll need to assemble an argument showing that the revenues you describe will actually come through; that you're offering something the current suppliers are not offering (better price, quality, delivery schedule, convenience, etc.). If there are no current suppliers, how do you know there are any customers? This work has probably already been done for you by Marketing; see what they know. Consider symbiotic effects of this venture, both good and bad. Will you be cannibalizing your own business in other areas? If your division makes a killing, but another division in your company is the one that gets killed, your board of directors will not be impressed. On the other hand, symbiotic effects can be good; two products that go together, from the same supplier, can boost market share for both products (just ask Microsoft). Sometimes you need to invest in a project just to stay in business at all. For instance, setting up a recall center or a warranty support office does not make you any money on its own, but it lets you remain competitive in your main line of work. In that case, you don't need to show a profit, just that you are getting the job done for the least cost possible. You are competing not with other revenue-generating ideas, but with other solutions to the same problem. Finally, always consider the reputation and image of your organization. If your short-term profits soar but your good name suffers, you might be in trouble in the long run through loss of other business. Will you be teaming with someone your customers cannot abide? Are you selling to your best customer's prime competition? These do not necessarily make a project untenable, but they do indicate that you should give it some serious thought. EXAMPLE Let's pull this all together with an example. Suppose you want to install a new heat treatment line for your transmission gears. You will incur startup costs (equipment, installation, wiring, training, change notices, etc.) of $2 million. You currently spend $1,600,000 on production of these gears each year, and expect the new line to shave off $450,000 each year. You will also be able to sell some of your old equipment for $1 million, but not until two years after the new line is installed because you will still need it for some rework of gears from the old process. Your Capital Review Board will not even consider a proposal with less than a 20% payback in the first five years. Does your proposed change meet the hurdle rate during the first five years? First, we must convert everything to a Present Value, using our formulas or the appropriate tables, and assuming the 20% hurdle rate and a five year horizon: Startup Costs = - $2,000,000 (already a PV) PV of Savings = $450,000[((1 + 0.20)5 - 1) / (0.20(1 + 0.20)5)] = $1,345,950 PV of Equipment Sale = $1,000,000(1+ 0.20)-2 = $694,400 Total PV of project = - ($2,000,000) + $1,345,950 + $694,400 = $40,350 Since the present value is positive, the project meets, and exceeds, the hurdle rate of 20% payback during the first five years. Since we have only profits after the five year mark, we don't have to worry about the further out years. FOR FURTHER READING This has just been an overview of the Cost Benefit Analysis topic, of course. We haven't discussed future value analysis, gradient cash flows, sunk costs, continuous compounding, etc. Further details can be found in any good reference book, such as those listed below. Also, a number of software packages are available to automate the calculations, as described in the sidebar. 1. Engineering Economic Analysis, Donald G. Newnan, Engineering Press, Inc., San Jose, 1988 2. Cost-Benefit Analysis, 2nd Ed., R. Layard and S. Glaister, Cambridge University Press, 1994 3. A Guide to Benefit-Cost Analysis, Edward M. Gramlich, Prentice Hall, 1990 4. Cost Benefit Analysis: Concepts and Practice, Anthony E. Boardman, Prentice Hall, 1996 5. Applied Cost-Benefit Analysis, Robert J. Brent, Edward Elgar Publishing, 1997 |
