Incorporating Risk Into Capital Budgeting Decisions

RIF 004

Speakers:

Kevin Moss, Michelin Dan McGarvey, Marsh

Learning Objectives At the end of this session, you will:

•  Understand the capital budgeting process and various methods for allocating capital to competing projects

•  Be able to articulate several options for incorporating the risk associated with each project into the evaluation process

•  Understand the value of risk evaluation and tough questions in selecting the best from among several competing options that all present a degree of risk

•  Be armed with suggestions for alternatives to reduce the risk associated with an individual capital budgeting proposal

CFO For a Day

CFO For a Day

Rule #1: You Can’t Make Everybody Happy

Free Cash Flow – A Precious Commodity

 Opera'ng  Revenues  -­‐  Opera'ng  Expenses    =  EBITDA  -­‐  Deprec./Amor'za'on  =  EBIT  -­‐  Taxes  -­‐  Interest  Expense  =  Net  Income  

 From  Net  Income  we  subtract  dividends  to  

be  paid  to  shareholders  along  with  any  mandatory  expenses  –  leaving  us  a  small  amount  to  invest  in  the  firm.  

Options for Free Cash Flow

•  Hold for Later Use •  Invest in Business •  Buy Back Stock •  Increase Dividend •  Declare Special Dividend

Investors  watch  the  capital  Budge5ng  process  with  interest,  in  that  any  funds  reinvested  in  the  business  –  at  least  in  theory  –  came  out  of  their  pockets.  

Capital Budgeting – It Is a Hard Science…

And Risk Management

is at the heart of it!

Capital Budgeting •  Free cash flow is a scarce resource – there will never be

enough to fund all proposals received

•  Traditional capital budgeting orders the proposals according to the greatest potential return (highest Net Present Value (NPV) or Internal Rate of Return (IRR))

•  Project cash requirements and estimated cash inflows are estimated for a foreseeable timeframe (5 – 10 years)

•  A discount rate is applied to reduce all cash inflows and outlays into present value dollars. Another option reduces these flows to an effective Internal Rate of Return (IRR)

•  All other things being equal, the highest NPV (or IRR) is the first to be funded, followed by the next, until investment funds are exhausted

The “Hurdle Rate” •  We know the risk tolerance and reward expectations for the

shareholders of any company

•  The golden rule of resource allocation: If the return presented is lower than the minimum expected by shareholders, GIVE THE MONEY TO THEM INSTEAD AS DIVIDENDS

•  The Hurdle Rate is this minimum threshold for capital investments needed to meet shareholder expectations

•  Of course, many capital expenditures do not yield profitable returns, but may be required by regulators or otherwise considered mandatory

•  In any case, the first evaluation factor for any investment is whether it is in line with stated corporate objectives and the established risk philosophy of the firm

The First Cut

Does this proposal make good sense for us?

•  Is it consistent with the company’s stated objectives?

•  Is it in line with the expectations of our stakeholders?

•  Do we have the skills and experience to make this work?

•  Is there any risk to our brand?

Sample Options: $5 Million Develop and launch a three-year marketing campaign to increase familiarity of our signature product with a younger audience:

•  New packaging •  Product placement in key

movies/TV shows •  One Super Bowl ad •  Social networking •  Internet ad campaign •  “Our product is hip!”

Sample Options: $5 Million Enter a new geography that our market researchers believe has the potential to create expanded demand for our product:

•  Partnership with local distributor

•  Advertising campaign •  Modified packaging •  Local celebrity endorsement •  Free product sample

campaign •  Lease production facility

Sample Options: $5 Million Partner with a startup chain of food court / airport sandwich stands specializing in Philadelphia cheese steaks:

•  Exclusive customer • Advertising tie-in • Broaden appeal for

product • Drive demand for product •  Potentially profitable

investment

Sample Options: $5 Million Develop new flavors of existing product to draw in new customers based upon market research surveys as to what would make customers consider our brand:

Initial Concepts: •  Smoked flavor •  Bacon flavor •  Hot chili flavor

CFO Challenge: “Make Good Choices”

How Would You Characterize the Risk Associated With These Four Options? •  Youth oriented advertising campaign? •  Expand to foreign market with partnership

investment? •  Investing in startup restaurant chain? •  Launch two new product flavors?

Net Present Value (NPV) •  Calculates the net worth

in dollars of investments and returns spread over a number of years

•  Requires a company to determine its “Discount Rate” – typically a minimum acceptable rate of return for the organization

Basis for Net Present Value •  A dollar in hand is worth more than the same

dollar promised in a future period •  There is an “Opportunity Cost” associated with a

dollar committed today to any project •  A project launched today must return a greater

rate than our capital cost to fund it

TIME REALLY IS MONEY! YOU MUST BELIEVE THIS!

NPV – Advertising Campaign

Year 2016 2017 2018 2019 2020

Cost (2,500) (1250) (1250) 0 0

Revenue 500 2700 2550 1100 900

Net (2,000) 1450 1300 1100 900

NPV1 (2000) 1343 1115 873 662

Net Present Value (Advertising) = $1,993,300

1 Discount rate 8%

Risk Adjusted Discount Rates

•  Assign categories of risk – perhaps 1 (results fairly assured) to 4 (high degree of volatility)

•  Amend discount rate appropriately – if normal rate is 8, a project rated “3” might be evaluated with a discount rate of 10

•  This essentially allows options to be compared on an “apples to apples” risk basis

•  It essentially raises the “hurdle rate” for projects offering greater risk

•  Requires the skills of a risk professional to ask hard questions and assign appropriate risk scores

NPV – International Launch

Net Present Value = $2,020,000

 1Discount rate 8%

Year 2016 2017 2018 2019 2020

Cost (2,000) (450) (700) (850) (950)

Revenue 550 1200 1,800 2,000 2,200

Net (1,450) 750 1,100 1,150 1,250

NPV1 (1,450) 695 943 914 918

NPV – International Launch

Risk Adjusted Net Present Value = $1,856,000

1Discount rate 10%

Year 2016 2017 2018 2019 2020

Cost (2,000) (450) (700) (850) (950)

Revenue 550 1200 1,800 2,000 2,200

Net (1,450) 750 1,100 1,150 1,250

NPV1 (1,450) 681 908 863 854

Time as a Risk Factor

•  All other things being equal, a project that breaks into profitability in the shorter time period presents lower risk

•  It is not uncommon, therefore, to prescribe a minimum “Breakeven Period” to weed out projects that require long periods of time to mature

•  Why does a longer time period increase risk?

The Value of the “Real Option”

•  A risky project that offers the opportunity for some optionality in implementation or the option to exit without undue brand damage is more attractive than one with limited flexibility

•  It is useful to ask the optionality question when evaluating a project perceived to present a greater than average degree of risk

•  For two projects with an equal opportunity for success (but both perceived to be risky) – the best option might be the one whose exit cost NPV is lower in the event of abject failure

Risk Adjusted Internal Rate of Return

•  Assign categories of risk – perhaps 1 (results fairly assured) to 4 (high degree of volatility)

•  Amend required IRR – if normal required IRR is 10%, a project rated “4” might be evaluated with a minimum required IRR of 18%

•  Once again, this exercise essentially raises the “hurdle rate” for projects offering greater risk

•  An accurate and objective risk scoring exercise remains key, and requires the efforts of a seasoned and knowledgeable risk professionals

Using Risk Adjusted Cash Flows •  Through the use of modeling and simulation (fault trees, etc.), it

is possible to determine a range of cash flows for each period

•  The range of possible outcomes (standard deviation) is likely tied to the measure of risk or volatility

•  NPV analysis could therefore be applied against the most probable value for each period

Questions for the Risky Project

•  Is the project in line with stated corporate objectives and not in violation of any risk parameters?

•  Does the implementation team have experience in this area of endeavor?

•  Has a risk management plan been formulated to address key potential concerns?

•  If specialty insurance or risk services are part of this project, is the cost reflected in the business plan?

•  Are there “off-ramps” available? Can the project be phased in over time to allow periodic evaluation?

Adding a Dollar Cost of Risk Very often a proposed business plan fails to incorporate an appropriate cost of risk

•  Potential questions to address: –  Have you built in the cost of specialty insurances required? –  Does your manning plan incorporate an appropriate number

of loss control and/or quality assurance personnel? –  Do you have all the permits required to support this

venture? Are there hidden frictional/transactional costs? –  What is the financial condition of our prospective partner?

Accoun'ng  for  Poten'al  Delay

•  Is insurance, liquidated damages, or other vehicle available to help partially offset the cost of project delay?

•  What has been the experience of similar projects in the last three years? Why do we believe our experience would be any more favorable?

•  Sensitivity analysis – what impact on profitability would a delay equal to the longest peer delay have on the project?

The Outcome •  The cost of Political Risk insurance and a 2% higher discount

rate rendered the overseas expansion opportunity unattractive as respects profitability. Questions also arose concerning the track record of the proposed partner

•  A venture capital fund specializing in hospitality enterprises was identified to partner with the restaurant chain. An agreement was struck to serve as sole supplier and for an advertising tie-in

•  The advertising campaign was launched with an added feature of an “off ramp” at the two year point. The campaign will be halted in the event it does not produce 75% of projected sales

•  Two new flavors were moved to additional market research testing, with an option to launch if favorable results obtained

Thank You For Your Kind Attention

Ques'ons?