Lecture 8 ATH Microtechnologies

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Lecture 8 ATH Microtechnologies Project
Valuation and ROI - I

• Steve Montgomery

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Introduction To The Business Environment

• What to do when someones not telling you what to
  do
• Topics covered
• Course introduction and Overview of corporate
  structure (1 session)
• Fundamentals of business strategy (2 sessions)
• Introduction to Marketing (2 sessions)
• Overview of Accounting and Finance (2 sessions)
• Project Valuation and ROI (2 sessions)
• Course review strategy illustration (1 session)

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Accounting/Finance

• Accounting Two types
• Bookkeeping and managerial
• Bookkeeping Your companys overall financial
  health
• Balance sheets income statements and how to read
  them
• Managerial Measurable metrics that drive
  decision making
• What incentives are you creating, and can you
  measure the right things?
• Finance The art and science of cash management
• Cash is King
• Treat it like its yours
• Time money

End goal Understanding your business, how you
reach customers, and your firms business
condition allow you to pick smart projects and
sell them to management
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Project Valuation and ROI

• The project decision Is this project a good use
  of company resources?
• How can we tell? What should we measure?
• What are we not doing by starting this project?
• Techniques for estimating Return on Investment

End goal Understanding your business, how you
reach customers, your firms business condition
and the potential impact your of your work allow
you to pick smart projects and sell them to
management
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Lecture 8 Project Valuation and ROI I

• ATH Microtechnologies Case
• Finance and the time value of money
• Present/future value problems

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ATH Microtechnologies

• Founding Period
• Scepters bid
• 90M initial payment
• 30M if new product approved by FDA
• 35M if independent study proved product
  superiority
• Up to 120M in cash for sales/profit goals
• What are some features of this payment system?
• Is there anything missing here?

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ATH Microtechnologies, cont.

• Did the earn out structure focus on the right
  performance goals?
• Were there adequate controls in place?
• What are some good metrics to measure ATHs
  performance by?

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ATH Microtechnologies, cont.

• Growth Phase
• Autonomy granted to ATH (why?)
• Goal Get market share through new product
  development and marketing
• Were bonuses linked to market share growth?
• First earn out paid as FDA approved product, but
  European tech proved superior in test, so no
  second phase earn out

Growth
Profit
Control
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ATH Microtechnologies, cont.

• How did they do during the growth period?
• Did they achieve their strategic objectives?

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ATH Microtechnologies, cont.

• Push to profitability
• 20 bonus and trip for two to Hawaii if were
  profitable!
• Whats not to like?
• Would you design an incentive program this way?

Growth
Profit
Control
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ATH Microtechnologies, cont.

• Was ATH successful in becoming profitable?
• How did they do it?
• What effects did this have on the rest of the
  business?

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ATH Microtechnologies, cont.

• Refocus on Process
• Issued vision statement ?
• Restructured bonus program
• Launched education initiative

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ATH Microtechnologies, cont.
Growth

• How did they do?
• Were the issues contained at this point?
• Final earn out paid at this point

Profit
Control
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ATH Microtechnologies, cont.

• New Management
• Declining sales
• Founders left the company
• New European tech eating at business other
  competitors entering market
• New spending focused on new product development
  and tech leadership
• Newest products withdrawn from market corners
  cut to make deadlines

Growth
Profit
Control
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ATH Microtechnologies, cont.

• How well is ATH positioned for the future?

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ATH Summary

• People respond to incentives
• You get what you measure!
• Consequently, measures need to be balanced
  Reward one thing, get one thing
• Strategy is everything!
• In this case, did ATH focus on the short or the
  long term?
• Its difficult to balance short vs. long term
  goals, but
• Design incentives that try to do both
• How could that have been done here?
• Keep tension in the system between growth, profit
  and control
• If one is sacrificed completely, negative
  consequences can appear later!

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TimeIs Money

• The key to understanding financing decisions is
  to note that the value of money decreases over
  time
• Two factors contribute
• Inflation. It takes more dollars to buy
  something tomorrow that it does today
• Opportunity cost. By doing x instead of y, you
  lost out on potential revenue.
• How do we assign a value to these things?

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Time Is Money, cont.
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Future Value

• Future value Example
• You take 100 and buy a CD paying 4 annual
  interest rate
• ValueYear 1 100(14) 104.00
• ValueYear 2 104(14) 108.16
• Therefore, your 100 has a future value of
  108.16 after 2 years.

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Future Value, cont.

• CFj Cash flow value at some jth compounding
  period
• j The jth compounding period
• F0 The initial investment
• i The interest rate (Also called the discount
  rate)
• Note that this is the value of some single
  investment at some future date
• The factor (1i)j is called the Future Value
  interest factor
• Sometimes tabulated
• Handy to use in spreadsheets when doing
  discounted cash flow analysis

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Using Future Value to Derive Present Value

• Sometimes its desirable to know what the present
  value of a future payment will be
• Drives decision making If you know what
  something is worth in todays dollars, is this a
  good investment or not?
• The value of money isnt static
• Inflation degrades its value
• Other opportunities that werent pursued should
  be thought of as costs

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Using Future Value to Derive Present Value, cont.

• Revisit the equation ?
• Recast slightly
• Note that the initial investment is the same
  as the value of that investment today, or is also
  the Present Value

Becomes
Where PV Present Value
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Using Future Value to Derive Present Value, cont.

• Solving for present value
• Same formula, were just thinking about it
  differently.
• The factor 1/(1i)j is called the Present Value
  interest factor (PVIF)
• Sometimes tabulated
• Handy to use in spreadsheets when doing
  discounted cash flow analysis

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Present Value Example

• A friend of yours owes you 1,000. He cant pay
  you back today, but promises that he will pay you
  back one year from now.
• Suppose that inflation is 3. What is the
  present value of the 1,000 payment (that happens
  1 year from now)?

(You lost 30 on that deal)
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Present Value Example, cont.

• A friend of yours owes you 1,000. He cant pay
  you back today, but promises that he will pay you
  back one year from now.
• Suppose you could have invested some money at 7
  interest. How much would you have had to set
  aside this year to get 1000 next year?

(This time your friend cost you 65)
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What About A Series Of Cash Flows?

• Suppose you invest 4,000 a year in an IRA, and
  that you expect the IRA to earn 5.5 on average
  for the next 20 years.
• How much will you have 20 years from now?
• This is a sum of future years problem Add the
  future value of each of the next 20 years
  together

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Stream Of Cash Flows, cont.
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Visualizing Cash Flows

• Sometimes its helpful to consider a picture
• Each of these cash flows is listed in their value
  at that particular time period. We then use
  discounting (more on this in a minute) to relate
  them all back to today.

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Present Value of a Stream Of Cash Flows
k interest rate n number of periods

• Note that CFn PV(1k)n
• Cash flow (or future value) at some year (or
  compounding period) equals the initial investment
  adjusted by the interest rate and number of
  periods)

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Present Value of a Stream Of Cash Flows, cont.

• Considering inflation, the value of a dollar
  degrades over time
• Example Whats the value of 1 ten years from
  now in todays dollars? (Assume inflation rate of
  3)
• Ans
• Note that theres no summation here, since
  theres only 1 cash flow in this case (or think
  of it as a series of zero cash flows)

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Present Value of a Stream Of Cash Flows, cont.

• What if we have multiple cash flows?
• Example Ichiro Suzuki signs an endorsement deal
  with Mizuno paying him 2M/year for the next 4
  years (payment starts 1 year from now). Whats
  the present value of this contract? (Assume
  inflation is 3)
• In other words, inflation knocks 565k off the
  value of his contract.

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Visualizing Cash Flows, again

• To visualize what happens when we perform the
  discounting, multiply each CF by the PVIF of that
  period and see

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PV, cont.

• A good way to format this on spreadsheets is the
  following
• What if Ichiro took this class and wanted 8M in
  todays dollars? How would we figure out what
  his payments should be?

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Back to Ichiro

• Notice the power of inflation to get 8M in
  todays dollars, he needs to be paid 618k more
  over the course of 4 years
• Why do the payments get bigger further out in
  time?

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A Bond Example

• You want to invest in something, yet youre leery
  of the stock market. How about buying bonds?
• A bond is a promissory note from an entity
  obligating the payee to pay out interest over the
  life of the bond, and refund the principal at
  some later date
• Corporate bonds
• Municipal bonds (tax-free!)

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A Bond Example, cont.

• Bonds are present value problems You get the
  interest (Called coupon payments) the amount of
  the bond (Called the face value) back when the
  bond expires
• Bonds are issued in lots of 1000 (Face) with
  some pre-determined interest rate (Coupon)
• Typically paid annually or semi-annually
• Lets buy a bond and figure out how much our
  investment is worth

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Bond Example, cont.

• Suppose you want to buy a bond for 1000 face
  value and a coupon rate of 10 The market
  interest rate is 12 (The market expects to earn
  a 12 return on this bond).
• Bond makes payments annually
• Say there are 10 years to maturity, or 10
  compounding periods
• What is this bond worth today?

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Bond Example, cont.

• First, how much is each interest payment?
• Each payment (10)(1000) 100
• Next step is to find the present value of each of
  the interest payments, then add those up
• Next, find the present value of 1000 at a rate
  of 12 in 10 years (321.97)
• The sum is the price of the bond 287.48
  565.02 887.

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Bond Example, cont.
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Bonds, cont.

• When a bond is first issued, you can pay the face
  value and realize payments at the coupon rate
• But, the market will value/devalue bonds just
  like stocks! This affects the math
• Also, theres the matter of getting in on a bond
  at the beginning of its term or somewhere in the
  middle
• Lets go buy a real bond

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Bond Example, Cont.

• Emerson Electric
• 5 coupon, semi-annual
• 1000 face
• 10 payments remaining of (5)(1000)/2 25.
• Whats the price of this bond?

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Bond Example, cont.

• The markets expected rate of return is called
  the Yield To Maturity (2.456 in this case)
• So the interest rate to use is (2.456/2)
• The actual price of this bond is 1120.31 why
  the difference?

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Lump Sum or Monthly Payments?

• You being a hot commodity thanks to some class
  you took at UW has landed you a new job. Upon
  leaving your old company, you have the option to
  take your retirement plan savings as either
• Lump sum of 50,000 now
• 18 monthly payments of 3,000 (for a total of
  54k)
• In either case, you can invest your money at
  6/year (0.5/month)

Example adapted from J. Karpoff, UW
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Take The Monthly Payments

• With the monthly payments, at this interest rate
  you came our ahead by 1,518.30.
• What would change this situation?

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Present/Future Value Problem Summary

• PV/FV techniques are useful for a variety of
  different calculations
• Investment decisions
• Retirement savings
• Bond buying
• and much more
• Theyre also useful for evaluating projects. The
  only thing we do differently is change the
  discount rate and the cash flows