week 7-1.pptx

CHOOSING INNOVATION PROJECTS Week 7  Learning outcomes  The development budget and capital rationing  Research and development intensity  Quantitative methods of choosing projects  Qualitative methods of choosing projects  Combining qua...

CHOOSING INNOVATION PROJECTS Week 7  Learning outcomes  The development budget and capital rationing  Research and development intensity  Quantitative methods of choosing projects  Qualitative methods of choosing projects  Combining quantitative and qualitative information 1-2  The Development Budget  Most firms face serious constraints in capital and other resources they can invest in projects.  Firms thus often use capital rationing: they set a fixed R&D budget and rank order projects to support. ◦ R&D budget is often a percentage of previous year’s sales. ◦ Percentage is typically determined through industry benchmarking, or historical benchmarking of firm’s performance. 1-3 3  The Development Budget  R&D Intensity (R&D as a percent of sales) varies considerably across and within industries. 1-4 4 The Development Budget 1-5 5  Theory In Action Financing New Technology Ventures  Large firms can fund innovation internally; new start-ups must often obtain external financing.  In first stages of start-up and growth, entrepreneurs may have to rely on family, friends, and credit cards.  Start-ups might be able to obtain some funding from government grants and loans  If idea and management are especially promising, entrepreneur may secure funds from “angel investors” (typically seed stage and $1 million). 1-6 6 Quantitative Methods for Choosing Projects  Quantitative methods of analyzing new projects usually entail converting projects into some estimate of future cash returns from a project ◦ Discounted cash flow method ◦ Real options. 1-7  Discounted cash flow method  Discounted cash flows are quantitative methods for assessing whether the anticipated future benefits are large enough to justify expenditure, given the risks.  Discounted cash flow methods take into account the payback period, risk, and time value of money ◦ Net present value (NPV) ◦ Internal rate of return (IRR). 1-8  Net Present Value (NPV)  NPV is used in capital budgeting to analyze the profitability of an investment or project.  NPV is the difference between the present value of cash inflows and the present value of cash outflows.  NPV compares the value of a dollar today to the value of that same dollar in the future, taking inflation and returns into account. If the NPV of a prospective project is positive, it should be accepted. However, if NPV is negative, the project should probably be rejected because cash flows will also be negative.  For example, if a retail clothing business wants to purchase an existing store, it would first estimate the future cash flows that store would generate, and then discount those cash flows into one lump-sum present value amount, say $565,000. ◦ If the owner of the store was willing to sell his business for less than $565,000, the purchasing company would likely accept the offer as it presents a positive NPV investment. ◦ Conversely, if the owner would not sell for less than $565,000, the purchaser would not buy the store, as the investment would present a negative NPV at that time and would, therefore, reduce the overall value of the clothing company. 1-9 9  Quantitative Methods for Choosing Projects  NPV = Net Present value = Present value of net cash flows ◦ Each cash inflow/outflow is discounted back to its PV and then they are summed. t - the time of the cash flow N - the total time of the project r - the discount rate (the rate of return that could be earned on an investment in the financial markets with similar risk.) Ct - the net cash flow (the amount of cash) at time t 1 - 10  Net Present Value (NPV)…  Net Present Value (NPV): Expected cash inflows are discounted and compared to outlays.  In Excel use the formula NPV(interest rate, cell range of cashflows) $943.3 9 1 - 11 11  Internal Rate of Return (IRR)  The discount rate that makes the net present value of investment zero. ◦ It is an indicator of the efficiency of an investment, as opposed to NPV, which indicates value or magnitude. ◦ The IRR is the annualized effective compounded return rate which can be earned on the invested capital, i.e., the yield on the investment. ◦ A project is a good investment proposition if its IRR is greater than the rate of return that could be earned by alternate investments (investing in other projects, buying bonds, even putting the money in a bank account).  Thus, the IRR should be compared to any alternate costs of capital including an appropriate risk premium. 1 - 12 12  Internal Rate of Return (IRR)  Mathematically the IRR is defined as any discount rate that results in an NPV of zero of a series of cash flows.  In general, if the IRR is greater than the project's cost of capital, or hurdle rate (minimum rate of return that must be met for a company to undertake a particular project), the project will add value for the company. 1 - 13 13  Real options are based on stock options  A call option on a stock enables an investor to purchase the stock at a specified price (the exercise price) in the future  If, in the future, the stock is worth more than the exercise price, the holder of the option will typically exercise the option by buying the stock  If the stock is worth more than the exercise price plus the price paid for the original option, the option holder makes a profit  If it is worth less, the option holder will typically choose not to exercise the option, allowing it to expire. The amount paid for the initial option is a loss.  If the stock is worth more than the exercise price but not more than the exercise price plus the amount paid for the original option, the stockholder will typically exercise the option. The amount lost is less than if the option were to expire. 1 - 14 14  Real Options  Applies stock option model to nonfinancial resource investments. e.g., with respect to R&D: ◦ The cost of the R&D program can be considered the price of a call option. ◦ The cost of future investment required to capitalize on the R&D program (such as the cost of commercializing a new technology that is developed) can be considered the exercise price. ◦ The returns to the R&D investment are analogous to the value of a stock purchased with a call option. 1 - 15 15  Qualitative Methods of Choosing Projects  Many factors in the choice of development projects are extremely difficult (or misleading) to quantify.  Almost all firms thus use some qualitative methods. ◦ Screening Questions may be used to assess different dimensions of the project decision including:  Role of customer (market, use, compatibility and ease of use, distribution and pricing)  Role of capabilities (existing capabilities, competitors’ capabilities, future capabilities)  Project timing and cost (time to complete, first to market, readiness of market, project cost, other costs) ◦ Can create a scoring mechanism that can weight the questions according to importance 1 - 16 16 The Aggregate Project Planning Framework 1 - 17 17  The Aggregate Project Planning Framework…  Advanced R&D Projects: develop cutting-edge technologies; often no immediate commercial application.  Breakthrough Projects: incorporate revolutionary new technologies into a commercial application.  Platform Projects: not revolutionary, but offer fundamental improvements in cost, quality and performance of a technology over preceding generations of products.  Derivative Projects: incremental improvements in products and/or processes to provide a variety in design features. ◦ Toyota’s Camry platform offers LE, SE and XLE models to appeal to different market segments  Derivative projects pay off the quickest, and help service the firm’s short-term cash flow needs. Advanced R&D projects take a long time to pay off (or may not pay off at all), but can position the firm to be a technological leader. 1 - 18 18  The Aggregate Project Planning Framework…  Managers then compare actual balance of projects with desired balance of projects. ◦ A typical firm experiencing moderate growth might allocate 10% of it’s R&D budget to breakthrough innovation, 30% to platform projects and 60% to derivative projects ◦ A firm pursuing a more significant growth might allocate higher percentages to breakthrough and platform projects ◦ A firm that needs to generate more short-term profit might allocate a higher percentage to derivative projects 1 - 19  Q-Sort  A simple method for ranking ideas on different dimensions. ◦ Used for many diverse purposes – from identifying personality disorders to establishing scales of customer preferences ◦ Individuals in a group are each given a stack of cards with an object or idea on each card (e.g., a potential project). ◦ A series of project selection criteria are presented (technical feasibility, market impact, fit with strategic intent) and, for each criterion, the individuals sort their cards in rank order (e.g., best fit with strategic intent) or in categories (technically feasible vs infeasible) according to that criterion ◦ Individuals compare their ran ordering and use these comparisons to structure a debate about the projects ◦ After several rounds of sorting and debating, the group is expected to arrive at a consensus about the best projects. 1 - 20 20  Combining Quantitative and Qualitative Information  Managers may use multiple methods in combination. ◦ Use quantitative methods to estimate the cash flows anticipated from a project when balancing their R&D portfolio on a project map  May also use methods that convert qualitative information into quantitative form ◦ Conjoint analysis ◦ Data envelopment analysis 1 - 21  Conjoint Analysis  Conjoint analysis is a popular marketing research technique that marketers use to determine what features a new product should have and how it should be priced.  Estimates the relative value individuals place on attributes of a choice which can then be used in development and pricing decisions.  Individuals given a card with products (or projects) with different features and prices.  Individuals rate each in terms of desirability or rank them.  Multiple regression then used to assess the degree to which an attribute influences rating. These weights quantify the trade-offs involved in providing different features 1 - 22  Theory In Action: Courtyard by Marriot  Marriot used conjoint analysis to help it develop a midprice hotel line.  First used focus groups to identify customer segments and attributes they cared about in a hotel. These included: ◦ external surroundings, room, food, lounge, services, leisure activities and security  Then created potential hotel profiles that varied on these features and asked participants to rate the profiles. ◦ For example, under the services factor was reservations  Two levels were devised- Call the hotel directly or call an 800 reservation number ◦ A sample of hotel customers were given 7 cards, each containing one of the factors above with a dollar value assigned to each level of service within a factor. A maximum of $35 could be budgeted to creating a profile of features  If the budget was exceeded, features had to be eliminated or a less expensive level of services had to be chosen  The participants set their own priorities and made their own trade-offs. This help management understand what was important to different customer segments 1 - 23 23  Theory In Action: Courtyard by Marriot  Participants were then asked to rate each of the profiles created  Regression was then used to assess how different levels of service within a specific attribute influenced customer ratings of the hotel overall  Based on the results, Marriott developed Courtyard concept: relatively small hotels with limited amenities, small restaurants and meeting rooms, courtyards, high security, and rates of $40-$60 a night.  By the end of 2002, there were 553 Courtyard hotels and their average occupancy rate of 72% was well above the industry average 1 - 24 24  Data Envelopment Analysis (DEA)  A method of ranking projects based on multiple decision criteria by comparing them to a hypothetical efficiency frontier  Uses linear programming to combine measures of projects based on different units (e.g., rank vs. dollars) into an efficiency frontier. ◦ Projects can be ranked by assessing their distance from efficiency frontier. ◦ As with other quantitative methods, DEA results only as good as the data utilized; managers must be careful in their choice of measures and their accuracy.  DEA has been applied in many situations such as: ◦ health care (hospitals, doctors), education (schools, universities) ◦ banks, manufacturing ◦ benchmarking, management evaluation 1 - 25 25