Investing in growth:Decision techniques

for SMEs

Contents

• The purpose of decision support• Opportunity cost, alternative investment,

relevant costs• Enough about DCF to understand its

weaknesses• Simple alternatives • Infrastructure/enabling projects which

don’t have a clear payback

The purpose of decision models and the role of judgement

• The practical purpose of financial decision-support models is to tell you what a proposed investment needs to do to justify spending money on it

• A human being, a decision maker, needs to decide if the project can perform at or above the that level. No financial tool can do that.

Topics

• Some theory about corporate decision making

• Why it doesn’t work well at SMEs• Some quick and simple techniques• What to do about essential investments

which don’t clearly create separate cashflows?

Jargon

• We’ll cover some theory about cashflows• Some shortcut and simple techniques• We’ll cover “contribution margin”,

“relevant costs”, “risk” and “opportunity cost”

What do big businesses and SMEs have in common regarding investment decisions?

• Need to make wise decisions about where to invest and now much to invest

• Need to set benchmarks to evaluate decisions

• Need to set priorities• Need to deal with uncertainty

The limitations of finance techniques

• Estimated costs and outcomes are crucial to all finance techniques but they need human expert judgement

• Not many big innovations and growth opportunities come from spreadsheets (although many smaller profitability improvements do)

The formal decision-making “maturity curve”

• 0. Gut-feel• 1. Basic budget and concept of payback• 2. Choose superior projects from a pool of

alternatives• 3. Develop cashflows and scenarios based

on key drivers• 4. Apply multiple methods and share

calculations with third parties to obtain funding

Major reasons to use finance techniques for decision making

• The process of analysis establishes the definition of a financially successful project

• Helps reveal risks and ways that the project could fail

• Increases the confidence of third parties in decision making (and therefore access to funding)

• Gives targets to measure the performance of the project along the way

• Genuinely useful in setting priorities

Key concepts: Opportunity Cost and The Alternative Investment

Opportunity cost, and the alternativeYou can only spend a dollar once

A decision to invest in a project is always made by comparing it to the next best alternative

Often we use a ‘theoretical’ alternative (eg “compared to putting the money in the bank”)

The two concepts are linked: the return from the next best alternative is the opportunity cost of proceeding with the investment opportunity (what you forego)

Opportunity costs can be subtle

• If you have $100,000 in the bank, it’s clear that spending it on a new website means you can’t spend it on product development

• But if you have $100K equity in your house and borrow against that to fund the website, you may think that there is no opportunity cost, because you didn’t have the $100K until you decided to do the project

• That’s false. Now you have $100K less equity to borrow against for an alternative project

Key concepts: Relevant cashflows

Relevant costsWhen evaluating a decision, we must only

consider the consequences of that decision vs the alternative (which is often not making the investment)

Relevant costs illuminated

• Last month you bought 10 100W incandescent lightbulbs, which cost $2 each, and $3 a month to run

• Someone says “buy 15W energy savers for $6, they cost $0.50 a month to run”

• You say “No, that’s silly, I just bought the new bulbs. I’ll wait for them to fail before replacing them”

• Bad decision! You save money as soon as you use the new light bulbs. The purchase cost of the existing light bulbs is not relevant to the decision to replace them because it is not affected by the decision

Key concepts: Risk

Risk simply means the possibility of surprise, good or bad.Theoretically, all investments turn into cash at some point in the future. A higher risk investment means less certainly about what that future value will be.The demand for higher risk investment opportunities is not as great as low risk investment opportunities, so it costs more to get money for high risk investments.

What is risk?

• Risk means unpredictability.• A ‘riskier’ investment means you are less sure about

how well it will do. We guess a “mid-range” return, but it could do better or worse.

• A ‘risk-free’ or ‘low-risk’ investment will do exactly what we expect. No nasty surprises, and no pleasant surprises.

• High-risk investments have a place.• Equity investments (shares) have higher risk because

they are the left-overs (for better or worse)• Small business owners making investment decisions

are usually facing “equity” decisions, since they are majority shareholders

Investment alternatives: the theory

• Investment decisions are about comparing alternative investments which are of the same risk.

• We start by assuming we are prepared to take a certain risk.

• We then evaluate our project against a known alternative of the same risk

Some basics about cashflows

• Cashflows are money AND timing• Cashflows are negative for cash out

(investment)• And positive for cash in• They show only the changes in cash due

to the decision• They can therefore include both

additional profits and costs avoided due to the decision

What’s needed for perfect decision making

• Complete accuracy of costs and resulting cashlows, both in amount and timing

• An alternative investment of the same risk with a known return

• These are the two major weaknesses of financial decision-making tools

Discounted Cash Flows: The academic approach to investment decisions

• DCF solves many technical problems. It allows comparison of projects with different durations, and projects which requires a one-off investment with projects which require multiple investments.

• However, it doesn’t overcome the key weaknesses mentioned earlier.

• If its weaknesses are misunderstood, it leads to false confidence and bad decisions

DCFs are a professional tool

• DCFs should be designed by a finance professional. There are many subtle points. DCFs assume an infinite series of cash flows, for example. And replacement costs need to be considered.

• Tax calculations are not obvious and need to be tuned to the circumstances

A checklist to validate a DCF

• Ask what is the basis for the discount rate: it should be based on next best alternative

• Ask how the final cash flow approximates the “infinite cashflow” theoretical requirement

• Make sure that further injections of cash needed to sustain the original investment are included

• You should see scenarios which cover a wide range of possible cashflows.

• Ask how tax has been treated

The ‘time value of money’

• You often hear that DCFs reflect the “time value of money” that is, that future money is worth less than today’s money.

• Bad concept. Too easily confused with inflation.

• Discounted Cash Flows are discounted by a risk rate which converts future cash to an equivalent today based on compound interest. It’s a powerful trick to compare projects of different duration. Nothing to do with the “time value of money” or inflation.

DCFs: The key outcome

• A project which as a Net Present Value of zero is a project which performs exactly as well as the alternative.

• Negative NPV means you’d be better off not doing the project, but investing in the alternative instead.

The theory assumes risk is priced correctly by the market

• Australian government bonds at about 4%• BHP bonds about 8%• SME overdrafts about 12%• Large corporates work out the average cost of

money provided to them by investors (shareholders, bond-holders) and then they know that investments in growth have to return at least that amount.

• Then they hope to say to investors: Look, you thought we were a 14% risk, but our projects delivered 16% return: we “added value”.

What’s the right discount rate?

• This is tricky.• For small businesses, you’d probably be

looking at rates in the range 20% to 35% before tax.

• Lower rates should be carefully justified by an especially low risk

When to use DCF

• For medium term and large decisions• Where you have reasonable confidence

about the cashflow forecasts because the new activity is similar to an existing activity

• Eg investing in a new clinic.• The discipline of preparing cashflow

forecasts has good side-effects

Other simpler techniques

• Payback: how fast before the initial investment is returned?

• EBIT multiplier: Assume the value of your business increases $3 for each $1 of sustained profit you can add

Why payback is not popular with theoreticians

• Payback doesn’t cope with projects with multiple waves of investment

• It doesn’t compare large and small investments very well; it may be biased towards big investments, when several small projects would be better.

• It ignores compound interest

Why payback is still popular

• It’s simple and fast• It’s not a bad way to rule a simple project

in or out• While it has big theoretical limitations, it’s

also less hostage to the danger of misunderstanding the power of assumptions crucial to DCF

The EBIT multiplier method

• Many small businesses are sold based on a multiplier applied to EBIT (between 2 to 5 usually)

• So a project which increases EBIT by $500K (sustainably) is worth, say, 3 x 500K

• (once again, ignoring tax)

The EBIT multiplier method

• If a website costs $100K, what level of extra sales are necessary for a ‘break-even’ return?

• Using a multiplier of 3, we need $33K of EBIT.

• Assume a EBIT margin of 10%• So that’s a sales level boost of $33K / 10%

= $330K per year (on top of now). This is very rough and short-term (good if selling the business in the next two years)

Theory: converting EBIT multiplier to a discount rate for DCF

• Assume that EBIT is a terminal cashflow of $1• Assume the value is $1 x EBIT Multiplier• Assume a certain growth (in line with GDP, say

3%)• The value of a $1 terminal cashflow is• V = 1/(r – g) where r is discount rate, g is growth• V = Ebit Multiplier since the cashflow is $1• Therefore, r = g + 1/v• If EBIT multiplier is 4, then r = 28%• If EBIT multiplier is 3, then r = 36%• So, discount factors are high for small businesses

Other short term decision making techniques

Contribution margin:• You plan to spend $100,000 on an advertising

campaign to bring in $200,000 of new sales. • Estimate the contribution margin: for every $1 of

new sales, what new costs are triggered?• Assume cost of sales 45% and one temp at the

front desk for three months ($15K)• Net cash: $200K- $100K - $15K – 45%*200K • = -$5K • So no, not convincing.• Note the use of “relevant costs”.

What about “enabling” or “infrastructure” decisions?

• All the theory about decision making starts with being able to measure cash that results from a decision to invest in something.

• But some decisions are essential yet vague.

• Such as a new IT framework

• This is a good chance to remember to ask the right question

In the case of a new finance system

A key part of the value of the project is that it unblocks other projects.So the question is not really whether to invest or not.The question is which system to buy.If the value of the new system is purely enabling, then we weigh up the speed to implement and the cost. Unnecessary functionality and complexity which goes beyond the enabling requirement must be justified by the return on invesemtne

Summary: key concepts

• Opportunity Cost and comparison to an alternativeEvery investment decision is based on

comparing another way to use the money

Summary: Relevant cashflows

• When evaluating an investment, we consider only the cashflows which change due to the decision

Summary: Risk

• Risk is a measure of surprise.• High risk investments can be large flops

or big hits• Investors choose a balance of risk• It only makes sense to compare

investment alternatives which have about the same risk