Critical questions all small and medium sized businesses ask is whether or not to allocate resources an innovation project, or which projects should be selected over others. Our research shows that minimal or no analysis is used to kick-off or fund product development and innovation projects in small businesses. Often, these projects are funded due to management support, a corporate initiative, or a customer request for a new product or feature, but often the question left unanswered is “will this project create value for the company?”
It is essential for small and medium businesses to identify critical decision criteria to answer that question. A forward-looking methodology that allows better decision-making is essential. The following key decision criteria – Net Present Value (NPV), Internal Rate of return (IRR), and Profitability Index (PI) – used support a this basic and powerful methodology.
Net Present Value (NPV): The net present value measures the change in value that should result from an investment. This is a forward-looking measure that measures gain from alternative opportunities at similar risk. NPV takes into account the future value of money and the risk of the cash flows.
Internal Rate of Return (IRR): The internal rate of return measures the expected average annual rate of return.
Cost of Capital: Corporate interest rate + estimated inflation + project risk premium
Profitability Index (PI): Is the present value of future cash flows over the initial investment. The profitability index allows firms to rank innovation projects based on the best-combined net present value.
Our team has developed two fictionalized case studies to show how to use these concepts in a simple and efficient way. These cases based on real discussions with customers and recreated data, and present the issues innovation executives face everyday.
Case Study 1 – Technology Licensing
An advanced materials firm is looking to acquire a technology developed by a research institution. The team has completed the required technical and financial due diligence and they are ready to sign a licensing agreement. The cash flows from the commercialization of the technology are expected to be $100,000 per year with an annual decline of 2%. The research institution has valued the technology at $525,000, and is offering the materials firm three options.
- Make 3 installment payments. Two $250,000 payments at the time of licensing and in year 4 and a $200,000 payment in year 8.
- Make a single payment of $525,000 at the time of licensing.
- Make an upfront payment of $300,000 and pay an annual royalty of $50,000, tapered at $5,000 per year.
The table below shows the projected cash flow of the technology, the different payment options, net cash flows and the calculated NPV and IRR of the different options. For this project we have assumed a cost of capital of 10%.
When selecting the ideal licensing option we have to look at different selection criteria. It is clear all options meet the investment criteria, positive NPV and an IRR higher that the cost of capital (10%).
If we use the NPV-IRR methodology, it is clear that Option C created the most value for the firm than the other two options (NPV of $78,000 vs. $57,000 and $46,000). However if risk is not an issue between the choices (the cash inflow for the company is the same in all three options and if the payments have no risk associated to them), we might be tempted to take the option with higher return in this case Option A (IRR of 16.5% vs. 15.2% and 12.0%).
Case Study 2 – Project Selection and Budget Allocation
An industrial device firm is looking to select and fund their innovation projects. The firm has $1,000,000 of product development and innovation budget available. The executive team is reviewing the current 7 competing projects that require funding.
The team is presented with the required initial investments and the expected net present value of each of the projects. Project risk is different for each alternative, only IRR higher that cost of capital is required. The table on the right shows the different project allocation criteria. The management team uses the profitability index (PI) to rank the projects and allocate the available resources.
Based the data offered to the executive team the present value of the projects is calculated (PV=NPV + Initial Investment) providing the value of project inflows. Once the PV of the inflows is calculated we can calculate the profitability index (PI = PV/Initial Investment) of each of the project. Now the projects can be ranked according to their PI.
The table below shows that project F has the highest PI, followed by A, E and D, in this case. Furthermore, the cumulative investment is calculated to identify where the $1,000,000 budget limit is.
This is a basic methodology that can be easily implemented at any firm. It can be used in an open innovation environment, where both internal and external projects compete for resources. The methodology provides compelling decision-making criteria to the executive team. More advanced methodologies using options or statistical models can be develop from this basic methodology to further optimize the decision making process.
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