Today we begin a series on financial management tools for the Research Manager. As we have said in the past, most research, like any other business endeavor, ought to be focused on acceptable financial return. This ignores for the time being “basic research” that is intended to expand the horizons of knowledge often for the sake of knowing. The “value” of basic research is a topic that cannot be dealt with fully here. Although I would contend that there should still be a value proposition, much of that value could be non-monetary and not amenable to the kind of analysis we are going to talk about. I don’t want to get sucked into a philosophical discussion, so I am willing to, for practical purposes, allow the discussion to be limited to “applied research” or “development” if that would put the reader at ease.
The basic dilemma of the Research Manager is balancing current costs with potential future benefits. We begin by introducing the idea of the Time Value of Money. We will extend the basic concept to include Risk. Simply stated, money in hand today is of greater value than money promised in the future. There are two reasons for this. The first is that money in hand can be invested in very low risk investments that will grow at a reliable rate. Although these rates are at historic lows, it is still the case that $10,000 put in a Certificate of Deposit (CD) will be worth more than $10,000 in a few years. Hence, $10,000 promised in three years is not worth $10,000 today. In other words, a future payment must be discounted for comparison to current dollars.
We can calculate this discount rate by using the idea of compound interest. If the money we hold in our hand can be invested at a government guaranteed rate of 2% compounded annually, $10,000 today would grow to $10,612 in three years. This is shown in the simple table below:
Naturally, if someone offered us less than $10,612 in three years for an investment of $10,000 today we would laugh at them. We would want at least that much money or more, and the “more” would depend on how reliable we thought the deal might be.
It is the “more” that begins to put into the equation the notion of Risk. If a reliable real estate agent were making us this offer on a deal to help finance a house that he/she thought they could flip in three years at a profit, we might consider a payout of $15,000 in three years. This would be the same as collecting 14.47% interest on our money. If, on the other hand, a convicted con artist were making us an offer on a certain bridge in London, we would want a lot more than $15,000. In fact, there might not be any amount of money we would consider “worth the risk.” When we think like this we are creating a Time/Risk Value of Money. We want a higher payout based on how long we have to wait and how risky we think the deal might be.
We have been talking about a single final payment to this point. We discount that payment by the compound interest factor, (1+i)n, where ‘i’ is the interest rate and ‘n’ is the year. This same idea can be applied to multiple payments by adjusting ‘n’ for the appropriate year. This can be applied to payments or costs that are the same from year to year and to those that vary from year to year. Of course we don’t have to do this my hand. Excel and other spreadsheets have functions that can do this automatically.
Now let’s think about how our Research Manager might apply this thinking. Let’s start with a very simple scenario. Let’s suppose that we are thinking about our HVAC system in our Research Lab. Right now we are spending $10,000 per month on heating and cooling. Now suppose that an HVAC salesman proposes that we spend $125,000 on a new system that will save us 20% on our utilities. Let us also suppose that the system will last about 10 years before requiring a major overhaul. Should the Research Manager support the idea of putting in a new system?
The first thing that we should notice is that we have several payments and not just one. We actually have to consider the savings in years 1, 2, 3, etc. The easiest way to do this is to set up a table in Excel that shows all the costs and benefits. We can then discount each payment or savings and add them up. Our analysis might look something like:
Here we discount at 15%, 25% and 35%. Notice that this was done in a single step in the highlighted lower left hand corner by using the PV function of Excel. Also notice that the Present Value at a 15% discount is pretty close to our required investment. We could also apply a built in function in Excel called IRR (“Internal Rate of Return”). If we set it up correctly we will get an exact calculation of the discount rate where the investment matches the cash flows. Notice that it is just slightly less than 15%.
So…should we do it? Should we spend $125K on a new HVAC system? Well, maybe not. A 14% IRR is kind of at the bottom of required return on these kinds of investments (more on this later). Furthermore, the whole project runs 10 years. A lot can happen – some good and some bad. Utility prices might go up. That would probably make this a better deal. The HVAC might breakdown in year 7 and require $20K in repairs. We might kick ourselves for having tied up so much money in the new system. Of course, the salesman might be fibbing about the savings. And finally, we might have a better way to spend that $125K today. If there is another project with similar risk that pays out at 25%, we would want to do that first. All these factors need to be considered.
This approach helps a lot, but we still need to apply a lot of judgement. We can see that this technique can help us choose between options that have similar risks. Nevertheless, we need some absolute guidance. What discount rates should we use? What is the minimum IRR for different types of investments? We can only give very general guidance.
First of all we need to recognize that the discount rate we choose is based on both the Cost of Capital and Risk. Today the Cost of Capital is theoretically low, but, practically speaking, is actually fairly high. In theory interest rates are low. Hence, borrowed money should be cheap. Well, for most folks, it isn’t. In fact, some would argue that for Small Businesses today, credit exists only in very limited ways. It can be used to fund sales, buy real estate and purchase of some machinery, but rates are 8% to 18% depending on the use. Business Credit has been tight for years. Much of the credit in the world has been absorbed by governments trying to fund their economies or destroy their enemies. The US Government is a major player in both the domestic and world credit market.
In today’s markets, low business risk decisions like we illustrated above generally require around 15% as the minimum cut off on any discussion. Even when we know costs and savings very well, we still have the Cost of Capital plus general business Risk. Even if one is sure that the new HVAC system will save money, it is never clear if we will still be using the Research Lab as we have planned. We may decide to expand, contract, change the use or even move our operations. Hence, even the most certain of business decisions have generally required about 15% as a minimum discount rate for many years.
When the decision to be made involves new methods or procedures, the appropriate discount rate quickly increase to 25%. This would apply to well know processes that are being applied to projected conditions. In other words, if we are expanding our business to try to capture new sales, we need to increase our discount rate. We may know precisely how to make more widgets, but now our plan includes assumptions about the behavior of others. We are expecting widgets to stay a hot commodity. We are assuming that our competition won’t destroy the widget market, nor will widgets suddenly turn out to be declared “unsafe at any speed.”
When new technologies are involved, the discount rate can go to 35% and beyond. We are now entering the Venture Capital world of high risk and high reward. Rules of thumb like “double your money in 2 to 3 years” translates to IRR’s of 26% to 41%. This is the realm of where the Research Manager can give his/her greatest value to the organization. Certainly a good manager can weigh the merits of fairly simple decisions like buying a new HVAC system, but the real worth of the Research Manager comes in the area of actually impacting the Risk of a technical project. Few projects will ever be funded that require 35% return on investment or higher. The real job of the Research Manager is getting the risk down to more manageable levels. When that happens, new ideas suddenly become hot commodities. We will talk more about this process in subsequent blogs.
Ron Stites holds a BS in Chemistry and an MBA in Finance and Accounting. Stites & Associates, LLC, is a group of technical professionals who work with clients to improve laboratory performance and evaluate and improve technology by applying good management judgment based on objective evidence and sound scientific thinking. For more information see: www.tek-dev.net.
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