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Speakers:
Kevin Moss, Michelin
Dan McGarvey, Marsh
Learning Objectives
At the end of this session, you will:
• Understand the capital budgeting process and various methods
for allocating capital to competing projects
And Risk
Management
is at the
heart of it!
Capital Budgeting
• Free cash flow is a scarce resource – there will never be
enough to fund all proposals received
• All other things being equal, the highest NPV (or IRR) is the
first to be funded, followed by the next, until investment funds
are exhausted
The “Hurdle Rate”
• We know the risk tolerance and reward expectations for the
shareholders of any company
• The golden rule of resource allocation: If the return presented
is lower than the minimum expected by shareholders, GIVE
THE MONEY TO THEM INSTEAD AS DIVIDENDS
• The Hurdle Rate is this minimum threshold for capital
investments needed to meet shareholder expectations
• Of course, many capital expenditures do not yield profitable
returns, but may be required by regulators or otherwise
considered mandatory
• In any case, the first evaluation factor for any investment is
whether it is in line with stated corporate objectives and the
established risk philosophy of the firm
The First Cut
Does this proposal make
good sense for us?
• Is it consistent with the company’s stated
objectives?
• Is it in line with the expectations of our
stakeholders?
• Do we have the skills and experience to make
this work?
• Is there any risk to our brand?
Sample Options: $5 Million
Develop and launch a three-year marketing campaign
to increase familiarity of our signature product with a
younger audience:
• New packaging
• Product placement in key
movies/TV shows
• One Super Bowl ad
• Social networking
• Internet ad campaign
• “Our product is hip!”
Sample Options: $5 Million
Enter a new geography that our market researchers
believe has the potential to create expanded demand
for our product:
• Exclusive customer
• Advertising tie-in
• Broaden appeal for
product
• Drive demand for product
• Potentially profitable
investment
Sample Options: $5 Million
Develop new flavors of existing product to draw in new
customers based upon market research surveys as to
what would make customers consider our brand:
Initial Concepts:
• Smoked flavor
• Bacon flavor
• Hot chili flavor
CFO Challenge:
“Make Good Choices”
How Would You Characterize the Risk
Associated With These Four Options?
• Youth oriented advertising campaign?
• Expand to foreign market with partnership
investment?
• Investing in startup restaurant chain?
• Launch two new product flavors?
Net Present Value (NPV)
• Calculates the net worth
in dollars of investments
and returns spread over a
number of years
• Requires a company to
determine its “Discount
Rate” – typically a
minimum acceptable rate
of return for the
organization
Basis for Net Present Value
• A dollar in hand is worth more than the same
dollar promised in a future period
• There is an “Opportunity Cost” associated with a
dollar committed today to any project
• A project launched today must return a greater
rate than our capital cost to fund it
1 Discount rate 8%
1Discount rate 8%
• It is not uncommon,
therefore, to prescribe a
minimum “Breakeven
Period” to weed out projects
that require long periods of
time to mature