Homework help (excel)
Gogold 
AET702Ch7.pptxChapter 7
Choosing Innovation Projects
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Overview
Methods of choosing innovation projects range from informal to highly structured, and from entirely qualitative to strictly quantitative.
Often firms use a combination of method to more completely evaluate the potential (and risk) of an innovation project.
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The Development Budget 1
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.
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Quantitative Methods for Choosing Projects 1
Commonly used quantitative methods include discounted cash flow methods and real options.
Discounted Cash Flow (DCF).
Net Present Value (NPV): Expected cash inflows are discounted and compared to outlays.
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F/P and P/F for Spreadsheets
Future value F is calculated using FV function:
FV(i%,n,,P)
Present value P is calculated using PV function:
PV(i%,n,,F)
Note the use of double commas in each function
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5
Example: Finding Future Value
A person deposits $5000 into an account which pays interest at a rate of 8% per year. The amount in the account after 10 years is closest to:
(A) $2,792 (B) $9,000 (C) $10,795 (D) $12,165
The cash flow diagram is:
FV(i%,n,,P)
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6
Example: Finding Present Value
A small company wants to make a single deposit now so it will have enough money to purchase a backhoe costing $50,000 five years from now. If the account will earn interest of 10% per year, the amount that must be deposited now is nearest to:
(A) $10,000 (B) $ 31,050 (C) $ 33,250 (D) $319,160
The cash flow diagram is:
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7
Quantitative Methods for Choosing Projects 2
Internal Rate of Return (IRR): The discount rate that makes the net present value of investment zero.
Calculators and computers perform by trial and error.
Potential for multiple IRR if cash flows vary.
Strengths and Weaknesses of DCF Methods:
Strengths.
Provide concrete financial estimates.
Explicitly consider timing of investment and time value of money.
Weaknesses.
May be deceptive; only as accurate as original estimates of cash flows.
May fail to capture strategic importance of project.
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Internal Rate of Return
The interest rate at which the present worth and equivalent uniform annual worth are equal to 0.
(For borrowing) The interest rate paid on the unpaid balance of a loan such that the payment schedule makes the unpaid loan balance equal to 0 when the final payment is made.
(For investment) The interest rate earned on the un-recovered investment such that the payment schedule makes the un-recovered investment equal to 0 at the end of the investment life.
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9
Combining Quantitative and Qualitative Information 2
Data Envelopment Analysis (DEA) uses linear programming to combine measures of projects based on different units (for example, rank versus 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.
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Linear Programming
Weekly supply of raw materials:
6 Large Bricks
8 Small Bricks
Products:
Table Chair
Profit = $20/Table Profit = $15/Chair
2 large
2 small
1 large
2 small
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Linear Programming
Linear programming uses a mathematical model to find the best allocation of scarce resources to various activities so as to maximize profit or minimize cost
Objective function: Mathematical statement of profit (or cost) for a given solution
Decision variables: Amounts of either inputs or outputs
Constraints: Limitations that restrict the available alternatives
Parameters: Numerical constants
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Select projects to maximize PW at i 15% and b $70,000
| Project | Initial investment, $ | Annual NCF, $ | Life, years | Salvage value, $ |
| A | 25,000 | 6,000 | 4 | 4,000 |
| B | 20,000 | 9,000 | 4 | 0 |
| C | 50,000 | 15,000 | 4 | 20,000 |
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Maximize
($
15
)
Chairs
+
($
20
)
Tables
subject to
Large Bricks:
Chairs
+
2
Tables
£
6
Small Bricks:
2
Chairs
+
2
Tables
£
8
and
Chairs
³
0
,
Tables
³
0
.
