“Is this investment a positive NPV (Net Present Value)”, used to ask Prof. Raghavendra Rau, while solving case studies in the 1st year Advanced Corporate Finance course. Solving some case studies required us to calculate the NPV, taking into account forecasted cash inflows (benefits of the investment) and cash outflows (costs of the investment) of the investment, which were provided in the case study. If the calculated NPV is positive, the investment could be profitably pursued and if it is negative, it would be better off not pursuing, as the investment would be loss-making. This popular capital budgeting technique is used as a base to accept or reject a proposed investment.
While just the NPV calculation is straight forward, I am a bit confused and thus curious about the process of forecasting cash inflows and cash outflows. How does one precisely know the cash inflows and cash outflows of an investment before it is actually implemented? Who is responsible in the company to provide these forecasts to the analyst? Are there any real-world instances when the forecasts have gone terribly wrong in large multi-national corporations? Is there any process or methodology to be followed to make a near-perfect forecast and appropriate investment decision?
Making the Compelling Business Case, taught by Prof. Wolfgang Messner, in Myra School of Business, has overwhelmingly answered my previous questions and, in fact, busted few faulty assumptions of mine. While the course name itself is self-explanatory about its scope, I believe my key takeaway from this course is – Investment decision in an organization should be pursued by building a robust BUSINESS CASE, rather than just based on mere analysis or just intuition or gut feeling.
Through the course, it is unfortunate to learn that most of the companies even today go-ahead on the investment decisions without proper cost-benefit analysis, due to lack of knowledge and experience, leading to failed projects or missed targets in the projects. Also, in many companies despite a proper cost-benefit analysis, the final decision is taken based on decision maker’s intuition or guts feeling or even based on his/her personal agenda. In fact, we can reflect on our own previous decisions in our own life, when we trusted our intuition more than logic and reason.
This should not be the case in a company, as we might end up making huge losses due to our inability to build a logical and rational process for deciding on a proposed investment. Just to quote an example of bad investment which is exemplified in the course, KIN phone by Microsoft is a disastrous $ 1 Billion investment which has hardly reaped any benefits to the company. There were only 503 phone sales, during its two-month presence in the market. How can a company like Microsoft make such a pathetic investment decision? Are all their forecasts just a fiction? Or else did they go ahead with the investment decision without proper cost-benefit analysis?
Thus, this course emphasizes on building a robust business case and encourages using it as a process, as well as a tool to guide a decision maker on an investment. Business Case, from a process perspective, has six phases – Understating the investment need, Analyzing the costs (cash outflows), Discovering the benefits (cash-inflows), Evaluating NPV & risk & uncertainty, Presentation of analysis to senior management and Measuring the investment’s performance. Each phase in the process builds on the previous phase and acts as a learning process to discover the wins and losses of the investment while the business case is developed. I believe a process approach would provide an analyst a systematic approach to exploring all the possibilities in terms of costs, benefits, risks and strategic future options that are relevant to the investment decision. The end result is a business case document with recommendations on investment alternatives, which can be considered as a tool to convince the different stakeholders in the organization along with the senior management.
As a part of the course, we are required to build a business case on a hypothetical investment case which interests us, to serve as a practice. During building the business case, I have realized the importance and difficulty in identifying and forecasting the costs and benefits of the investment. It could be quite difficult if not impossible to chalk down all the costs & benefits and forecast their values for the investment period, which may range from 1 year to 20 years depending on the type of the investment. Beyond the cost and benefits, it is important to understand the impact of certain variables to understand the risk involved in the investment and scope for strategic flexibility options in future. However, certain tools and frameworks provided in the course textbook – Making the compelling business case are of specific use during this process.
Other key learning during the course includes – the importance of presentation skills (Presentation slides and vocal communication). Right from my under-graduation, I am not a firm believer of need for outstanding presentation skills though I value them to a certain extent. However, I am convinced with the professor argument for the need of outstanding presentation skills in the real business world. He has a rich experience as a consultant, and I believe he is right. We have spent almost equal time on building a good presentation compared to the time spent on analysis. The whole effort in building the business case goes futile if it is not well presented to the decision makers.
Sai Deepak Reddy
February 23, 2016