Although Net Present Value calculations are often blamed for companies’ under-investing in innovation projects, and are a big problem for people trying to drive growth into new areas, it can be useful to get some sense of what the potential NPV of a prospective project might be. My colleague, Ian MacMillan, working with Alan Abrahams and several other folks have come up with a nifty idea they call the “BareBones” NPV approach. Essentially, it asks you to assemble the following information for a project:
1. Launch Time: How long will it be before the project begins to generate its first revenues?
2. Ramp up time: How long will it take from first revenues to reach steady state? The BareBones NPV estimator will assume there is a linear ramp up in revenues from the period of first revenue to the period of steady state.
3. Competitive response time: How long after launch will it take for competitors to respond?
4. Competitive erosion time: How long will it take for the competitors to erode your profits to the point that you are only just recovering your fixed costs? The BareBones NPV estimator will assume that profits drop off linearly from the start of the competitive response time to the end of the erosion time.
5. Total investment. What is the total investment expected to be? The BareBones NPV estimator will assume that this is a one-time investment incurred at the end of the launch time.
6. Discount rate. This number is used to discount future cash flows to account for the fact that if you weren’t doing this project, you could just as easily leave your money in a bank account and earn interest. The idea is that a sum of money in your pocket today is worth more than the same amount 5 years from now, because today’s money could earn interest. If you don’t know the rate for your firm, your finance guys should be able to give you this (and they might insist that you adjust it upward for risk, as well). They might refer to it as the cost of capital but the idea is the same – using money for your project means you can’t use it for something else, and unless your project offers better returns than a savings account, it’s a value-destroyer for your firm.
They have very kindly offered to allow me to put this idea together with a tutorial and software tool, up on this site. If you would like to give it a try, you can download two files: the first is a tutorial which explains how the software works, and the second is a ZIP software file that you can download to play with the actual software. This is a demo version—if you’d like to use the real thing, there are instructions in the zip file for how to get a full copy.
Feedback and suggestions on this are most welcome!
This is the tutorial file: BareBonesNPV_Tutorial.doc
This is the software ZIP file: BareBonesNPV.zip