management of technology & innovation mktg5603 ...€¦ · risk analysis with options pricing...

©Mazzarol 2015 all rights reserved

Management of Technology & Innovation MKTG5603 &

Biotechnology Commercialisation MKTG5604

Workshop 3 Part B: Assessing

Risk Professor Tim Mazzarol – UWA Business School

UWA Business School MBA Program

M Biotech Program

[email protected] MOTI MKTG5603

BC MKTG5604



Risk Management Basics

Identify risks

Analyse the risks

Evaluate the risks

Treat the risks

Monitor the risks Establish

Context

Source: Schnepple 2006

Hi Tech Venture

Failure to get patents or regulatory

approvals. Laboratory needs 24/7

power and IT, product launch in 3

months.

Product launch needs:

plastic injection parts;

packaging, marketing

materials & distribution

agreement signed.

Plastic injection parts tooling

not finished, awaiting first

samples to validate

production process - (High

Risk)

Schedule design review of

part, tooling and chosen

plastic raw material with

external experts. Draw up

contingency plan for 100%

inspection.

Monitor % yield of production

process once started, tooling

may deteriorate or raw

material quality may vary.


Technical versus Market Risk

0

10

20

1 11 21

Market

Te

ch

no

log

y

Existing New

Evolutionary Leverage base

RadicalDiscontinuity

Ne

wE

xis

tin

g

Increasing

Risk

Technical Success Factors:

• Proprietary Position

• Competencies/Skills

• Complexity

• Access to External Technology

• Manufacturing capability

Source: Davis et al. 2001


Technical versus Market Risk

Source: Davis et al. 2001

0

10

20

1 11 21

Market

Te

ch

no

log

y

Existing New

Evolutionary Leverage base

RadicalDiscontinuity

Ne

wE

xis

tin

g

Increasing

Risk

Commercial Success Factors:

• Customer/Market Need

• Market/Brand recognition

• Distribution Channels

• Customer Strength

• Raw Materials Supply

• Environment, Health & Safety


Technology & Market Risk


Risk Assessment

• Rank projects using economic or net present

value (NPV)

• NPV (a form of Discounted Cash Flow) can be

used in two ways:

– To make “Go/Kill” decisions at gates based on NPV

“hurdle rates”

• if positive Go, if negative Kill.

– As part of a portfolio review with all projects ranked

according to NPV

• Go projects are at top of the list.

• Other techniques:

– Internal Rate of Return (IRR)

• Value of discount rate that forces NPV to zero

• Project’s ROI%

– Payback Period Source: Cooper (2011)

Assessing the financial, technical and market risk of a project is important in order

to avoid wasting resources on dead ends. It is key to the “Go/Kill” decisions

required in the NPD process.


Discounted Cash Flow (DCF)

• DCF (discounted cash flow) analysis:

– Recognizes that money has a time value.

– Is a cash flow method not caught by accounting practices

(e.g. accruals).

Source: Cooper (2011)

Example:

• $200m payable in 5 years by Reserve Bank of Australia

• What is it worth today?

• At a Discount Rate of 20%, NPV =

• The Discount Rate depends on the risk:

• Government bond rate

• Share market investment

• Venture capital investment

mm

4.80$2.1

200$5


Finding the Hurdle Rate

• Normally the Discount Rate used is the

firm’s cost of capital adjusted for the “risk

level” for that type of project.

• An alternative can be to use a discount

rate equal to the lowest rate achieved by

projects of this type within the product

portfolio. – Use the IRR of the lowest-return project of that

type.

– Projects with negative NPV are below the worst

projects of that type in the portfolio and should be

killed.

– Helps to boost up the quality of the portfolio.



Using Project NPV to Rank Projects


1 2 3 4 5 6 7

Project PV (present value of

future earnings)

Development

Cost

Commercial-

ization cost

NPV (Net present

value)

Ranking

based on NPV

Decision

Alpha $30m $3m $5m $22m 4 Hold

Beta $64m $5m $2m $57m 2 Go

Gamma $9m $2m $1m $6m 5 Hold

Delta $3m $1m $0.5m $1.5m 6 Hold

Echo $50m $5m $3m $42m 3 Hold

Foxtrot $66m $10m $2m $58m 1 Go

Notes:

• Top four projects are Foxtrot, Beta, Echo and Alpha.

• There is a resource limitation of $15m so only two projects can “Go”.

• NPV portfolio value = $115m from both projects.


Rank Projects using Productivity Index

• Under conditions of resource limitation

the use of NPV alone is too restrictive.

• Use NPV for “Go/Kill” decisions on

projects but the “Productivity Index” to

rank and prioritize them.


Productivity Index =

NPV of the project

Total resources remaining to be

spent on the project


Productivity Index Project Ranking


1 2 3 4 5

Project NPV Development

cost

Productivity

Index

(NPV/Dev Cost)

Sum of Dev

Costs

Beta $57m $5m $11.4m $5m

Echo $42m $5m $8.4m $10m

Alpha $22m $3m $7.3m $13m

Foxtrot $58m $10m $5.8m $23m

Gamma $6m $2m $3.0m $25m

Delta $1.5m $1m $1.5m $26m

Notes:

• Productivity index used to rank projects until out of resources.

• “Go” projects are now Beta, Echo and Alpha, Foxtrot drops below the line.

• NPV portfolio value = $121m from three projects if Gamma is added this boosts to $127m.

Resource

Limit

$15m


Risk Analysis with Options Pricing Theory

• DCF / NPV methods fail to deal well with

high levels of risk and uncertainty.

• They assume “all or nothing” decisions

and don’t work well with NPD that has

staged development process.

• As the NPD process moves forward the

project’s risk is adjusted. Options pricing

theory is therefore considered better

than NPV for many NPD situations.



First Chicago Method

• Based on DCF method.

• Considers the likelihood of the

R&D succeeding.

• Predicts 3 possible outcomes:

– Best Case

– Most Likely Case

– Worst Case


Decision Tree Analysis

Development

$D

($3m)

Launch

$C

($5m)

$10m

$15m

$30m

$0m $8m

$5m

$ECV

Commercial Success

$PV

Commercial Failure

YES

NO

YES

NO Technical Failure

Technical Success

Notes:

• $ECV = Expected Commercial Value of the project.

• Probability of technical success = 80%.

• Probability of commercial success (given technical success) = 50%.

• $D = Development costs remaining in project = $3m.

• $C = Commercialization costs = $5m.

• $PV = Net Present Value of project’s future earnings (discounted to today) = $30m. Source: Cooper (2011)

80

20

50

50

Expected value before launch =

0.5 x $30m + 0.5 x 0 = $15m Expected value once in development =

0.8 x $10m + 0.2 x 0 = $8m


T=0

Invest $3m x 4 years T=4, Invest $70m

for commercialisation

T=5

Terminal value

Invest R&D

R&D Success

R&D Fail

0.7

0.3

0.12

0.48

0.4

Best Case

$600m

Best Guess

$100m

Blocked

$0m

Commercialise

$120

At T=4 NPV=

$120/1.2-70=$30m

NPV of R&D = -9.32m

NPV of Project = $-9.32 +0.7*14.47 = $0.81m

Discounted to T=0:

30m/1.2^4=14.47m

First Chicago Method

Source: Steffens & Douglas 2004

=Uncertain

Event

Discount

Rate

Valuation

($m)

15% $3.90

20% $0.81

25% -$1.40

30% -$2.98

40% -$4.90

50% -$5.84

(20% discount rate)


T=0

Invest $3m x 4 years T=4, Invest $70m for

commercialisation?

T=5

Terminal value

Invest R&D

R&D Success

R&D Fail

0.7

0.3

0.3

0.7

Good Market

Poor Market

Commercialise

Abandon

0.4

0.2

0.4

Best Case

$600m

Best Guess

$100m

Blocked

$0m

Best Case

$600m

Best Guess

$100m

Blocked

$0m

0.0

0.6

0.4

Commercialise

Abandon

$260

$60

At T=4 NPV=

$260/1.2-70=$146m

At T=4 NPV=

$60/1.2-70=$-20m

NPV of R&D = -9.32m

NPV of Project = $-9.32 +0.7*0.3*70.7 = $5.53m

Discounted to T=0:

146m/1.2^4=70.7m =Uncertain Event

=Management

Decision

Decision Tree Analysis (20% discount rate)

Source: Steffens & Douglas 2004


Sensitivity to Discount Rate

Discount

Rate

Valuation

DCF

($m)

Valuation

First Chicago

($m)

Valuation

Decision Tree

($m)

15% $55.28 $3.90 $8.89

20% $42.12 $0.81 $5.53

25% $32.10 -$1.40 $3.01

30% $24.41 -$2.98 $1.10

40% $13.80 -$4.90 -$1.44

50% $7.26 -$5.84 -$2.94

DCF: all risk is penalised via single discount rate leading to wide range of

valuations vs. discount rate

First Chicago: Discount rate and risk are treated separately, NPV is much

less sensitive to discount rate

Decision Tree: Shows the value of the option to abandon (in this case

under poor market conditions at T=4)



Risk Management 3 Approaches


1. Keep it simple “Low/Medium/High” only. Higher precision

is not realistic, focus instead on

understanding cause/effect relationships

2. Rate 0…100% using

expert opinion

Most commonly used method, but even the

most qualified experts can be way off the

mark

3. Anchored scales Provide a set scale with precise

descriptions for each value (e.g. from 0 to

10) – reduces spread of ratings by different

individuals


FACTOR Very low 0-10 Very high

1. Strategic Fit & Importance: • Alignment of project with business strategy. • Importance of project to the strategy. • Impact on the business.

0

5

10

2. Product & Competitive Advantage: • Product delivers unique customer or user benefits. • Product offers customer/user excellent value for money. • Differentiated product vs. competitors. • Positive customer/user feedback on product concept (concept test results).

0

6

10

3. Market Attractiveness: • Market size. • Market growth and future potential. • Margins earned by competitors in the market. • Competitiveness – how tough & intense is competition.

0

8

10

4. Core Competencies Leverage: • Project leverage our core competencies & strengths in technology, operations, marketing, sales &

distribution.

0

9

10

5. Technical Feasibility: • Size of technical gap. • Familiarity of technology to the business. • Newness of technology (base to embryonic). • Technical complexity. • Technical results to date (proof of concept).

0

1

10

6. Financial Reward versus Risk: • Size of financial opportunity. • Financial returns (NPV, ECV). • Productivity index • Certainty of financial estimates. • Level of risk & ability to address risks.

0

7

10

Scorecard for NPD Project Selection

Project Attractiveness Score: 36/60 = 60% • Projects scored 0-10 rating scales for 6 factors. • Project Attractiveness score taken out of 100. • Scores >60/100 usually given “Go” decision.


New Technology Projects are Different

• Financial risk assessment methods don’t

work very well for technology-platforms

and advanced-technology projects.

• Use a scorecard with more strategic and

qualitative criteria to assess risk.

• Strategy drives the portfolio and new

high-tech projects should be assessed

with custom-tailored systems not forced

through the stage-gate process.



Strategic Buckets “Mercedes Star” Method


1. Business Strategy Fit 0 Score 0-10 10 Congruence Only peripheral fit with our strategy 1 Strong fit with our strategy

Impact Minimal impact no harm if dropped 2 Firm's future depends on project

2. Strategic Leverage 0 10 Propriety position Easily copied no protection 5 Strong protection difficult to copy

Platform for growth Dead end, one of a kind or one off 6 Offers strong plaform for new products

Durability (technical & marketing) No distinct advantage easily leapfrogged 8 Long lifecycle with opportunity for growth

Synergy with other operations Limited to single business area 7 Could be offered across company

3. Probability of technical success 0 10 Technical gap Radical innovation new scientific paradigm 6 Incremental improvement easy to do

Program complexity Highly complex with many hurdles 10 Easy to produce, straightforward to do

Technology skill base No existing technological skills in firm 8 Technology widely practiced within the firm

Availability of people & facilities Must hire and build 8 People and facilities already available

4. Probability of commercial success 0 10 Market need No clear market need identified 5 Large existing market need identified

Market maturity Market is declining 3 Market is growing

Comptetitive intensity Many strong competitors in the market 2 Few competitors in the market

Commercial application skills New company without commercial skills 6 Company already has strong commercial skills

Commercial assumptions High uncertainty of commercial success 8 High certainty of commercial success

Regulatory/Social/Political impact Highly negative 7 Highly positive

5. Reward 0 10 Absolute contribution to profitability (5 year cumulative)

Very weak contribution 8 Very strong contribution

Payback period (guesstimate) Very long 7 Very short

Time to commercial start-up Very long 6 Very short

Total score 113 Maximum score 190

Score/100 59% Project attractiveness total 100

Project attractiveness score 59


Group Discussion

Working in teams

• Review the project’s technical and

commercial risk.

• Examine the financial returns

using available tools:

– NPV/IRR/DCF

– Decision tree analysis

• Examine project risk using:

– Project attractiveness

scorecards

• How does the project stack up?

– What are the “Go/Kill” issues?

End of Presentation

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