Dan McGarvey, CPCU, ARMDan McGarvey, CPCU, ARMManaging Director, MarshManaging Director, Marsh

Financial Fluency - Financial Fluency - Communicating Your Communicating Your Ideas With the BossIdeas With the Boss

March 22, 2007March 22, 2007

RIMS 2007 Webinar SeriesRIMS 2007 Webinar Series““Speak Finance Like a Native”Speak Finance Like a Native”

Module 2Module 2

2

Greetings Greetings fromfrom::

3

Your Webcast HostYour Webcast Host

• Dan McGarveyDan McGarvey• Naval Nuclear EngineerNaval Nuclear Engineer• 17 Yr Marsh Veteran17 Yr Marsh Veteran• Utility and ConstructionUtility and Construction• MBA Univ. of Rhode IslandMBA Univ. of Rhode Island• CPCU, ARM, CEBSCPCU, ARM, CEBS

4

Your questions are most Your questions are most welcome…welcome…

…and will be answered - one …and will be answered - one way or another. way or another.

5

Thanks for your terrific Thanks for your terrific feedback from Session 1…feedback from Session 1…

““It was worth every penny It was worth every penny it cost me to listen in”it cost me to listen in”

Unnamed Risk ManagerUnnamed Risk Manager

6

In Our Last Episode...In Our Last Episode...

Who are your owners?Who are your owners?What is their appetite for risk?What is their appetite for risk?What can capital structure andWhat can capital structure and enterprise lifecycle tell meenterprise lifecycle tell meResearching to find the answersResearching to find the answers

Don’t miss the exciting conclusionDon’t miss the exciting conclusion

at: at: www.RIMS.orgwww.RIMS.org

7

The value of a dollar, depends on The value of a dollar, depends on whose it is…whose it is…

8

The Risk-Reward ContinuumThe Risk-Reward Continuum

Level of RiskLevel of Risk

Exp

ecte

d R

ewar

d

Where isWhere is your firm?your firm?

3.7% (historical T-bill average)3.7% (historical T-bill average)

EquityEquityRiskRisk

PremiumPremium

9

The Beta Factor and the Volatility The Beta Factor and the Volatility Continuum Continuum

Volatility (Beta)Volatility (Beta)

Exp

ecte

d R

ewar

d

Where isWhere is your firm?your firm?

10

The Risk-Reward ContinuumThe Risk-Reward Continuum

Level of Risk/VolatilityLevel of Risk/Volatility

Exp

ecte

d R

ewar

dIs your riskIs your risk

management program management program in step with thein step with the

risk appetite of yourrisk appetite of yourowners?owners?

11

The Enterprise LifecycleThe Enterprise Lifecycle

StartupStartup

Growth

Growth

MaturityMaturity Decline

Decline

12

Introduction to Dividend TheoryIntroduction to Dividend Theory

StartupStartup

Growth

Growth

MaturityMaturity Decline

Decline“Income” Companies

“Growth” Companies

What type ofWhat type ofinvestor wouldinvestor wouldfavor one overfavor one over

the other?the other?

13

The Golden Rule ofThe Golden Rule of Dividend Theory Dividend Theory

If you have run out of capitalIf you have run out of capitalinvestment opportunities thatinvestment opportunities thatmeet shareholder expectations meet shareholder expectations for Rate of Return…for Rate of Return…

Give the money to them!Give the money to them!

14

Where the Money GoesWhere the Money Goes

FreeFreeCashCashFlowFlow

ReinvestReinvestIn FirmIn Firm

Pay Pay DividendsDividends

RetainedRetainedEarningsEarnings

15

Competition With Other Department Leaders for Competition With Other Department Leaders for Scarce Financial Resources is Most Evident Scarce Financial Resources is Most Evident

During the During the Capital BudgetingCapital Budgeting Process Process

16

Risk Management Investments:Risk Management Investments:Unique AspectsUnique Aspects • Normally little real down side Normally little real down side

exposureexposure

• Buoyed by “reputational risk” Buoyed by “reputational risk” considerationsconsiderations

• Assumptions no less subjective than Assumptions no less subjective than any other business disciplineany other business discipline

• Seldom run afoul of any Mission Seldom run afoul of any Mission Statements or objectivesStatements or objectives

17

Initial PreparationInitial Preparation

• How do we propose / evaluate?How do we propose / evaluate?

• How does the expenditure I am How does the expenditure I am contemplating support the mission of contemplating support the mission of the enterprise?the enterprise?

• Where can I find support for this from Where can I find support for this from within the firm?within the firm?

• How do our competitors handle this?How do our competitors handle this?

18

Starting Point for Capital Budgeting…Starting Point for Capital Budgeting…

How do we model and evaluate How do we model and evaluate competing capital projects?competing capital projects?

• What discount rate do we use?What discount rate do we use?

• What is our evaluation horizon?What is our evaluation horizon?

• What is our “hurdle rate”?What is our “hurdle rate”?

• How do we account for risk?How do we account for risk?

19

Capital Budgeting MethodsCapital Budgeting Methods

• All require development of a formal All require development of a formal business case with estimated cash business case with estimated cash outlays and inflowsoutlays and inflows

• Payback PeriodPayback Period• Net Present ValueNet Present Value• Internal Rate of ReturnInternal Rate of Return

20

Evaluating “Payback Period”Evaluating “Payback Period”

• The most primitive capital budgeting The most primitive capital budgeting methodology – a thumb rule at bestmethodology – a thumb rule at best

• Use might suggest the firm is in a cash Use might suggest the firm is in a cash crunch or other difficult periodcrunch or other difficult period

• Quite simply – the number of years it will Quite simply – the number of years it will require to make back the value of the require to make back the value of the investment requiredinvestment required

21

““Payback Period” ExamplePayback Period” Example

• A $500,000 ergonomic adjustment to our A $500,000 ergonomic adjustment to our assembly line will save us $100,000 per assembly line will save us $100,000 per year in back injury costsyear in back injury costs

• The payback period for this investment The payback period for this investment is five yearsis five years

• Problem: Problem: Payback Period analysis Payback Period analysis ignores the length of time value is ignores the length of time value is provide and the time value of moneyprovide and the time value of money

22

The Other Two Capital Budgeting Methods The Other Two Capital Budgeting Methods Require Recognition of The Time Value of Require Recognition of The Time Value of

MoneyMoney

It’s Not a It’s Not a Myth!Myth!My Own ExperienceMy Own Experience

is Proof Enough !is Proof Enough !

23

A dollar received today is worth A dollar received today is worth more than one promised in the more than one promised in the future…future…

24

Four Types of ProblemsFour Types of ProblemsFuture value of present amountFuture value of present amountFuture value of an annuityFuture value of an annuityPresent value of future amountPresent value of future amountPresent value of an annuityPresent value of an annuity

25

8% 9% 10% 11% 12% 13% 14%

1 1.0800 1.0900 1.1000 1.1100 1.1200 1.1300 1.1400

2 1.1664 1.1881 1.2100 1.2321 1.2544 1.2769 1.2996

3 1.2597 1.2950 1.3310 1.3676 1.4049 1.4429 1.4815

4 1.3605 1.4116 1.4641 1.5181 1.5735 1.6305 1.6890

5 1.4693 1.5386 1.6105 1.6851 1.7623 1.8424 1.9254

6 1.5869 1.6771 1.7716 1.8704 1.9738 2.0820 2.1950

7 1.7138 1.8280 1.9487 2.0762 2.2107 2.3526 2.5023

8 1.8509 1.9926 2.1436 2.3045 2.4760 2.6584 2.8526

9 1.9990 2.1719 2.3579 2.5580 2.7731 3.0040 3.2519

10 2.1589 2.3674 2.5937 2.8394 3.1058 3.3946 3.7072

11 2.3316 2.5804 2.8531 3.1518 3.4786 3.8359 4.2263

12 2.5182 2.8127 3.1384 3.4985 3.8960 4.3345 4.8179

13 2.7196 3.0658 3.4523 3.8833 4.3635 4.8981 5.4924

14 2.9372 3.3417 3.7975 4.3104 4.8871 5.5348 6.2613

15 3.1722 3.6425 4.1772 4.7846 5.4736 6.2543 7.1379

16 3.4259 3.9703 4.5950 5.3109 6.1304 7.0673 8.1372

Future Value TableFuture Value TablePeri

od

sPeri

od

sDiscount Factor

26

The Paper RouteThe Paper Route

I earned $1200 per year for threeI earned $1200 per year for three years ending at age thirteenyears ending at age thirteenWhat could this be worth today?What could this be worth today?

$3,600 lump sum invested$3,600 lump sum investedThirty five years of growthThirty five years of growthAssume 10% compounded RORAssume 10% compounded ROR

News

27

Future Value Table

35 14.7853 20.4140 28.1024 38.5749 52.7996 72.0685 98.1002

Periods 8% 9% 10% 11% 12% 13% 14%

The initial investment of $3600 would beThe initial investment of $3600 would beworth more than $100,000 today!!worth more than $100,000 today!!

28

Annuity Future Value TableAnnuity Future Value TablePeri

od

sPeri

od

sDiscount Factor

8%8% 9%9% 10%10% 11%11% 12%12% 13%13% 14%14%

11 1.00001.0000 1.00001.0000 1.00001.0000 .1.0000.1.0000 1.00001.0000 1.00001.0000 1.00001.0000

22 2.08002.0800 2.09002.0900 2.10002.1000 2.11002.1100 2.12002.1200 2.13002.1300 2.14002.1400

33 3.24643.2464 3.27813.2781 3.31003.3100 3.34213.3421 3.37443.3744 3.40693.4069 3.43963.4396

44 4.50614.5061 4.57314.5731 4.64104.6410 4.70974.7097 4.77934.7793 4.84984.8498 4.92114.9211

55 5.86665.8666 5.98475.9847 6.10516.1051 6.22786.2278 6.35286.3528 6.48036.4803 6.61016.6101

66 7.33597.3359 7.52337.5233 7.71567.7156 7.91297.9129 8.11528.1152 8.32278.3227 8.53558.5355

77 8.92288.9228 9.20049.2004 9.48729.4872 9.78339.7833 10.089010.0890 10.404710.4047 10.730510.7305

88 10.636610.6366 11.028511.0285 11.435911.4359 11.859411.8594 12.299712.2997 12.757312.7573 13.232813.2328

99 12.487612.4876 13.021013.0210 13.579513.5795 14.164014.1640 14.775714.7757 15.415715.4157 16.085316.0853

1010 14.486614.4866 15.192915.1929 15.937415.9374 16.722016.7220 17.548717.5487 18.419718.4197 19.337319.3373

1111 16.645516.6455 17.560317.5603 18.531218.5312 19.561419.5614 20.654620.6546 21.814321.8143 23.044523.0445

1212 18.977118.9771 20.140720.1407 21.384321.3843 22.713222.7132 24.133124.1331 25.650225.6502 27.270727.2707

1313 21.495321.4953 22.953422.9534 24.522724.5227 26.211626.2116 28.029128.0291 29.9X4729.9X47 32.088732.0887

1414 24.214924.2149 26.019226.0192 27.975027.9750 30.094930.0949 32.392632.3926 34.882734.8827 37.581137.5811

1515 27.152127.1521 29.360929.3609 31.772531.7725 34.405434.4054 37.279737.2797 40.417540.4175 43.842443.8424

1616 30.324330.3243 33.003433.0034 35.949735.9497 39.189939.1899 42.753342.7533 46.671746.6717 50.980450.9804

29

College Savings 101College Savings 101

Target - Target - $130,000$130,000 at age eighteen at age eighteen Monthly contribution requiredMonthly contribution required (assume 9% ROR) starting:(assume 9% ROR) starting:

At birthAt birthAt age fiveAt age fiveAt age tenAt age ten

30

FV Annuity Table – “Funding for College”FV Annuity Table – “Funding for College”

Peri

od

sPeri

od

s8%8% 9%9% 10%10% 11%11% 12%12% 13%13% 14%14%

11 1.00001.0000 1.00001.0000 1.00001.0000 .1.0000.1.0000 1.00001.0000 1.00001.0000 1.00001.0000

22 2.08002.0800 2.09002.0900 2.10002.1000 2.11002.1100 2.12002.1200 2.13002.1300 2.14002.1400

33 3.24643.2464 3.27813.2781 3.31003.3100 3.34213.3421 3.37443.3744 3.40693.4069 3.43963.4396

44 4.50614.5061 4.57314.5731 4.64104.6410 4.70974.7097 4.77934.7793 4.84984.8498 4.92114.9211

55 5.86665.8666 5.98475.9847 6.10516.1051 6.22786.2278 6.35286.3528 6.48036.4803 6.61016.6101

66 7.33597.3359 7.52337.5233 7.71567.7156 7.91297.9129 8.11528.1152 8.32278.3227 8.53558.5355

77 8.92288.9228 9.20049.2004 9.48729.4872 9.78339.7833 10.089010.0890 10.404710.4047 10.730510.7305

88 10.636610.6366 11.028511.0285 11.435911.4359 11.859411.8594 12.299712.2997 12.757312.7573 13.232813.2328

99 12.487612.4876 13.021013.0210 13.579513.5795 14.164014.1640 14.775714.7757 15.415715.4157 16.085316.0853

1010 14.486614.4866 15.192915.1929 15.937415.9374 16.722016.7220 17.548717.5487 18.419718.4197 19.337319.3373

1111 16.645516.6455 17.560317.5603 18.531218.5312 19.561419.5614 20.654620.6546 21.814321.8143 23.044523.0445

1212 18.977118.9771 20.140720.1407 21.384321.3843 22.713222.7132 24.133124.1331 25.650225.6502 27.270727.2707

1313 21.495321.4953 22.953422.9534 24.522724.5227 26.211626.2116 28.029128.0291 29.9X4729.9X47 32.088732.0887

1414 24.214924.2149 26.019226.0192 27.975027.9750 30.094930.0949 32.392632.3926 34.882734.8827 37.581137.5811

1515 27.152127.1521 29.360929.3609 31.772531.7725 34.405434.4054 37.279737.2797 40.417540.4175 43.842443.8424

1616 30.324330.3243 33.003433.0034 35.949735.9497 39.189939.1899 42.753342.7533 46.671746.6717 50.980450.9804

1717 33.750233.7502 36.973736.9737 40.544740.5447 44.500844.5008 48.883748.8837 53.739153.7391 59,117659,1176

1818 37.450237.4502 41.301341.3013 45.599245.5992 50.395950.3959 55.749755.7497 61.725161.7251 68.394168.3941

31

College Savings 101College Savings 101

Target - $130,000 at age eighteenTarget - $130,000 at age eighteen Monthly contribution requiredMonthly contribution required (assume 10% ROR) starting:(assume 10% ROR) starting:

At birthAt birth - $ 262 - $ 262 At age fiveAt age five - $ 472 - $ 472 At age tenAt age ten - $ 982- $ 982

32

College Savings 101College Savings 101

Target - $130,000 at age eighteenTarget - $130,000 at age eighteen Monthly contribution requiredMonthly contribution required (assume 10% ROR) starting:(assume 10% ROR) starting:

At birthAt birth - $ 262 - $ 262 ($ 56,592)($ 56,592)At age fiveAt age five - $ 472 - $ 472 ($ 73,632)($ 73,632)At age tenAt age ten - $ 982 - $ 982 ($ 94,272)($ 94,272)

33

401K – When to Start?401K – When to Start?

$10,000 invested per year for 25$10,000 invested per year for 25 years 9% compounded rateyears 9% compounded rateWhat if you took the first yearWhat if you took the first year off?off? (How much could it possibly hurt?)(How much could it possibly hurt?)

34

8%8% 9%9% 10%10% 11%11% 12%12% 13%13% 14%14%

Annuity Future Value TableAnnuity Future Value TablePeri

od

sPeri

od

sDiscount Factor

20 45.7620 51.1601 57.2750 64.2028 72.0524 80.9468 91.0249

21 50.4229 56.7645 64.0025 72.2651 81.6987 92.4699 104.7684

22 55.4568 62.8733 71.4027 81.2143 92.5026 105.4910 120.4360

23 60.8933 69.5319 79.5430 91.1479 104.6029 120.2048 138.2970

24 66.7648 76.7898 88.4973 102.1742 118.1552 136.8315 158.6586

25 73.1059 84.7009 98.3471 114.4133 133.3339 155.6196 181.8708

$10,000 X 84.7 =$10,000 X 84.7 = $ 847,000$ 847,000

35

8%8% 9%9% 10%10% 11%11% 12%12% 13%13% 14%14%

Annuity Future Value TableAnnuity Future Value TablePeri

od

sPeri

od

sDiscount Factor

20 45.7620 51.1601 57.2750 64.2028 72.0524 80.9468 91.0249

21 50.4229 56.7645 64.0025 72.2651 81.6987 92.4699 104.7684

22 55.4568 62.8733 71.4027 81.2143 92.5026 105.4910 120.4360

23 60.8933 69.5319 79.5430 91.1479 104.6029 120.2048 138.2970

24 66.7648 76.7898 88.4973 102.1742 118.1552 136.8315 158.6586

25 73.1059 84.7009 98.3471 114.4133 133.3339 155.6196 181.8708

$10,000 X 84.7 =$10,000 X 84.7 = $ 847,000$ 847,000 $79,000 !! $79,000 !! $10,000 X 76.8 = $10,000 X 76.8 = $ 768,000$ 768,000

36

Present Value AnnuityPresent Value Annuity

Lottery winnings of $1,000,000Lottery winnings of $1,000,000Ten annual payments of $100,000Ten annual payments of $100,000Can I have it all now?Can I have it all now?Lottery discount factor is .8Lottery discount factor is .8

37

Annuity Present Value TableAnnuity Present Value TablePeri

od

sPeri

od

sDiscount Factor

8%8% 9%9% 10%10% 11%11% 12%12% 13%13% 14%14%

11 .9259.9259 .9174.9174 .9091.9091 .9009.9009 .8929.8929 .8850.8850 .8772.8772

22 1.78331.7833 1.75911.7591 1.73551.7355 1.71251.7125 1.69011.6901 1.66811.6681 1.64671.6467

33 2.57712.5771 2.53132.5313 2.48692.4869 2.44372.4437 2.40182.4018 2.36122.3612 2.32162.3216

44 3.31213.3121 3.23973.2397 3.16993.1699 3.10243.1024 3.03733.0373 2.97452.9745 2.91372.9137

55 3.99273.9927 3.88973.8897 3.79083.7908 3.69593.6959 3.60483.6048 3.51723.5172 3.43313.4331

66 4.62294.6229 4.48594.4859 4.35534.3553 4.23054.2305 4.11144.1114 3.99763.9976 3.88873.8887

77 5.20645.2064 5.03305.0330 4.86844.8684 4.71224.7122 4.56384.5638 4,42264,4226 4.28834.2883

88 5.74665.7466 5.53485.5348 5.33495.3349 5.14615.1461 4.96764.9676 4.79884.7988 4.63894.6389

99 6.24696.2469 5.99525.9952 5.75905.7590 5.53705.5370 5.32835.3283 5.13175.1317 4.94644.9464

1010 6.71016.7101 6.41776.4177 6.14466.1446 5.88925.8892 5.65025.6502 5.42625.4262 5.21615.2161

1111 7.13907.1390 6.80526.8052 6.49516.4951 6.20656.2065 5.93775.9377 5.68695.6869 5.45275.4527

1212 7.53617.5361 7.16077.1607 6.81376.8137 6.49246.4924 6.19446.1944 5.91765.9176 5.66035.6603

1313 7.90387.9038 7.48697.4869 7.10347.1034 6.74996.7499 6.42356.4235 6.12186.1218 5.84245.8424

1414 8.24428.2442 7.78627.7862 7.36677.3667 6.98196.9819 6.62826.6282 6.30256.3025 6.00216.0021

1515 8.55958.5595 8.06078.0607 7.60617.6061 7.19097.1909 6.81096.8109 6.46246.4624 6.14226.1422

1616 8.85148.8514 8.31268.3126 7.82377.8237 7.37927.3792 6.97406.9740 6.60396.6039 6.26516.2651

38

Present Value AnnuityPresent Value Annuity

Lottery winnings of $1,000,000Lottery winnings of $1,000,000Ten annual payments of $100,000Ten annual payments of $100,000Can I have it all now?Can I have it all now?Lottery discount factor is .8Lottery discount factor is .8

Answer: $ 671,000Answer: $ 671,000

39

Net Present Value (NPV)Net Present Value (NPV)

• An effective capital budgeting toolAn effective capital budgeting tool

• Simply project the net cash flows Simply project the net cash flows required for and resulting from your idea required for and resulting from your idea for the period to be evaluatedfor the period to be evaluated

• Calculate the net present value of this Calculate the net present value of this stream of cash flowsstream of cash flows

• Positive NPV is good – the larger, the Positive NPV is good – the larger, the betterbetter

40

To Sprinkler, or Not to Sprinkler...To Sprinkler, or Not to Sprinkler...

Developing a winning business caseDeveloping a winning business case

41

What is your firm’s mission statement?What is your firm’s mission statement?

What are the firm’s key goals for the year?What are the firm’s key goals for the year?

What is your department mission statement?What is your department mission statement?

How does what you are proposing support How does what you are proposing support the key objectives of the firm?the key objectives of the firm?

Before You Begin…Before You Begin…

42

Analyst Expectations

Analyst Expectations

Know Your Situation…Know Your Situation…

How is the firm’s year going?How is the firm’s year going?

43

Installation Cost:Installation Cost: $(300,000)$(300,000)Annual Maintenance Annual Maintenance $ (2,000)$ (2,000)Annual Ins. SavingsAnnual Ins. Savings $ $ 10,00010,000Net Annual Impact $ 8,000Net Annual Impact $ 8,000

Brigade EquipmentBrigade Equipment $(20,000)$(20,000)Replace in Five YearsReplace in Five Years $(20,000)$(20,000)Ann. Training/DrillsAnn. Training/Drills $(30,000)$(30,000)

To Sprinkler, or Not to Sprinkler...To Sprinkler, or Not to Sprinkler...

44

Question:Question:

How do I know what How do I know what discount rate to use in discount rate to use in evaluating net present evaluating net present value problems?value problems?

45

$300,000 Today$300,000 Today $ 300,000$ 300,000$8,000 savings (10 years)$8,000 savings (10 years) $ ( 53,680) $ ( 53,680)

Total -Total - $ 246,320$ 246,320

Sprinkler Option:Sprinkler Option:

Net Present Cost of Sprinkler ProtectionNet Present Cost of Sprinkler Protection

(Note: 8% discount rate applied)(Note: 8% discount rate applied)

46

Annuity Present Value TableAnnuity Present Value TablePeri

od

sPeri

od

sDiscount Factor

8%8% 9%9% 10%10% 11%11% 12%12% 13%13% 14%14%

11 .9259.9259 .9174.9174 .9091.9091 .9009.9009 .8929.8929 .8850.8850 .8772.8772

22 1.78331.7833 1.75911.7591 1.73551.7355 1.71251.7125 1.69011.6901 1.66811.6681 1.64671.6467

33 2.57712.5771 2.53132.5313 2.48692.4869 2.44372.4437 2.40182.4018 2.36122.3612 2.32162.3216

44 3.31213.3121 3.23973.2397 3.16993.1699 3.10243.1024 3.03733.0373 2.97452.9745 2.91372.9137

55 3.99273.9927 3.88973.8897 3.79083.7908 3.69593.6959 3.60483.6048 3.51723.5172 3.43313.4331

66 4.62294.6229 4.48594.4859 4.35534.3553 4.23054.2305 4.11144.1114 3.99763.9976 3.88873.8887

77 5.20645.2064 5.03305.0330 4.86844.8684 4.71224.7122 4.56384.5638 4,42264,4226 4.28834.2883

88 5.74665.7466 5.53485.5348 5.33495.3349 5.14615.1461 4.96764.9676 4.79884.7988 4.63894.6389

99 6.24696.2469 5.99525.9952 5.75905.7590 5.53705.5370 5.32835.3283 5.13175.1317 4.94644.9464

1010 6.71016.7101 6.41776.4177 6.14466.1446 5.88925.8892 5.65025.6502 5.42625.4262 5.21615.2161

1111 7.13907.1390 6.80526.8052 6.49516.4951 6.20656.2065 5.93775.9377 5.68695.6869 5.45275.4527

1212 7.53617.5361 7.16077.1607 6.81376.8137 6.49246.4924 6.19446.1944 5.91765.9176 5.66035.6603

1313 7.90387.9038 7.48697.4869 7.10347.1034 6.74996.7499 6.42356.4235 6.12186.1218 5.84245.8424

1414 8.24428.2442 7.78627.7862 7.36677.3667 6.98196.9819 6.62826.6282 6.30256.3025 6.00216.0021

1515 8.55958.5595 8.06078.0607 7.60617.6061 7.19097.1909 6.81096.8109 6.46246.4624 6.14226.1422

1616 8.85148.8514 8.31268.3126 7.82377.8237 7.37927.3792 6.97406.9740 6.60396.6039 6.26516.2651

47

$20,000 Today$20,000 Today $ 20,000$ 20,000+$20,000 Five Years fm now+$20,000 Five Years fm now $$+$30,000 NPV for ten years+$30,000 NPV for ten years $_______$_______

Fire Brigade Option:Fire Brigade Option:

Net Present Cost of the Fire BrigadeNet Present Cost of the Fire Brigade

48

Present Value TablePresent Value TablePeri

od

sPeri

od

sDiscount Factor

8%8% 9%9% 10%10% 11%11% 12%12% 13%13% 14%14%

11 .9259.9259 .9174.9174 .9091.9091 .9009.9009 .8929.8929 .8850.8850 .8772.8772

22 .8573.8573 .8417.8417 .8264.8264 .8116.8116 .7972.7972 .7831.7831 .7695.7695

33 .7938.7938 .7722.7722 .7513.7513 .7312.7312 .7118.7118 .6931.6931 .6750.6750

44 .7350.7350 .7084.7084 .6830.6830 .6587.6587 .6355.6355 .6133.6133 .5921.5921

55 .6806.6806 .6499.6499 .6209.6209 .5935.5935 .5674.5674 .5428.5428 .5194.5194

66 .6302.6302 .5963.5963 .5645.5645 .5346.5346 .5066.5066 .4803.4803 .4556.4556

77 .5835.5835 .5470.5470 .5132.5132 .4817.4817 .4523.4523 .4251.4251 .3996.3996

88 .5403.5403 .5019.5019 .4665.4665 .4339.4339 .4039.4039 .3762.3762 .3506.3506

99 .5002.5002 .4604.4604 .4241.4241 .3909.3909 .3606.3606 .3329.3329 .3075.3075

1010 .4632.4632 .4224.4224 .3855.3855 .3522.3522 .3220.3220 .2946.2946 .2697.2697

1111 .4289.4289 .3875.3875 .3505.3505 .3173.3173 .2875.2875 .2607.2607 .2366.2366

1212 .3971.3971 .3555.3555 .3186.3186 .2858.2858 .2567.2567 .2307.2307 .2076.2076

1313 .3677.3677 .3262.3262 .2897.2897 .2575.2575 .2292.2292 .2042.2042 .1821.1821

1414 .3405.3405 .2992.2992 .2633.2633 .2320.2320 .2046.2046 .1807.1807 .1597.1597

1515 .3152.3152 .2745.2745 .2394.2394 .2090.2090 .1827.1827 .1599.1599 .1401.1401

1616 .2919.2919 .2519.2519 .2176.2176 .1883.1883 .1631.1631 .1415.1415 .1229.1229

49

$20,000 Today$20,000 Today $ 20,000$ 20,000+$20,000 Five Years fm now+$20,000 Five Years fm now $ 13,600$ 13,600+$30,000 NPV for ten years+$30,000 NPV for ten years $ 201,300$ 201,300 Total -Total - $ 234,900$ 234,900

Fire Brigade Option:Fire Brigade Option:

(Versus $246,320 for Sprinklers)(Versus $246,320 for Sprinklers)

Net Present Cost of the Fire BrigadeNet Present Cost of the Fire Brigade

50

Other Considerations...Other Considerations...

Cost of sleepCost of sleepDamage to reputationDamage to reputationService interruptionService interruptionPotential injury costPotential injury cost

Is it worth $11,420 ?Is it worth $11,420 ?

51

You’ve Made This a “No-Brainer”You’ve Made This a “No-Brainer”

52

Internal Rate of Return (IRR)Internal Rate of Return (IRR)

• Another effective capital budgeting toolAnother effective capital budgeting tool

• Unlike NPV, cannot be manually Unlike NPV, cannot be manually calculated. IRR determination requires calculated. IRR determination requires an iterative calculation processan iterative calculation process

• One shortcoming – IRR calculation One shortcoming – IRR calculation requires one to assume that the firm can requires one to assume that the firm can make the same ROR on other options as make the same ROR on other options as the one being evaluatedthe one being evaluated

53

The “Hurdle Rate”The “Hurdle Rate”

Anything lesswould be

irresponsible!

54

The “Hurdle Rate”The “Hurdle Rate”

• You must show a case for exceeding You must show a case for exceeding this rate of return using IRR this rate of return using IRR calculation to have a project fundedcalculation to have a project funded

• Hurdle rate contemplates cost of Hurdle rate contemplates cost of capital, returns required by our capital, returns required by our shareholders, and riskshareholders, and risk

• How does your firm adjust for risk How does your firm adjust for risk when evaluating capital projects?when evaluating capital projects?

55

Hurdle Rate DeterminationHurdle Rate Determination

• Start with cost of capitalStart with cost of capital• Add factor for overheadAdd factor for overhead• Add acceptable marginAdd acceptable margin• Add factor for riskAdd factor for risk• Check horoscopeCheck horoscope

Note: There is no standardNote: There is no standard formula or approachformula or approach to setting this barto setting this bar

56

The Answer is on Your ComputerThe Answer is on Your Computer

Tables represent ideal conditionsTables represent ideal conditionsExcel and all spreadsheet programs Excel and all spreadsheet programs help address real world scenarioshelp address real world scenariosIRR calculations are complex and IRR calculations are complex and require the use of a spreadsheetrequire the use of a spreadsheetAdded advantage – sensitivity analysisAdded advantage – sensitivity analysis

Example: $1,000,000 investment savesExample: $1,000,000 investment saves$500,000 year one, then $300,000, $200,000,$500,000 year one, then $300,000, $200,000,$150,000 and $75,000. Find IRR and NPV. $150,000 and $75,000. Find IRR and NPV.

57

The Answer is on Your ComputerThe Answer is on Your Computer

1.1. Lay out Lay out netnet cash flows per year in cells cash flows per year in cells2.2. Select “Insert” then “Function”Select “Insert” then “Function”3.3. NPV requires cells + discount factorNPV requires cells + discount factor4.4. IRR requires cells + IRR “guess”IRR requires cells + IRR “guess”

1 2 3 4 5

-500,000 300,000 200,000 150,000 75,000 NPV = $103,233

-500,000 300,000 200,000 150,000 75,000 IRR = 22%

Payback Period = 3 Years

58

Business Case Study

“ “Don’t Panic – Don’t Panic – They’re Organic!”They’re Organic!”

59

Business Case StudyBusiness Case Study

• Privately held firmPrivately held firm

• Mature industry segment Mature industry segment

• Historic total return – 8%Historic total return – 8%

• Discount rate for NPV – 8%Discount rate for NPV – 8%

• Hurdle rate required – 13%*Hurdle rate required – 13%*

* May be adjusted for risk* May be adjusted for risk

60

House RulesHouse Rules• $1 million Free Cash Flow available $1 million Free Cash Flow available

for capital investmentfor capital investment

• No new debt authorizedNo new debt authorized

• Use IRR and NPV to presentUse IRR and NPV to present

• Five year evaluation periodFive year evaluation period

• Explain how your proposal meets Explain how your proposal meets our corporate objectivesour corporate objectives

61

Proposal 1: “Superbowl Ad”Proposal 1: “Superbowl Ad”

• Thirty second ad is a $1 mil. BargainThirty second ad is a $1 mil. Bargain

• Suggest a new use for our product:Suggest a new use for our product:

““Beans for Breakfast”Beans for Breakfast”• Aim to attract curious new usersAim to attract curious new users

• Cash flow projections:Cash flow projections:($500,000), $300,000, $175,000($500,000), $300,000, $175,000$100,000, $75,000$100,000, $75,000

62

Proposal 2: “New Market”Proposal 2: “New Market”• $1 million to launch product in $1 million to launch product in

selected markets in Chinaselected markets in China

• A billion new bean eaters!A billion new bean eaters!

• Not a traditional part of the Not a traditional part of the Chinese dietChinese diet

• Might have to “tweak” recipeMight have to “tweak” recipe• Cash flow: Cash flow: ($1,000,000), $150,000, ($1,000,000), $150,000,

$350,000, $450,000, $500,000$350,000, $450,000, $500,000

63

Proposal 3: “Behavior-Based Proposal 3: “Behavior-Based Safety” InvestmentSafety” Investment• $1 million for high impact program$1 million for high impact program

• Other foodservice industry customers Other foodservice industry customers have reduced losses by 30%have reduced losses by 30%

• For us this will be $250,000For us this will be $250,000

• Assume program impact will remain Assume program impact will remain after the initial training periodafter the initial training period

• Cash flows: Cash flows: ($750,000), $250,000, $250,000, ($750,000), $250,000, $250,000, $250,000, $250,000$250,000, $250,000

64

““Sexiness Quotient” Sexiness Quotient” vs. vs.

“Riskiness Quotient”“Riskiness Quotient”

Project 1 2 3 4 5 IRR NPV

Super-B -500000 $300,000 $175,000 $100,000 $75,000 15% $57,706.05

Peking -1,000,000 $150,000 $350,000 $450,000 $500,000 14% $151,571.21

Hurt-Free -750,000 $250,000 $250,000 $250,000 $250,000 13% $72,251.58

65

Capital Budgeting withCapital Budgeting with RiskRisk• Certainty Equivalent approachCertainty Equivalent approach• Multi discount rate approachMulti discount rate approach• Stair-stepped hurdle ratesStair-stepped hurdle rates• Sensitivity AnalysisSensitivity Analysis

Don’t forget consistency with Don’t forget consistency with organizational mission! This isorganizational mission! This ismore important than ever whenmore important than ever whenrisk is introducedrisk is introduced

66

Presenting Your Plan…Presenting Your Plan…• Know your assumptionsKnow your assumptions• Avoid jargonAvoid jargon• Anticipate questions Anticipate questions

67

Don’t Under Any Circumstances Don’t Under Any Circumstances Use an Iceberg AnalogyUse an Iceberg Analogy

68

Predictable “Spoilers”Predictable “Spoilers”

• What are your assumptions?What are your assumptions?• Why haven’t we done this before?Why haven’t we done this before?• Who else is doing this?Who else is doing this?• What do our competitors do?What do our competitors do?• Has legal/accounting/tax signed off?Has legal/accounting/tax signed off?

69

The Secrets to Becoming Conversant The Secrets to Becoming Conversant in Finance and Accounting in Finance and Accounting

• Finance and Accounting have a language Finance and Accounting have a language all their ownall their own

• Risk management also has its own set of Risk management also has its own set of terms - which can generate frustrationterms - which can generate frustration

• Actively listen and ask questions to Actively listen and ask questions to increase your vocabularyincrease your vocabulary

• Its not all about numbers and mathIts not all about numbers and math!!

70

Thanks to Marsh and RIMS forThanks to Marsh and RIMS fortheir sponsorship of this seriestheir sponsorship of this series

Module 1 is archived at RIMS.org and Module 1 is archived at RIMS.org and available for your accessavailable for your access

Please join us again on April 17Please join us again on April 17thth

from 1:00 to 2:00 PM for module 3, from 1:00 to 2:00 PM for module 3, which is titled:which is titled:

Shameless Plug:Shameless Plug:

71

The OtherThe Other Face of RiskFace of RiskManagementManagement

The Art and ScienceThe Art and Scienceof Hedgingof Hedging

..

Options, futures,Options, futures,swaps, derivatives,swaps, derivatives,collars, forwards, collars, forwards, Value at Risk, puts,Value at Risk, puts,calls, strike price, calls, strike price, etc…etc…

72

Thank You for Thank You for Your KindYour KindAttentionAttention