Page 1 Making Finance Relevant Creating Shareholder Value Through Corporate Finance Reengineering...

Making Finance RelevantMaking Finance Relevant

Creating Shareholder Value Through Creating Shareholder Value Through Corporate Finance ReengineeringCorporate Finance Reengineering

Finegan & Company LLCFinegan & Company LLC

Creating Shareholder Value Through Creating Shareholder Value Through Corporate Finance ReengineeringCorporate Finance Reengineering

Finegan & Company LLCFinegan & Company LLC

What Reengineering Does Not MeanWhat Reengineering Does Not Mean

Reengineering does not mean cost-cutting.Reengineering does not mean cost-cutting. It does not mean improving technology to do the It does not mean improving technology to do the

same tasks faster.same tasks faster. It does not mean TQM.It does not mean TQM. It does not mean continuous improvement.It does not mean continuous improvement.

What Reengineering Does MeanWhat Reengineering Does Mean

““the fundamental rethinking and radical redesign of the fundamental rethinking and radical redesign of business processes to achieve dramatic business processes to achieve dramatic improvements in critical, contemporary measures of improvements in critical, contemporary measures of performance”performance”

——M. Hammer, M. Hammer, Reengineering the CorporationReengineering the Corporation

Closely allied with:Closely allied with: Identifying and exploiting core competencies.Identifying and exploiting core competencies. Eliminating hand-offs and bureaucracy.Eliminating hand-offs and bureaucracy. Empowering employees to make their own decisions.Empowering employees to make their own decisions. Identifying the unmet, often unarticulated needs of customers.Identifying the unmet, often unarticulated needs of customers. Starting with a blank sheet of paper.Starting with a blank sheet of paper.

Why “Reengineering” Degenerates Into Cost-CuttingWhy “Reengineering” Degenerates Into Cost-Cutting

The finance functions seem too diverse for The finance functions seem too diverse for comprehensive, radical improvement.comprehensive, radical improvement.

It’s nearly impossible to measure the value It’s nearly impossible to measure the value created by any particular finance function.created by any particular finance function.

To Reengineer:Focus on the Process, Not the TaskTo Reengineer:Focus on the Process, Not the Task

Problem:Problem: The classical tools (or “tasks”) of The classical tools (or “tasks”) of finance are too slow, disconnected, finance are too slow, disconnected, and one-sided to be of practical and one-sided to be of practical value to line managers and value to line managers and stockholders.stockholders.

Consequence:Consequence: The entire strategic planning process The entire strategic planning process is discredited.is discredited.

Technology is the Essential EnablerTechnology is the Essential Enabler

Classical FinanceClassical Finance Reengineered FinanceReengineered Finance Developed to explainDeveloped to explain Developed to monitorDeveloped to monitor

investor behavior investor behavior and assist corporateand assist corporate(Shoe-horned into evaluating(Shoe-horned into evaluating behaviorbehaviorcorporate behavior)corporate behavior)

Mathematically basedMathematically based Simulation-basedSimulation-based (Inherently simplistic) (Inherently simplistic) (Comprehensive, potentially (Comprehensive, potentially

realistic)realistic)

One set of answers perOne set of answers per Multiple answersMultiple answersassumption setassumption set per assumption setper assumption set(Inherently reactive) (Inherently reactive) (Responsive and proactive)(Responsive and proactive)

The Proper Objectives ofFinance ReengineeringThe Proper Objectives ofFinance Reengineering

Improved quality and consistency of business Improved quality and consistency of business plan assumptions.plan assumptions.

Improved relevance and clarity to line managers.Improved relevance and clarity to line managers.

Sustained relevance throughout the year.Sustained relevance throughout the year.

Better contingency planning.Better contingency planning.

Don’t Get DistractedDon’t Get Distracted

Reengineering is not about cost-cutting. It’s about making Reengineering is not about cost-cutting. It’s about making planning and reporting processes facilitate better business planning and reporting processes facilitate better business decisions. Finance processes must be as flexible, decisions. Finance processes must be as flexible, responsive and “just-in-time” as the business processes responsive and “just-in-time” as the business processes they assist.they assist.

For many companies, devoting adequate attention to For many companies, devoting adequate attention to uncertainty would create far more value, at the margin, uncertainty would create far more value, at the margin, than devoting further financial resources to projecting, than devoting further financial resources to projecting, prescribing and policing “expected” returns.prescribing and policing “expected” returns.

Classic Signs of Disfunction:The Decentralization Paradox

Classic Signs of Disfunction:The Decentralization Paradox

Decentralization and empowerment Decentralization and empowerment lead to inconsistent assumptions, lead to inconsistent assumptions, benchmarks and objectives.benchmarks and objectives.

VisionVision

Decentralization and empowerment Decentralization and empowerment lead to improved responsiveness, lead to improved responsiveness, coordination, feedback and coordination, feedback and accuracy.accuracy.

RealityReality

Classic Signs of Disfunction:The Project Selection Paradox

Classic Signs of Disfunction:The Project Selection Paradox

Capital costs differ wildly between projects—even Capital costs differ wildly between projects—even within business units.within business units.

Line managers forced to forgo projects which, on paper, Line managers forced to forgo projects which, on paper, promise profitable IRR’s.promise profitable IRR’s.

VisionVision

Uniform cost of capital for each Uniform cost of capital for each business unit.business unit.

Projects selected on basis of Projects selected on basis of rank IRR or EVA.rank IRR or EVA.

RealityReality

Classic Signs of Disfunction:The Efficiency Paradox

Classic Signs of Disfunction:The Efficiency Paradox

Managers encouraged to pursue marginal Managers encouraged to pursue marginal product line extensions and efficiency gains, product line extensions and efficiency gains, instead of identifying new opportunities.instead of identifying new opportunities.

VisionVision

Managers encouraged to pursue all Managers encouraged to pursue all value-enhancing opportunities, value-enhancing opportunities, whether from efficiency whether from efficiency improvements, downsizing or growth.improvements, downsizing or growth.

1992

1993

1994

?RealityReality

1992

1993

1994

Defects of the Traditional Financial Planning ProcessDefects of the Traditional Financial Planning Process

Can't tell whether the “Base Can't tell whether the “Base Case” is the mean, mode, Case” is the mean, mode, median or—more likely—an median or—more likely—an arbitrary product of arbitrary product of negotiation.negotiation.

Can't tell whether the “Worst Can't tell whether the “Worst Case” represents a 0.01% Case” represents a 0.01% probability or a 25% probability or a 25% probability.probability.

Provides no guidance six Provides no guidance six months out about how to get months out about how to get back on plan if off.back on plan if off.

ImplicationsImplications

Capital Capital budgeting is budgeting is distorted by distorted by ignoring ignoring asymmetries in asymmetries in the distribution the distribution of value drivers.of value drivers.


Valuation Valuation efforts are efforts are compromised compromised by confusing by confusing goals with goals with expectations, expectations, modes with modes with means.means.


Incentive Incentive payments are payments are rendered rendered arbitrary by arbitrary by not reflecting not reflecting difficulty of difficulty of attainment.attainment.


Financing Financing decisions are decisions are distorted by not distorted by not gauging gauging downside risk downside risk accurately, and accurately, and by not by not evaluating the evaluating the fatness of fatness of “tails.”“tails.”


Communications Communications between the between the corporate office corporate office and the field are and the field are frustrated by not frustrated by not being sensitive to being sensitive to macroeconomic macroeconomic factors beyond factors beyond the control of the control of management.management.

The relationship between weather and resort attendance means . . .The relationship between weather and resort attendance means . . .


Communications Communications between the between the corporate office corporate office and the field are and the field are frustrated by not frustrated by not being sensitive to being sensitive to macroeconomic macroeconomic factors beyond factors beyond the control of the control of management.management.

It’s easy to confuse bad luck with bad managementIt’s easy to confuse bad luck with bad management

The Reengineering Approach:Focus on the Model, Not Point Estimates

The Reengineering Approach:Focus on the Model, Not Point Estimates

Express forecasts of value drivers as verifiable ranges, not point Express forecasts of value drivers as verifiable ranges, not point estimates.estimates.

Focus attention on how those value drivers inter-relate in the face Focus attention on how those value drivers inter-relate in the face of uncertainty.of uncertainty.

Manage business decisions and expectations on the basis of how Manage business decisions and expectations on the basis of how aggregate performance measures cluster, given variability in the aggregate performance measures cluster, given variability in the underlying value drivers.underlying value drivers.

Make strategic planning proactive and “contingency aware,” and Make strategic planning proactive and “contingency aware,” and thus useful to guiding investment decisions—not just policing thus useful to guiding investment decisions—not just policing them.them.

The Six Steps of Corporate Finance ReengineeringThe Six Steps of Corporate Finance Reengineering

Identify Value Drivers

Assign meaningful (if Assign meaningful (if possible, verifiable) patterns to possible, verifiable) patterns to the key ingredients or “value the key ingredients or “value drivers” of a forward plan.drivers” of a forward plan.

Posit relationships (again Posit relationships (again often verifiable) between often verifiable) between those value driversthose value drivers

Quantify RelationshipsQuantify Relationships

Build a better Build a better modelmodel

Identify Sources of Exposure


Re-compile management's forward Re-compile management's forward plan many, many times, allowing the plan many, many times, allowing the plan's value drivers to vary plan's value drivers to vary randomly.randomly.

Run Lots of Run Lots of SimulationsSimulations


Derive Derive distributions distributions for important for important aggregate aggregate measures.measures.

Re-examineRe-examine the Aggregates the Aggregates

0%

25%

50%

75%

100%

Total Revenue

Odds ofAttainingRevenue

Level

RelativeFrequency

“Base Case”

Mean


Base expectations, Base expectations, financing decisions financing decisions and rewards on and rewards on patterns in those patterns in those aggregate measures.aggregate measures.

Re-evaluate Re-evaluate ExpectationsExpectations


Use subset Use subset analysis to analysis to guide guide performance performance 6-to-18 6-to-18 months later.months later.

PlanPlanContingenciesContingencies


Plan ContingenciesPlan Contingencies

Summary of theReengineering ProcessSummary of theReengineering Process

Corporate finance reengineering tackles uncertainty by Corporate finance reengineering tackles uncertainty by concentrating attention on those components of performance where concentrating attention on those components of performance where randomness can be measured historically, and where it is thus randomness can be measured historically, and where it is thus easier to generate consensus among line managers as to bounds.easier to generate consensus among line managers as to bounds.

The alternative approach is to assign weights to arbitrary “best” The alternative approach is to assign weights to arbitrary “best” and “worst” scenarios. Although quicker, the approach does not and “worst” scenarios. Although quicker, the approach does not distill from historically verifiable relationships those factors over distill from historically verifiable relationships those factors over which management has influence, and is thus more prone to error. which management has influence, and is thus more prone to error. It is often impossible to explain the chosen weights to line It is often impossible to explain the chosen weights to line management, appearing instead to be a black box rationalization.management, appearing instead to be a black box rationalization.

Benefits of ReengineeringBenefits of Reengineering

Improves the quality and consistency of business plans and financial Improves the quality and consistency of business plans and financial reporting.reporting.

Makes finance understandable by shedding the black box, one answer Makes finance understandable by shedding the black box, one answer approach to financial modeling.approach to financial modeling.

Requires little or no statistical training.Requires little or no statistical training.

Makes fair calibration of bonus plans possible.Makes fair calibration of bonus plans possible.

Filters out the impact of macroeconomic factors beyond management’s Filters out the impact of macroeconomic factors beyond management’s control.control.

Extends the planning process’ relevance.Extends the planning process’ relevance.

Implications for IncentivesImplications for Incentives

Measure management's contribution to share value, not the economy's.Measure management's contribution to share value, not the economy's. The exercise price of employee stock options should be indexed against The exercise price of employee stock options should be indexed against

the stock price performance of competitors.the stock price performance of competitors. Cash bonuses should be based on discretionary EVA, not total EVA.Cash bonuses should be based on discretionary EVA, not total EVA.

Base expectations on verifiable levels of difficulty.Base expectations on verifiable levels of difficulty. Price options fairly.Price options fairly. Calibrate bonus plans fairly (a linear award schedule is presumptive Calibrate bonus plans fairly (a linear award schedule is presumptive

evidence of unfairness).evidence of unfairness). Revise goals and expectations to meet economic conditions at the Revise goals and expectations to meet economic conditions at the

time.time.

Other Areas of ApplicationOther Areas of Application

Annual planning and budgetingAnnual planning and budgeting Performance measurement and appraisalPerformance measurement and appraisal Interim planning and target-settingInterim planning and target-setting Capital budgeting and formationCapital budgeting and formation Treasury planningTreasury planning Stock option pricingStock option pricing Financial communicationFinancial communication Executive incentive compensationExecutive incentive compensation Acquisition pricing and planningAcquisition pricing and planning

In each of these areas, the framework for value-based planning is established.

What is needed now are explicit ways to measure, communicate and address uncertainty in a world where chaos has become the norm.

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