FinancialModel
New Product Development—A Financial Model
Application Note AN-8 by Christopher Moore Introduction Companies face many challenges in new product development, not the least of which is choosing the best projects. Many factors must be considered, but I’ll focus on projecting the financial performance of a project.
While there are a number of single measures intended to capture a product’s financial goodness, my view is that veral measures should be ud. I will discuss three of them--NPV, IRR, and total development cost--in this article.
Net prent value (NPV)
In each time period, a certain net number of real dollars flow in or out. We could just add all the cash flows and get a single number, but that would overlook the hidden cost of missing al-ternative investment opportunities and their financial rewards. For example, if we didn’t pay out $130,000 in development costs in Year 1, we could invest it in stocks or money market funds. So we ek an analy
sis that takes into account a rate of return for a comparable investment.
Another factor we would overlook if we just added up the cash flows is the time element. $40,000 net cash flow earned in Year 2 is less valuable than it would be if earned in Year 1 becau if it were earned earlier we could invest it and earn income at the rate of return during the year. Converly, an expen paid out in the future is less costly than one paid now becau we could invest the money and earn return until it was time to pay the ex-pen.
Net prent value analysis prents the various predicted cash flows of the project as a single number, called the NPV. All the projected expenditures and income, all the projected sales quan-tities, cost of units sold, etc. are wrapped up and distilled into one number. NPV is calculated by this formula:
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i
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NPV
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where i is the number of time periods from the start, r is the ex-pected rate of return, and value is the cash flow for time period i. Internal rate of return (IRR)
IRR is a clo cousin of NPV. In fact, the definitions are such that the NPV of a ries of cash flows, evaluated with an r equal to the IRR of the same ries of cash flows, is zero. The IRR of a ries of cash flows gives the rate of return that would result in an NPV of zero, hence it is the rate of return of the project itlf, with no comparison to any other investment’s rate of return. Spreadsheet entries
The spreadsheet shows the project running against a time line. Choo a time interval, probably quarters or months, perhaps years.
The example here shows only summary lines: you will almost certainly want to work from a more detailed estimate of each line item. It’s convenient to place the detail for each line on its own sheet in a spreadsheet workbook.
Product design costs include staff costs (burdened), outside con-sultants and rvice bureaus, project materials, small tools, equipment, etc.
Marketing and sales expens would include staff costs, adver-tising, product introduction activities, literature and documenta-tion, travel, etc.
怎么培养表达能力>英文qq网名Production startup costs would include production fixtures, test software development, etc.
Understanding the results
The results are summarized by three numbers.
The first is the project NPV, $91,812. This tells us that, com-pared to some other investment opportu
hangonity with a rate of return of 10%, this project will return $91,812 over and above the 10% return. We get a feeling for the magnitude of the financial return from NPV.
The IRR, 16%, shows us the rate of return of this project, a rate that we can compare to other investment opportunities. We choo to look at IRR as well as NPV to get a feeling for the profitability of the project in relative terms.
We also show a development cost, $835,000. This gives us an appreciation for the total amount we will have to put at risk to develop the product and prepare it for the factory and the mar-ketplace.
Finally, the distribution of development cost and cash flow viewed over the project time periods shows us how long we must wait before the spending winds down and the earning begins. Several other items could be added to the spreadsheet. Addi-tional rows (and perhaps graphs) could show the accumulating development cost and cash flow against time.
Comparing projects and alternative investments Comparison is at the heart of this kind of financial analysis. Even when modeling one project, we are comparing it to an
alternative investment via the rate of return ud in the NPV analysis, while the IRR gives us a rate of return which we com-pare to that of other opportunities.
While it is uful to look at each project individually, an analysis like this is most uful when we are trying to choo which of veral propod projects to develop. It is important to compare projects of similar risk and to u a rate of return that corre-
sponds to the project risk. A variant or line extension project (perhaps tested against a 10 to 20% rate of return) usually has lower risk than a new platform project (which might be com-pared with a rate of return of 20 to 30%).
Predicting: perhaps the toughest part of analysis
Financial forecasts are notoriously tough, and no part is tougher than estimating sales volumes. The more time you can spend getting real market data and refining your estimates, the better.Don’t forget to offt sales income to allow for new product cannibalization of sales of prent products.
经典英文歌曲100首Also difficult to forecast are schedule time for development and,naturally, development cost. Finally, estimates of the cost of units sold can be riously in error. Go into enough detail to become confide
nt of your numbers, but remember that one day planning must end, choices must be made, and development must begin.
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Explore various scenarios
The joy of spreadsheets (if there is any), lies in their ability to quickly run scenarios. I like to build a “realistic” scenario
first, then edit it into pessimistic and optimistic versions. It’s also uful to vary key parameters such as the cost of units sold,the sales volume, and the schedule duration to explore the nsi-tivity of the project to the parameters.When the project simply must go on
Sometimes new projects are chon despite poor projected NPV or IRR, as when it is simply imperative for a company to lead with new technology, play catch up with a competitor, or expand its line for synergistic effect with existing projects. In such cas, financial models are still important becau they give the company a basis for planning borrowing and cash flow.Handling projects with sunk costs
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If you develop the financial model some time after a project has started, after money has already been spent, you might be tempted to roll the previous costs, the “sunk costs,” into the model. While you might want to do that to get a sobering appre-ciation for the profitability of the project, you should not let
sunk costs influence the here and now decision of whether or not to go forward. A go/no go decision should only depend upon the viability of the project compared with alternative projects, from now forward.二次函数顶点式
Acknowledgement
Special thanks go to Merle Kummer of Kummer Consultants,Belmont, MA, for helpful contributions and
suggestions.Bibliography
Ulrich, Karl, and Eppinger, Steven, "Product Design and Devel-opment," McGraw-Hill, Inc., 1995.
Brealey, Richard, and Meyers, Stewart, “Principles of Corporate Finance,” McGraw-Hill, Inc., 1981.
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