Innovation in Technology

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Chapter7.docx

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Chapter seven

Choosing Innovation Projects

The Mahindra Shaan: Gambling on a Radical Innovation

Mahindra Tractors, the Farm Equipment Sector of the Mahindra & Mahindra Group in India is one of the world’s largest producers of tractors. a  In the late 1990’s, over 20 percent of Indian’s gross domestic product came from agriculture and nearly 70 percent of Indian workers were involved in agriculture in some way. b  However, seasonal rainfall meant that Indian farmers only used tractors for farming purposes about one-third of the year. The rest of the year they would use the tractors for personal transportation and to haul goods to earn extra income. Many farmers made modifications to their tractors to make them more useful as transporters. Furthermore, a large number of farmers had plots so small—perhaps 1–3 hectares—that it was difficult to raise enough funds to buy any tractor at all. Managers at Mahindra & Mahindra sensed that there might be an opportunity for a new kind of tractor that better served this market.

R.N. Nayak, R&D Manager at Mahindra & Mahindra (and a person well-known as a maverick that tended to break with company norms) began developing a prototype for a radical product concept he called the “Sactor”—a hybrid between a transporter and a tractor that farmers could use on and off the farm. Nayak believed that innovators should always start out with an attempt to gain deep insight into a customer problem through extensive observation rather than financial or technical analysis—too much analysis would stifle innovation. As he stated it, “start with the pictures not with the numbers.” c

In just over a year, he had developed a prototype of the futuristic looking vehicle. It had smaller tires than a typical tractor that would be better for driving on roads. It also drew from the aesthetics of the Jeeps Mahindra & Mahindra made in their automotive division. No marketing studies had been conducted and sales people were reluctant to support the new vehicle, particularly since Indian farm equipment market was in a deep downturn due to repeated droughts and excess tractor inventory. Nayak himself was unsure of how customers would react to the trade-offs that had been required to produce the economically priced page 130hybrid—after all, it would have lower farming performance than Mahindra & Mahindra’s other tractors. To make matters worse, even after 15 production prototypes had been built, the Sactor had technical problems that needed to be resolved. Frustrated with the project’s slow progress, Nayak left Mahindra & Mahindra.

Nayak’s departure could have meant the death of the project, however Sanjeev Goyle, Head of Mahindra & Mahindra’s Farm Equipment Sector was intrigued by the project, deeming it the “perfect confluence of M&M’s two core strengths: Jeeps and tractors.” His prior experience at American Home Products (healthcare) and Piaggio (motor scooters) made him realize how important dramatic innovation could be for a company. He felt that the company’s existing farm equipment lines were too similar to those of competitors; innovation had been too incremental and the products appealed primarily to older farmers. He wanted a way to invigorate the product line up and the brand. As he noted, “My background in fast-moving consumer goods and motor scooters makes me a firm believer that new products and innovation can create a new aura in brands and make the brands appear to be on the move.”

Goyle decided to send Sactor prototypes out to 14 dealers so that they could be used in customer trials. Feedback from the trails revealed that customers were primarily using the hybrid for hauling materials. Goyle also believed that the aesthetics of the Sactor needed some work. He overhauled the exterior of the vehicle to make it more “macho” and Jeep-like. The new vehicle, renamed the “Shaan” (Hindi for “pride”), had a 23.5 horsepower engine and a built in trolley capable of lifting up to 750 kilograms. It could run standard farm implements such as cultivators, rotators, and harrows, but it was also capable of traveling at about 40 kilometers per hour on the road. Its small turning radius (3.2 meters) made it especially maneuverable. To make the vehicle more comfortable for personal transportation, it had a spring leaf suspension (for fewer bumps and a more comfortable ride), a soft top canopy, and a windscreen with wipers. d  The target market would include lower income farmers and semi-urban youth.

Producing the vehicle would require building a new assembly line, and engineering that turned out to be necessary to increase its reliability led to higher production costs—this meant that the Shaan would have to be priced at 2.95 lakh (295,000) rupees to be profitable (a price that would buy a conventional 35 horsepower tractor). There was great uncertainty about how many of the vehicles could be sold at that price. Mahindra & Mahindra’s management, however, was swayed by Goyle’s argument that “even if we made small margins, we would be pioneers, be distinctive: innovative.”

The Shaan was launched in mid-2006 and won an award from the American Society of Agricultural and Biological Engineers as one of the 50 outstanding innovations of the year. Though many consumers were perplexed by its “funny looks” e  The Shaan turned out to be extremely useful for several specialty applications. f  For example, in the brick kiln industry, its small turning radius was a huge advantage (before the Shaan, workers were reliant on donkeys for moving the bricks due to the small spaces in which they had to work). By 2008, Mahindra & Mahindra’s senior management considered the Shaan a “runaway success.” g

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Discussion Questions:

1. Why does Nayak say it’s important to “start with the pictures not with the numbers”?

2. What are the challenges with doing a quantitative analysis of the value of the Shaan project?

3. What are the different sources of value that Mahindra’s management appears to think will arise from developing the Shaan?

a  www.Mahindra.com

b  Thomke, S. and Luthra, BD. “Innovation at Mahindra & Mahindra,” Harvard Business School Case (2009), May 5th.

c  Thomke, S. and Luthra, BD. “Innovation at Mahindra & Mahindra,” Harvard Business School Case (2009), May 5th.

d  Mahindra brochure, accessed at www.pakwheels.com, retrieved August 1, 2015.

e  www.pakwheels.com/forums/

f  www.superbrandsindia.com, retrieved August 1, 2015.

g  Stewart, TA and Raman, AP. “Finding a higher gear,” Harvard Business Review (2008), July-August, pg. 69–76.

OVERVIEW

Developing innovative new products and services is expensive and time-consuming. It is also extremely risky—most studies have indicated that the vast majority of development projects fail. Firms have to make difficult choices about which projects are worth the investment, and then they have to make sure those projects are pursued with a rigorous and well-thought-out development process. In this chapter, we will explore the various methods used to evaluate and choose innovation projects. The methods range from informal to highly structured, and from entirely qualitative to strictly quantitative. We will start by considering the role of capital rationing in the R&D investment decision, and then we will cover various methods used to evaluate projects including strictly quantitative methods, qualitative methods, and approaches that combine quantitative and qualitative techniques.

capital rationing The allocation of a finite quantity of resources over different possible uses.

THE DEVELOPMENT BUDGET

While many project valuation methods seem to assume that all valuable projects will be funded, most firms face serious constraints in capital and other resources, forcing them to choose between multiple valuable projects (or obtain external financing as discussed in the Theory in Action section). Many firms use a form of capital rationing in formulating their new product development plans. Under capital rationing, the firm sets a fixed research and development budget (often some percentage of the previous year’s sales), and then uses a rank ordering of possible projects to determine which will be funded. Firms might establish this budget on the basis of industry benchmarks or historical benchmarks of the firm’s own performance. To provide a sense of what firms in different industries spend on R&D, Figure 7.1 shows the ten industries with the highest R&D intensity (R&D expenditures as a percentage of sales), based on North American publicly held firms in 2013. Some industries (notably drugs, special industry machinery, and semiconductors and electronic components) spend considerably more of their revenues on R&D than other industries, on average.

R&D intensity The ratio of R&D expenditures to sales.

FIGURE 7.1 Top Ten Industries (three digit SIC) by R&D Intensity, 2013

Based on Compustat data for North American publicly held firms; only industries with greater than ten or more publicly listed firms were included. Data for sales and R&D were aggregated to the industry level prior to calculating the industry-level ratio to minimize the effect of exceptionally large outliers for firm-level RDI.

There is also considerable variation within each of the industries in the amount that individual firms spend. For example, as shown in Figure 7.2, Roche Holding’s R&D intensity is significantly higher than the average for drug producers (19% versus 16%), whereas Pfizer’s is somewhat lower than the industry average (13% versus 16%). Figure 7.2 also reveals the impact of firm size on R&D budgets: Whereas the absolute amount spent on R&D at Volkswagen surpasses the R&D spend at other firms by a large amount, Volkswagen’s R&D intensity is relatively low due its very large sales base.

The rank ordering used in capital rationing may be established by any number of methods, including quantitative methods, such as discounted cash flow analysis or options analysis, or qualitative methods, such as screening questions and portfolio mapping, or a combination of multiple methods. Knowing the requirements, strengths, and weaknesses of each method helps managers make sound decisions about which valuation techniques to employ.

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FIGURE 7.2 Top 20 Global R&D Spenders, 2013

Data from Compustat

QUANTITATIVE METHODS FOR CHOOSING PROJECTS

Quantitative methods of analyzing new projects usually entail converting projects into some estimate of future cash returns from a project. Quantitative methods enable managers to use rigorous mathematical and statistical comparisons of projects, though the quality of the comparison is ultimately a function of the quality of the original estimates. The accuracy of such estimates can be questionable—particularly in highly uncertain or rapidly changing environments. The most commonly used quantitative methods include discounted cash flow methods and real options.

Discounted Cash Flow Methods

Many firms use some form of discounted cash flow analysis to evaluate projects. Discounted cash flows are quantitative methods for assessing whether the anticipated future benefits are large enough to justify expenditure, given the risks. Discounted cash flow methods take into account the payback period, risk, and time value of money. The two most commonly used forms of discounted cash flow analysis for evaluating investment decisions are net present value (NPV) and internal rate of return (IRR). Both methods rely on the same basic discounted cash flow mechanics, but they look at the problem from different angles. NPV asks, “Given a particular level of expenditure, particular level(s) and rate of cash inflows, and a discount rate, what is this project worth today?” IRR asks instead, “Given a particular level of expenditure and particular level(s) and rate of cash inflows, what rate of return does this project yield?” For either method, managers must use estimates of the size and timing of expenditures and cash inflows. Both methods enable the decision maker to incorporate some basic measure of risk. For example, riskier projects may be examined by using a higher discount factor in NPV analysis. Managers also often calculate discounted cash flow measures using best-case and worst-case cash flow estimates.

net present value (NPV) The discounted cash inflows of a project minus the discounted cash outflows.

internal rate of return (IRR) The rate of return yielded by a project, normally calculated as the discount rate that makes the net present value of an investment equal zero.

Theory in Action  Financing New Technology Ventures

While large firms can fund innovation projects internally, new technology start-ups must often obtain external financing. This can sometimes be daunting. Because technology start-ups often have both an unproven technology and an unproven business concept (and sometimes an unproven management team), they typically face a much higher cost of capital than larger competitors, and their options for obtaining capital can be very limited. In the first few stages of start-up and growth, entrepreneurs may have to turn to friends, family, and personal debt. Start-ups might also be able to obtain some initial funding through government agencies. If the idea and the management team seem promising enough, the entrepreneur can tap “angel investors“ and venture capitalists as sources of both funds and mentoring.

FAMILY, FRIENDS, AND CREDIT CARDS

When a new venture is starting out, often the technology and/or management is unproven, making the venture appear very risky. In this stage, entrepreneurs must often rely on friends and family members who are willing to provide initial funding either in the form of a loan or an exchange for equity in the company. Alternatively, the entrepreneur may try to obtain debt financing from a local bank. A very large number of start-ups are actually funded with credit cards, resulting in a very high rate of interest!

GOVERNMENT GRANTS AND LOANS

Some new ventures obtain start-up funds from government sources. In the United States, the Small Business Administration (SBA) is designed to foster entrepreneurship and innovation by administering grants, loans, and venture capital programs from many different federal agencies including the Department of Commerce, Department of Agriculture, Department of Energy, NASA, and others. Similarly, in the United Kingdom, the Enterprise Fund administers a series of programs designed to fund small- to medium-size technology firms, and in Germany there are more than 800 federal and state government programs established to finance new firms. a

ANGEL INVESTORS

Angel investors are private investors who fund projects without utilizing a venture capital limited partnership structure. They are often wealthy individuals who have been very successful in business, and who enjoy the thrill of vicarious entrepreneurship afforded by investing in—and sometimes mentoring—start-up firms. Angels typically fund projects that are $1 million or less. While angel investors lose money in a significant share of their investments, those investments that pay off can earn very high returns. Angels are usually not listed in public directories, but are identified through professional networks (through one’s former colleagues, professors, or lawyers, for example). A large number of start-ups obtain “seed-stage” (before there is a real product or company organized) financing from angel investors. While it is difficult to get data on angel investing because most of the transactions are not publicly reported, estimates from the Center for Venture Research, indicate that angel investors funded 73,400 entrepreneurial ventures in 2014 for a total of $24.1 billion (an average of $328,500 per deal).

VENTURE CAPITAL

For projects that require more than $1 million, entrepreneurs often turn to venture capital, either from independent venture capital firms or corporate venture capital sources.

Independent venture capital firms manage a pool of funds that they invest in projects they believe to have rapid growth potential. Many venture capital firms specialize in particular industries, making them better able to evaluate the potential of start-ups in that industry. The venture capital funds are likely to be provided in a complex debt-equity hybrid contract that essentially looks more like equity if the firm performs well, or debt if the firm performs poorly. b  If and when the business is successful, the venture capitalist can cash out of the investment by negotiating an initial public offering or a buyout of the company by another firm. Venture capitalists are very selective, and reject the vast majority of proposals considered. However, for those projects that are funded, the support of the venture capitalist provides a number of valuable benefits including credibility among other investors (and thus better access to capital) and mentoring. While some venture capitalists specialize in providing seed-stage funding, venture capitalists are more likely to provide funding during page 135early stages—after the company has been organized and the product has shown early signs of success, but before it is able to sustain its development activities and growth through its own revenues. According to the U.S.-based National Venture Capital Association, in 2014 venture capitalists invested about $49.3 billion in 4,356 deals, of which 1,409 received funding for the first time.

Corporate venture capital is provided by firms that wish to take a minority equity stake in another firm’s technology development, often to gain access to cutting-edge technology that they may wish to develop further should it prove technically and commercially promising. Such firms may establish an internal venturing group that is closely tied to the firm’s own development operations, or they may create a dedicated external fund that has more independence from the firm’s own operations. c  The benefit of the former structure is that the firm should be better able to use its own expertise and resources to help the new venture succeed. However, under this structure, the entrepreneur may have concerns about the larger firm expropriating the entrepreneur’s proprietary technology. Under the latter structure, the independence of the external venture fund provides some reassurance that the entrepreneur’s technology will not be stolen, but it also limits the ability of the entrepreneur to leverage any of the larger firm’s nonfinancial resources. d  According to the National Venture Capital Association, there were 775 corporate venture capital deals totaling $5.4 billion (averaging almost $7 million per deal) in 2011. Examples of such programs include Google Ventures, Intel Capital, Johnson & Johnson Development Corporation, Dow Venture Capital, Siemens Venture Capital, Geisinger Ventures, and Ascension Health Ventures. These programs tend to invest in sectors that closely mirror those invested in by independent venture capital firms. e

a  B. Hall, “The Financing of Research and Development,” Oxford Review of Economic Policy 18 (2002), pp. 35–51.

b  Hall, “The Financing of Research and Development.”

c  P. A. Gompers, “Corporations and the Financing of Innovation: The Corporate Venturing Experience,” Economic Review—Federal Reserve Bank of Atlanta 87, no. 4 (2002), pp. 1–18.

d  G. Dushnitsky, “Limitations to External Knowledge Acquisition: The Paradox of Corporate Venture Capital,” doctoral dissertation, New York University, 2003.

e  M. Sheahan, “Corporate Spin Can’t Mask the VC Units’ Blunders,” Venture Capital Journal, March 1, 2003.

Net Present Value (NPV)

To calculate the NPV of a project, managers first estimate the costs of the project and the cash flows the project will yield (often under a number of different “what if” scenarios). Costs and cash flows that occur in the future must be discounted back to the current period to account for risk and the time value of money. The present value of cash inflows can then be compared to the present value of cash outflows:

NPV = Present value of cash inflow − Present value of cash outflows

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FIGURE 7.3 Example of Present Value of Future Cash Flows

If this value is greater than 0, then the project generates wealth, given the assumptions made in calculating its costs and cash inflows.

To find the present value of cash inflow and outflows, each cash flow must be discounted back to the current period using a discount rate (see Figure 7.3). If there is a single expenditure at the beginning of the project (year 0), the original expenditure can be compared directly to the present value of the future expected cash flows. In the example in Figure 7.3, the present value of the future cash flows (given a discount rate of 6%) is $3,465.11. Thus, if the initial cost of the project were less than $3,465.11, the net present value of the project is positive. If there are cash outflows for multiple periods (as is common with most development projects), those cash outflows would have to be discounted back to the current period.

If the cash inflows from the development project were expected to be the same each year (as they were in Figure 7.3), we can use the formula for calculating the present value of an annuity instead of discounting each of the cash inflows individually. This is particularly useful when cash inflows are expected for many years. The present value of C dollars per period, for t periods, with discount rate r is given by the following formula:

This amount can then be compared to the initial investment. If the cash flows are expected in perpetuity (forever), then a simpler formula can be used:

Perpetuity present value = C × 1/r

The present value of the costs and future cash flows can also be used to calculate the discounted payback period (that is, the time required to break even on the project using discounted cash flows). Suppose for the example above, the initial investment required was $2,000. Using the discounted cash inflows, the cumulative discounted cash flows for each year are:

discounted payback period The time required to break even on a project using discounted cash flows.

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Year

Cash Flow

1

$ 934.40

2

1,833.40

3

2,673.02

4

3,465.11

Thus, the investment will be paid back sometime between the end of year 2 and the end of year 3. The accumulated discounted cash flows by the end of year 2 are $1,833.40, so we need to recover $166.60 in year 3. Since the discounted cash flow expected for year 3 is $839.62, we will have to wait $166.60/$839.61 ≈ .20 of a year. Thus, the payback period is just over two years and two months.

Internal Rate of Return (IRR)

The internal rate of return of a project is the discount rate that makes the net present value of the investment zero. Managers can compare this rate of return to their required return to decide if the investment should be made. Calculating the IRR of a project typically must be done by trial and error, substituting progressively higher interest rates into the NPV equation until the NPV is driven down to zero. Calculators and computers can perform this trial and error. This measure should be used cautiously, however; if cash flows arrive in varying amounts per period, there can be multiple rates of return, and typical calculators or computer programs will often simply report the first IRR that is found.

Both net present value and internal rate of return techniques provide concrete financial estimates that facilitate strategic planning and trade-off decisions. They explicitly consider the timing of investment and cash flows, and the time value of money and risk. They can make the returns of the project seem unambiguous, and managers may find them very reassuring. However, this minimization of ambiguity may be deceptive; discounted cash flow estimates are only as accurate as the original estimates of the profits from the technology, and in many situations it is extremely difficult to anticipate the returns of the technology. Furthermore, such methods discriminate heavily against projects that are long term or risky, and the methods may fail to capture the strategic importance of the investment decision. Technology development projects play a crucial role in building and leveraging firm capabilities, and creating options for the future. Investments in new core technologies are investments in the organization’s capabilities and learning, and they create opportunities for the firm that might otherwise be unavailable.1 Thus, standard discounted cash flow analysis has the potential to severely undervalue a development project’s contribution to the firm. For example, Intel’s investment in DRAM technology might have been considered a total loss by NPV methods (Intel exited the DRAM business after Japanese competitors drove the price of DRAM to levels Intel could not match). However, the investment in DRAM technology laid the foundation for Intel’s ability to develop microprocessors—and this business has proved to be enormously profitable for Intel. To better incorporate strategic implications in the new product development investment decision, some managers and scholars have recently begun promoting the idea of treating new product development decisions as real options, as described below.

Real Options

When a firm develops new core technologies, it is simultaneously investing in its own learning and in the development of new capabilities. Thus, development projects can create valuable future opportunities for the firm that would otherwise be unavailable.2 Even development projects that appear unsuccessful (as Intel’s DRAM discussed above) may prove to be very valuable when they are considered from the perspective of the options they create for the future of the firm. Some managers and scholars have begun arguing that new product development decisions should be evaluated as “real options.”

real options The application of stock option valuation methods to investments in nonfinancial assets.

To understand real options, it is first useful to consider the financial model upon which they are based—stock options. A call option on a stock enables an investor to purchase the right to buy the stock at a specified price (the “exercise price”) in the future. If, in the future, the stock is worth more than the exercise price, the holder of the option will typically exercise the option by buying the stock. If the stock is worth more than the exercise price plus the price paid for the original option, the option holder makes money on the deal. If the stock is worth less than the exercise price, the option holder will typically choose not to exercise the option, allowing it to expire. In this case, the option holder loses the amount of money paid for the initial option. If, at the time the option is exercised, the stock is worth more than the exercise price but not more than the exercise price plus the amount paid for the original option, the stockholder will typically exercise the option. Even though the stockholder loses money on the deal (some portion of the price paid for the original option), he or she loses less than if he or she allowed the option to expire (the entire price paid for the original option).

In “real options,” the assets underlying the value of the option are nonfinancial resources.3 An investor who makes an initial investment in basic R&D or in breakthrough technologies is, it is argued, buying a real call option to implement that technology later should it prove to be valuable.4 Figure 7.4 provides examples of investment decisions that can be viewed as real call options. With respect to research and development:

· The cost of the R&D program can be considered the price of a call option.

· The cost of future investment required to capitalize on the R&D program (such as the cost of commercializing a new technology that is developed) can be considered the exercise price.

· The returns to the R&D investment are analogous to the value of a stock purchased with a call option.5

As shown in Figure 7.5, the value of a call stock option is zero as long as the price of the stock remains less than the exercise price. If the value of the stock rises above the exercise price, however, the value of the call rises with the value of the stock, dollar for dollar (thus the value of the call rises at a 45-degree angle).6

Options are valuable when there is uncertainty, and because technology trajectories are uncertain, an options approach may be useful. Though there has not yet been much empirical work in the area, several authors have developed methodologies and applications of options …