The return on an investment is perhaps the most obvious aspect of the investment decision for corporate finance. However, there’s more to evaluating an investment than just looking at the earnings. In this post we will talk more in detail about how to evaluate an investment in light of its potential returns.
First Things First: Cash flow
Before we get into the process of evaluating returns, we must consider how we are measuring returns. There are various ways of quantifying earnings, but which one makes sense?
We use cash flow to calculate the returns of an investment. Cash flow allows us to both quantify the returns and evaluate the timing of the returns. Furthermore, cash is something we can actually spend as opposed to earnings which are merely available on the books.
Incremental, because you want to evaluate returns related to the investment
Time-weighted, because early returns are more convenient than later returns
What Impacts Returns?
The next question to ask is what actually impacts returns. Turns out there are several factors:
Revenues may be overestimated
Revenues may be delayed
Operating costs and capital expenditure may be underestimated
Tax rate may increase
Interest rates may increase
Risk premiums and default spreads may increase
There may be unanticipated opportunity costs
Synergy within the company may be overestimated
All of the variables above will have an impact on the evaluation of the return of an investment and must be considered before approving a new investment
Estimating Cash flow Returns
The two main drivers of estimating the return are projected revenues and projected expenses.
Estimating operating income
The revenues include all income related to the investment.
The expenses include the capital expenditure required to initiate the project (such as buying land or machines) as well as fixed and variable operating expenses. Also take into account the depreciation, amortization, G&A costs and the taxes to be paid on the operating income as these will directly affect the cash flows.
The result of is an estimate of after-tax operating income related to the project. To get the cash flow view of the project we add back the non-cash charges, less the capital expenditures and change in non-cash work capital such as inventory and accounts receivable.
Cash flow to firm = + After-Tax Operating Income + Depreciation + Amortization + Tax benefits received - Capital Expenditures - Change in non-cash work capital
From cash flow to incremental cash flow
To calculate the incremental cash flows on the project, we include the pre-project sunk investment, less the tax on depreciation and add back tax on allocated G&A.
Now that we have an overview of the incremental cash flows to the firm, it’s time to factor in the time value of the cash flows. As said, we consider the timing of the cash flows because early returns are more convenient than later returns.
Net Present Value (NPV)
To calculate the time-weighted cash flow, we use Net Present Value of the cash flows. The NPV is the sum of the present value of all cash flows on the project including the initial investment.
The cash flows are discounted at the appropriate hurdle rate. Use cost of capital if the cash flows return to the firm, or use cost of equity of the cash flows return to equity investors.
If the Net Present Value is higher than Zero, then the project is acceptable.
Internal Rate of Return (IRR)
The internal rate of return is the discount rate for which the net present value is zero.
If the Internal Rate of Return is higher than the hurdle rate, then the project is acceptable
Salvage Value
If a project or investment is finite and short life, then you can calculate a salvage value. It is the expected proceeds from selling all of the investment in the project at the end of the project life. Typically the salvage value is sum of the book value of fixed assets and the working capital.
Terminal Value
For a project with undetermined or very long life, it is sometimes not reasonable to estimate the present value of all cash flows. It is reasonable to compute a terminal value which constitutes the present value of all cash flows beyond the estimated cash flows.
To calculate the terminal value, it is reasonable to use the inflation rate as growth rate. The terminal value in year n is then:
TV(n) = (Cash Flow in Year n+1) / (cost of capital – growth rate)
Uncertainty and Returns
In the beginning of the post we outlined the various factors that may impact the revenue. At the beginning of a project, we forecast revenues and costs as best as possible. But since we can never be sure about the future, there is always a certain degree of uncertainty. What can we do about it?
A simplistic approach to this problem is to calculate how quickly we earn back our money. Based on the projected cash flows we can determine the timing of investment payback.
Sadly, this method does not help us understand, value and mitigate the uncertainty. What degree of inaccuracy of which assumptions will are NPV and IRR most sensitive to?
With sensitivity analysis and what-if questions we can determine this. As sensitivity analysis can get complicated, we will cover this topic in a different post.
Side Costs and Benefits
Most projects or investments create side costs and benefits to the business that are not directly linked to the project.
The opportunity cost is allocated resources of a firm to a project that could otherwise have been allocated to another project. It represents the loss of opportunity of a project that could not be invested in.
Within the organization, multiple projects could create synergies that are not captured in the traditional capital budgeting analysis.
The returns on a project should incorporate these cost and benefits.
Debt is not per definition bad as it can help your company finance profitable projects at a lower overall cost to the firm than if you use own equity.
Towards the concluding lines of Investment Decision (1): Hurdle Rate and Risk we already hinted that debt plays an important role in determining the hurdle rate. Even in Investment Decision (2): Hurdle Rate and CAPM, where we discussed how to estimate the cost of equity for a firm, the word debt was brought up in relation to levered and unlevered beta estimates. In this post we dig a little deeper in the topic.
What is Debt?
Debt is a deferred repayment of a sum of money. It is a legal commitment to make fixed payments which have the benefit of being tax deductible. On the flip side, failure to make payments can lead to default or loss of control of the firm.
Debt includes all short-term and long-term interest bearing liabilities such as loans or bonds. Perhaps surprisingly, it should also include any lease obligations as those obligations also match the definition of debt. After all, monthly rent is not only a (1) legal commitment to make (2) fixed payments but also impacts your (3) working capital. Furthermore, (4) failure to make payments may lead to loss of control of the firm.
The cost of servicing debt matters in two major decisions of corporate finance:
Investment Decision: what is the cost of debt?
Finance Decision: what is the optimal and right kind of debt?
In this post we will talk about the impact of debt on the investment decision and we’ll cover the finance decision in a different post.
Estimating the Cost of Debt
The first important note is that the cost of debt must always be calculated in the same currency as the cost of equity!
To estimate the cost of debt, there are several options:
Yield to maturity on a long-term corporate bond as interest rate if the firm has issued bonds and those bonds are traded
Default spread associated with a rating if the firm has a rating determined by an external rating agency
Interest rate on a recent long-term borrowing if the firm has recently taken on a loan.
Try to estimate a synthetic rating for the firm
Actual and Synthetic Ratings
During the financial crisis of 2008 the credit rating agencies received a lot of public attention. Nearly everyone now has heard about Standard & Poor’s and Moody’s. These two organizations are world leader in attributing ratings to all kinds of companies. The exact algorithm of the rating is unknown, so it is challenging to determine the actual rating for an unrated company.
Estimate a Synthetic Rating
However, we can estimate a synthetic rating by calculating the interest coverage ratio. The ratio is very simple. It calculates how many times the interest on a debt can be covered with the earnings of a firm.
Interest Coverage Ratio = (Earnings Before Income and Tax) / (Interest Expenses)
Using a reference table we can then determine a typical default spread for a company with a certain interest coverage ratio.
Interest Coverage Ratios, Ratings and Default Spreads, table by Mr. Aswath Damodaran
From Synthetic Rating to Cost of Debt
To determine the cost of debt from the synthetic rating, we return to the description of hurdle rate. The hurdle rate is the riskfree rate with added risk premium. In the case of a synthetic rate, we can say the cost of debt is then the riskfree rate + default spread associated with the synthetic rating. However, we should factor in that interest expense on debt is tax deductible. So,
Pre-tax cost of debt = riskfree rate of local currency + default spread of synthetic rating
After-tax cost of debt = (pre-tax cost of debt) x (1 – tax rate)
Be careful when using actual ratings from different rating agencies. Some may or may not include the country risk in their evaluation. That case, remember that the total risk for a firm is the sum of the riskfree rate, the country risk, and the firm risk.
Market Value of Debt
For the calculation of the cost of capital, it is preferred to use market value for both the cost of equity and cost of debt. For public companies, the market value of equity is determined by its stock prices. However, it’s a bit more challenging to determine the market value of debt.
One way to determine the market value of debt is to consider the entire debt as one coupon bond. The coupon payment is set equal to the interest expenses on all debt, and maturity set to the (face-value) weighted average maturity of debt. Then, it’s easy to calculate the present value of the annuity. Add to that the coupon bond at current cost of debt for the firm.
You can find an example by Mr. Aswath Damodaran here.
Market Value of Operating Leases
As mentioned, we should include any operating leases in the debt calculation. To calculate the value of the operating leases, simply calculate the present value of the lease payments at a rate that reflects their risk. This rate is usually the pre-tax cost of debt.
The CAPM, or Capital Asset Pricing Model, is one of the models that describe the relationship between market risk and expected returns for an asset. We can use CAPM to determine how much of the expected return can be explained by the associated market risks. It is an important tool to determine the cost of equity for a firm. The cost of equity is used to determine the hurdle rate in the investment decision.
The formula of CAPM is:
Expected Return = Riskfree Rate + Beta x (Expected Return on Market Portfolio – Risk-free Rate)
The difference between expected return on market portfolio and the risk-free rate is called the market risk premium. It is the premium that investors demand for an investment riskier than the risk-free rate.
Thus, to use the model we need three inputs:
The current risk-free rate
The expected market risk premium
The beta of the analyzed asset
Risk-free rate
A risk-free asset is an asset where the future return is both certain and known. That means the actual return is equal to the expected return. Of course strictly speaking there are no risk-free assets but for practical purposes we assume that for some very safe investments the risk is so low that it can be ignored.
The conventional practice to estimate risk-free rates is to use the government bond rate, with government being the one that controls issuing the currency. For example, for US dollar we use the rate on a ten-year US treasury bond.
Note that not all government securities are risk-free. Some governments face risk of default so the rates on the bonds they issue will not be risk-free.
In case of a government with default risk, you can include the local currency default spread in your calculation. The risk-free rate will then be the government bond rate adjusted for (subtracted by) the default spread for the local currency as determined by the currency rating.
Market Risk Premium
The second input required by the CAPM is the (market) Equity Risk Premium. This is the premium of an investment relative to a risk-free investment. Thus, (1) the premium is greater than 0, (2) the premium increases with risk aversion of investors and (3) the premium increases with the riskiness of the investment.
There are two ways of estimating the Equity Risk Premium. Either (1) use historical data or (2) use future expectations as input.
Historical Equity Risk Premium
Historical data has as main advantage that factual information is available. If you choose to use historical data, make sure to use a long enough time window, as well as ensure it’s consistent with the risk-free rate and use a compounded average. However, always be aware that historical data is backward looking, noisy and subject to selection bias.
An implied equity risk premium, by Mr. Aswath Damodaran
The implied ERP model employs a basic discounted cash flow model. It equates the current value of the market with the expected future cash flow growth and solves the equation for the expected return rate.
The inputs needed to calculate the implied ERP are:
Current value of the market
Expected cash flow growth of the market
Terminal growth rate of the market
To practically calculate the implied ERP, you need a proxy for the market. One option is to use the S&P 500 index as proxy for the market. The S&P 500 is a stock market index based on the market cap of 500 large companies having common stock listed on the NYSE, NASDAQ, or the Cboe BZX Exchange.
To calculate the expected cash flow growth, Mr. Damodaran relies on analysts to forecast future retained earnings as well as future returns to shareholder in the form of dividends and buybacks. The time window is set to the next 5 years
The terminal growth rate is set equal to the risk-free rate.
The implied expected return on the stocks is then subtracted by the risk-free rate to come to the implied equity risk premium. In the example of using the S&P 500 as market proxy, we have the implied equity risk premium for the US.
Country Risk
In the example above, we assume the S&P 500 is a good proxy for the US market in general. But what about other countries?
If we follow the theory of the implied equity risk premium, we should calculate the implied ERP for any country using a proxy similar to the S&P 500. However, this is not very practical. Mr. Damodaran proposes a composite way of estimating ERP for countries. The composite way adds the risk of a specific country relative to the risk of a mature market.
First, you estimate an equity risk premium for a mature market either by using the backward looking historical ERP or a forward looking implied ERP.
Then, define what you consider to be a mature market. One option would be to go by country’s local currency rating and associated default spread. In that case, any AAA rated country is considered mature.
Finally, estimate the additional risk premium for non-mature markets. There are two options:
Default spread for the country, estimated based on the sovereign ratings or the CDS market
Scaled up default spread, where you adjust the default spread upwards for the additional risk in equity markets.
Beta
The beta of a firm or stock (asset) measures its exposure to the market risk. It indicates both the volatility of the asset as well as how the volatility correlates to the general market. The beta is normalized around 1, meaning that the weighted average of all betas of firms in the market is 1.
Beta > 1: either returns that are more volatile than the market, or returns that are not very correlated with the market
Example: cutting-edge technology companies are typically more volatile than the market because they have a faster innovation pace
Beta = 1: the returns are as volatile as the market, or correlated strongly with the market
Example: large and mature companies tend to follow the market behavior
Beta < 1: the returns are less volatile than the market, or are not very correlated with the market
Example: firms that operate in stable industries which produce common-use products will typically have a low beta
Beta <= 0: the asset is market risk inducing
Example: the price of gold typically correlates inversely with the market and thus firms operating in this industry will have a negative beta.
What Impacts Beta?
There are three main factors that will impact the beta of an asset.
Firstly, the industry a firm is operating in will impact its beta. Since the beta is a measurement of how exposed a firm is to market risk, firms that produce goods or services that are heavily dependent on the season will have a higher beta. For example: a firm that makes ice-cream cones will have greater volatility in earnings than a company that makes toilet paper. Ice cream is in high demand during the summer, but low demand during the winter, whereas toilet paper is used during all seasons. That higher volatility in earnings will result in a higher beta.
Secondly, the operating leverage will impact a firm’s beta too. Companies with a higher operating leverage, or fixed operating costs, will see their earnings vary more. For example, a ‘bad summer’ will result in lower ice cream sales. A business that has invested in a ice cream stall with inside seating and air conditioning will have higher fixed costs than someone who’s just selling at the side of the street. When revenues are lower, the higher fixed costs means lower earnings.
Thirdly, the financial leverage will impact a firm’s beta as well. A firm with debt has to repay interest fees which are deducted from the firm’s earnings. The interest payments are fixed, regardless of the revenue. Therefore a “bad sales season” will have a larger impact on the firm’s earnings.
Lastly, it’s important to note that the beta of a firm is the market-value weighted average of the businesses of the firm. A large corporate which operates in many industries will have a different beta than the industry-focused firms it competes with in those markets. This principle also applies to your personal investment portfolio; the beta of your total investment will be the weighted average of the betas of your assets.
Measuring Beta: Top-Down or Bottom-Up
When measuring beta, you can either choose a backward looking (top-down) or a forward looking (bottom-up ) approach.
Bottom-Up Beta
The bottom-up beta can be estimated using the following steps:
Find the businesses or industries the firm operates in and determine their impact on sales or operating income
Find the unlevered betas of other firms in these businesses
Determine the weighted average of the unlevered betas
Lever up using the firm’s debt/equity ratio
The main advantage of a bottom-up approach is that this approach reflects the current or even future mix of the businesses that the firm is in.
Top-Down Beta
The top-down beta can be estimated by regressing the stock returns against market returns. The formula is:
Rj = a + b x Rm
Where,
Rj is the stock returns
Rm is the market returns.
b, or slope, corresponds to the beta of a stock and measures its riskiness
a, or intercept, is a performance measurement of the stock.
R², or R-squared, is an estimate of the proportion of the variance attributed to market risk
The key challenge of using regression to estimate the beta is the data selection.
Choosing a larger period to evaluate a stock will yield a larger data set but may not accurately reflect the change a firm is going through during that period. Similarly, choosing shorter interval periods between returns will yield a larger data set, but may be affected by noise caused by lack of trading
Unlevered and Levered Beta
The term (un)levered beta usually refers to the debt of a firm. All top-down beta estimates are levered because the estimate is based on stock prices. Stock prices are set by the market and take into account the mix of equity and debt of a firm.
To calculate the unlevered beta (UB) you can use the following formula:
UB = Levered Beta / (1 + (1 – tax rate) x (D/E))
Where the tax rate is the marginal tax rate for the firm, and D/E is the average debt equity ratio during the regression period
Beta is the weighted average of the risk exposure of all the firm’s businesses to the general market
Market Equity Risk Premium is the weighted average of market risk premium of all the markets the firm operates in
Practically, we can choose to calculate the risk of operating in a mature market like the US and add risk associated with operating in a different country. In that case, we can say:
Expected Return = Country Gov’t Bond Rate + (Levered Beta) x (Mature Market Risk Premium + Country Risk Premium)
Where,
Country Government Bond Rate is the government in control of issuing the currency
If there’s a default risk associated with the government bond rate, adjust the borrowing rate for the default risk
What About Private Companies?
The methods to estimating the cost of equity discussed above are very useful when evaluating public companies. However, for private companies things are more complicated. The lack of stock prices and historical returns make it difficult to calculate how exposed the company is to market risk (beta).
There are two main ways to estimate a beta for non-traded assets: use comparable firms (bottom-up) or use accounting earnings (top-down).
When evaluating the levered betas of comparable firms, it’s important to still deleverage and releverage using the private firm’s debt equity ratio. Again, it’s difficult to estimate the market value of the firm’s equity or debt, so it’s reasonable to use book value instead.
R-squared
Last but not least, remember that beta is a measure of risk added on to a diversified portfolio. However, the owners of most private companies are not diversified. Therefore using beta only to come to the cost of equity will underestimate the cost of equity of the private firm.
To adjust for the added risk of an undiversified portfolio, we can use R-squared of the regression as it measures the proportion of risk that is market risk.
Beta = Market Beta / Correlation of sector with market
The correlation factor of industries like technology are relatively low compared to more mature industries. If you dig into it, you will quickly find that a private technology company is a risky business!
Risk is a central element of the business world. Risky but successful projects can give investors an incredible return on their investment. But risky and unsuccessful projects have the potential to leave you with nothing. Estimating the risk associated with an investment is therefore an essential part of business practice.
In this post we cover the first aspect of the Investment Decision for corporate finance: hurdle rate. The hurdle rate reflects the riskiness of an investment and the mix of debt and equity to fund it. Simply put, the hurdle rate sets the minimum expectation of return for a specific investment.
As mentioned in Fundamentals of Corporate Finance, the Risk Premium captures the difference between a safe investment and a risky investment. Thus, we can describe the hurdle rate as follows: Hurdle Rate = Riskless Rate + Risk Premium.
The description outlines three major questions.
What is risk and riskless?
How do we measure risk?
How to quantify risk into a risk premium?
Risk and Riskless
Mathematically, the variance in actual returns around expected returns is the measurement of the risk of an investment. Simply put, it describes the relationship between an expectation and an actual return. The larger the difference between the actual and expected returns, the riskier the investment.
Riskless
A riskless investment is an investment with a certain and known rate of return, and with no chance of default. Strictly speaking there are no riskless investments. In practical terms US treasury securities are considered riskless because the US government is considered the best possible issuer of securities in the market.
Even though riskless strictly speaking does not exist, the level of risk is so small it can be ignored. The downside of a riskless investment is that the rate of return is very low and that the returns are exposed to inflation risk.
Rewarded and Unrewarded Risk
There are two types of risk: rewarded and unrewarded risk.
Unrewarded risk, or market risk, is a risk that affects all investments across the market. It is unrewarded because taking the risk does not yield any advantage over the rest of the market. For example: risks associated with compliance to safety standards are unrewarded risks because all market players must comply.
Rewarded risk, or firm specific risk, is a risk that is specific to the investment. It is rewarded because it may give you a competitive advantage in the market.
A smart investor should diversify their investment portfolio so that the total firm-specific risk is averaged out across the portfolio. It’s reasonable to assume that any investor holds a “diversified” portfolio, thus investors price only market risk.
Market Risk
When we talk about market risk, it’s important to understand what we mean by ‘market’. The market pertains to not only the country where we sell our goods or services, but also the specific industry we compete in.
Considering the above, we can anticipate some challenges when trying to estimate the market risk.
A lot of businesses and corporations are operating worldwide. That means the risk of the firm depends on which markets they are exposed to and by how much. A firm which collects 90% of their revenue in the US market will be less risky than a firm that performs the same business in South Africa. The exact market risk for a firm depends on the specific mix of markets it operates in.
As a rule of thumb we could argue it’s more sensible to determine the risk based on where the firm is operating as opposed to where it is incorporated.
Furthermore, large corporations are active in different fields. A corporation such as McDonalds is in the business of not only selling food, but also real-estate. The industry risk associated with each business is different. The exact market risk for a firm will depend on the specific mix of industries it is active in
Measuring and Quantifying Risk
There are several methods to measure market risk.
CAPM or Capital Asset Pricing Model
APM: Asset Pricing Model
Multi-Factor Models
Proxy Models
While the CAPM is limited in many ways, it has survived as the default model for risk in equity valuation. The alternative models do a better job explaining past returns but are less effective in predicting future returns. Furthermore, they are much more complex and require a lot more information than CAPM. Lastly, the difference in expected returns predicted by the alternative models and CAPM is not significant enough to justify the additional work.
As it is an extensive topic, we will cover the CAPM in a different post.
The CAPM will give us the cost of equity related to an investment. However, a firm can also raise funds for an investment project from debt.
Debt
Simply put, debt is a deferred repayment of a sum of money. It is a commitment to make fixed payments with as main advantage that it is tax deductible. However, failure to make payments can lead to default or loss of control of the firm.
Debt includes short-term and long-term interest-bearing liabilities (i.e. loans or corporate bonds) or any lease obligations.
When we talk about the Cost of Debt, we talk about the cost associated with raising funds from debt.
We will cover debt in more detail in a different post.
Cost of Capital
The weighted average cost of equity and cost of debt is called the cost of capital. To determine the weight for equity and debt, the preferred method is to use market value. It is relatively easy to determine the market value for equity, but can be more difficult for private companies.
Determining the market value of debt is challenging for both public and private companies. Hence most practitioners opt for the book value of debt as a proxy for market value.
Choosing the Hurdle Rate
Finally, the choice of hurdle rate still depends on the preference of the managers. As said, the hurdle rate is the internal benchmark for projects. Using the cost of capital as hurdle rate is a common, solid choice but not mandatory.
If your firm is a start-up which is looking for angel investors to provide equity it is reasonable to use cost of equity as a hurdle rate.
Corporate finance is one of the most challenging topics to master in any business course. However, understanding finance is one of the most important aspects of managing a business. This post contains inputs from Frank Gong and course material by Aswath Damodaran.
What is Corporate Finance?
In any corporate or business we make decisions on a daily basis that have financial implications. Any decision which affects the finances of the business or corporate is a finance decision.
The broad view of corporate finance includes everything from determining the prices of your products, to employee wage increases, and even decisions related to the payment terms of your customers.
In a more practical sense, we can define the financial view of a firm as below
Assets
Assets in place (existing investments that generate cash flows today)
Growth assets (expected value that will be created by future investments)
Liabilities
Debt (fixed claim on cash flows, not so important for management)
Equity (residual claim on cash flows, important for management)
Principles of Corporate Finance
The fundamental principle of business is the shareholder paradigm which states that it is the goal of a firm, business, or corporate to maximize the value of the shareholder. From that fundamental principle flow the three major decisions related to corporate finance: (1) the investment decision, (2) the financing decision, and (3) the dividend decision.
The investment decision
To maximize the value of the firm, we must invest in assets that earn a return greater than the minimum acceptable hurdle rate. The hurdle rate reflects the riskiness of the investment and the mix of debt and equity to fund it. The return reflects the magnitude and timing of the cash flows resulting from the investment, as well as all its side effects.
The financing decision
To maximize the value of the firm, we must find and choose the right kind of debt and the right mix of debt and equity to fund our operations.
The dividend decision
In case you cannot find investments that will further grow the value of the firm, return the cash to the shareholders of the firm. The quantity of the return depends on the current and potential future investment opportunities. The method of returning cash depends on the shareholder preference. Some shareholders prefer dividend payout, others prefer stock buyback programs.
Consequences of the Principles
The purpose of maximizing the value of the firm gives corporate finance its focus.
It is because this single goal that corporate finance can focus on the “right” investment, the “right” mix of debt and equity, and the “right” amount of cash that should be returned to the shareholder. Among a wide range of choices, corporate finance aims to choose that exact option which will maximize the firm’s value.
The focus of the corporate finance will change across the life cycle of the firm. The available sources of capital will be more diverse for a mature business compared to a start-up business. A firm in young growth phase will most likely reinvest all of its earnings into fueling future growth.
The corporate life cycle, by Aswath Damodaran
In the next sections we give you a taste of what’s involved with each of the three major decisions.
The Investment Decision
The investment decision can be summarized with two key terms: hurdle rate and returns.
Hurdle Rate
As the financial resources of any firm are finite, the hurdle rate can be considered the internal benchmark for investment evaluation. If a project does not pass the benchmark it should not be accepted.
Additionally, some projects will be more riskier than others. The risk of a project is represented in its hurdle rate. The hurdle rate for a very risky investment will be much higher than the hurdle rate of a very safe investment. The difference between a safe investment and a risky investment is captured in the risk premium. Thus, we can describe the hurdle rate as follows:
Hurdle Rate = Riskless Rate + Risk Premium
This description outlines three major questions.
What is risk and riskless?
How do we measure risk?
How to quantify risk into a risk premium?
There are several models available that help find answers to these questions. We will discuss the models and dive deeper in the Capital Asset Pricing Model (CAPM) in another post.
Returns
The most obvious aspect of evaluating an investment is its future returns. There are two aspects to this problem.
First, we must decide how we will measure the returns. There are many ways to account for and measure returns. We could consider the accrual basis, where revenue is recorded when it is earned regardless of when the invoices are paid. However, a downside is that until the buyer pays the outstanding invoice the return from the sale cannot be reinvested.
Second, we must consider the timing of the returns. Early returns can be quickly reinvested by the firm, whereas late returns may hamper the firm to undertake other projects. Also, we must consider the time value of money.
Incremental, because you want to evaluate returns related to the investment
Time-weighted, because early returns are more convenient than later returns
In another post we will dive deeper in the topic and discuss terms such as Net Present Value (NPV), Internal Rate of Return (IRR), terminal value, sensitivity analysis and more
The Finance Decision
The finance decision can be summarized with one word: debt.
Debt is a deferred repayment of a sum of money. It is a legal commitment to make fixed payments which have the benefit of being tax deductible. On the flip side, failure to make payments can lead to default or loss of control of the firm.
Debt includes short-term and long-term interest-bearing liabilities (i.e. loans or corporate bonds) or any lease obligations.
When repaying a loan, you pay back the principal and interest on the principal, so the total amount repaid is higher than the amount lent. So you could say that taking on debt destroys value for the shareholder but that’s not necessarily true.
Apart from increasing the capital available to the firm which can be used to invest in profitable projects, there are other reasons why a firm would take on debt.
First and foremost, interest expenses on debt are tax deductible which means a firm can reduce its effective tax rate.
Also, since debt repayment is a directly taken from the firm’s earnings it reduces the available free cash flow. That could inspire the management team to be more disciplined about investments.
There are also some disadvantages: expected bankruptcy cost, agency costs and loss of flexibility.
As there are both advantages and disadvantages, to maximize the value of the firm we can determine what is the optimal debt ratio.
To determine the optimal debt ratio, we must take into account not only the cost of the debt but also the cost of the equity. This is closely linked to the cost of capital calculation and hurdle rate for the Investment Decision.
The Dividend Decision
The dividend decision can be summarized by a single question: to reinvest or to return?
The main purpose of a firm is to maximize the valued created for the shareholder. If the management can no longer grow the value of the firm, it should return the capital to the shareholders. The shareholders are then able to reinvest the capital in other ventures or firms that may increase their wealth.
There are two ways to return value to the shareholder: dividends and buyback programs.
Dividend
A dividend is a periodic return of cash to the shareholders. The dividend payout is the percentage of earnings the firm pays in dividend. The dividend yield is the return an investor can make from the dividends.
It is not always in the best interest of the shareholder to pay dividends as shareholders are taxed on income from capital gains.
Furthermore, firms that pay out dividends are expected to continue to do so in the future at the same rate and yield. Therefore, the payout becomes a measure of success for the management team. Paying dividends now makes it more challenging for the management to stop paying dividends in the future. This is annoying as it directly impacts the cash flow of the firm.
Buyback
In a buyback program the firm uses its cash to repurchase outstanding shares from shareholders.
A buyback program has many advantages.
Most importantly, it is not expected to be a periodic event. That means the management can choose to initiate a buyback when it believes to be the right choice rather than based on the expectation of the market.
Additionally, it allows the management to send a signal to the market. If the management believes the firm is currently undervalued, it will buy back outstanding shares at a much higher price than its currently traded at. This shows confidence as well as indicates what the management believes is a more accurate value of the firm.
Valuation
The main difference between corporate finance and valuation is that the former deals with decisions related to your firm, whereas the latter deals with the evaluation of other firms.
There are many reasons to perform a valuation of a firm. Maybe you are looking to invest in the company by buying shares. Using a proper valuation will help you find those companies that are currently undervalued and are most likely to earn you a good return. Perhaps you are interested in acquiring the firm. Then a proper valuation will help you to determine the correct price for the firm and prevent you from overpaying. Or maybe you are a consultant and want to help the firm improve. In that case a detailed valuation will help you identify problems related to finance you can help alleviate.
There are several methods to do valuation.
The intrinsic valuation will value an asset as function of its fundamentals. The fundamentals are (1) cash flows, (2) growth, and (3) risk. In general, discounted cash flows models are used for intrinsic valuation. In practical terms, it is very similar to the job of corporate finance but for a different company.
The relative valuation values an asset as function of what investors are paying for similar assets. You can use multiples and ratios of all kinds of numbers related to the firm’s financial statements.
The contingent claim valuation values an asset using option pricing models.
We will talk more about valuation and Discounted Cash Flow (DCF) models in a different post.
In many business courses the material pings back and forth between business and corporate. As the two terms are sometimes used interchangeably, it is not easy to understand the difference between corporate and business. So, what is the difference?
In this post we aim to create a better understanding of corporate and its relation to business.
Business
In a previous post we discussed the topic of business strategy. We outlined that a business is the trade of a good or service in exchange for some money. If demand exceeds supply, simply making the good or doing the service is enough to have a successful business. If supply exceeds demand, you need a business strategy to be competitive and successful.
The business strategy is a plan that defines the unique set of specific attributes the firm chooses to focus on aiming to achieve superior long-term return on invested capital.
The functions and activities within the business support the execution of this plan. The business manager decides how to employ the available capital such that it creates a surplus. For a starting business, the surplus created often is equal to the net profit at the end of the year.
If a business creates profit, or surplus financial capital, the business manager has the choice to either reinvest the capital in the business or return the capital to the shareholders. For a young and growing business it’s important to reinvest all the surplus created to support future growth. The reinvested capital, the available capital and the employed capital helps the firm execute its business strategy and achieve superior long-term return on invested capital.
Returning Capital to Shareholders
In the shareholder business paradigm, it is the goal of a business to maximize the value of the shareholder. The business should return the value to its shareholders if reinvestment creates less return on investment than the cost of capital.
Herein lies a fundamental problem: is it possible to return all excess capital to the shareholders?
For excess financial capital, this is reasonably easy as you can use dividend payments or initiate a buy-back program. But, what about other excess capital?
For example, a business creates value for its shareholder by increasing the operating margin making its manufacturing process 20% more efficient. Thus, to support the manufacturing operations the business only needs 80% of the available machines. The surplus of machines represents excess capital not reinvested in the business. It’s not easy to return this surplus to the shareholder unless you sell the machines and turn them into surplus financial capital.
A common-sense solution to this problem is for the business manager to use the machines for another business activity. This is diversification and represents one of the three available corporate strategies.
Corporate
From the problem described in the previous section emerges the role of the corporate.
The purpose of a corporate is to employ excess capital surplus created by its businesses to maximize the value of the shareholders. It does so by diversifying the business portfolio, deepening the business operations with vertical integration, or expanding the business operations geographically with globalization.
The corporate functions required to support the activities include the COO (operations), CMO (marketing), CTO (technology), CEO (executive team leader), and more. The functions exist to support the corporate drivers of shareholder value:
Strategic drivers
Revenue growth
Duration of revenue growth
Operational drivers
Operating margin
Investment in fixed capital
Investment in working capital
Financial drivers
Effective tax rate
Cost of capital (WACC)
Example of Surplus Non-Financial Capital
The example of excess surplus capital that is difficult to return to the shareholder mentioned earlier is not ideal. As pointed out, you can sell the machines and return the value to the shareholders with dividends or buyback.
A more interesting example is to look at human capital. Let’s consider the business employs a talented engineer who turns an idea in a commercial product. Throughout their career at the firm, the engineer will learn about new processes, technologies, applications, etc. Ideally the business would use everything the engineer knows to create more surplus, but that’s hardly ever the case. So, there is excess surplus human capital.
Following the shareholder paradigm, if the return on reinvestment is not an option then the value should be returned to the shareholder. But how to return excess surplus human capital?
Using the corporate strategy of diversification allows you to reinvest this excess human capital. In this example, the engineer could be assigned to work on a product for a related business.
Corporate with One Business
Another interesting topic is to consider a special case: the corporate with only business.
If the purpose of a corporate is to employ excess capital surpluses created by businesses so it maximizes the value of the shareholders, this still holds for a single business. The corporate functions that support the strategic, operational and financial value drivers still exist. It’s just that there’s a lot less to do in a corporate with a single business. You don’t need additional people to perform those functions. The responsibilities can be assigned to people already employed in the business.
Completing the Circle
A consequence of the corporate dedicated to the employment of excess surplus capital is that it encourages good business strategy. After all, in a competitive market the most excess surplus capital will be generated by businesses with successful business strategies. In that regard, we could say that as a rule of thumb the people in leading corporate functions should be concerned with the businesses in the group and their strategies.
Over the course of the past couple of months I spent a lot of time thinking and talking about the dynamic between value and price. With expert input from Frank Gong, you can read some thoughts in this post.
The premise of the discussion flows from the definition of a business strategy. In the post titled What Is (Good) Business (Strategy) we proposed that any good business strategy involves focusing on those attributes for which the customer is willing to pay some money. In other words, the value created by the business should convince the customer to purchase the good or service for the listed price.
We will discuss the concepts and consequences using the image below.
Value and price dynamic, inspired by Frédéric Dalsace (HEC Paris)
Value
We can define value as the resulting sum of the benefits of ownership and the costs of ownership.
Benefits and costs of ownership
Benefits of ownership include all tangible and intangible elements or attributes the good or service offered allows the customer to achieve when it operates over the lifetime of the offer.
Tangible: increased productivity, better production quality
Intangible: status, security
Costs of ownership includes all tangible and intangible elements or attributes, excluding the price, the customer needs to spend to enable the offer to operate over the lifetime of the offer.
The value of an offer increases if there are more benefits, and the value of an offer decreases if there are more costs.
Value gap
The value gap defines the difference between the value offered by the firm and the perceived value by the customer. In an ideal world the value gap is zero but in the real world the value gap will always exist.
There are a couple of reasons for the value gap to exist.
Firstly, a firm typically creates an offer that covers several use case scenarios and segments of the market. On the contrary, a customer’s use-case is usually very well defined. The value gap captures the difference between the customer need and the firm’s offer.
For example, a mobile carrier may offer a range of plans that includes data, voice and text. The value offered is the total of all minutes, gigabytes and message included in the plan. If I’m a customer who is only interested in a plan with data, the value perceived is determined by the number of gigabytes included in the plan. The value gap consists of the minutes and messages included in the plan but of no interest to me.
Secondly, firms may not understand the customer’s needs very well. In that case it may focus on attributes that the customer simply does not care about.
For example, smartphone makers emphasize and charge a premium for marginally thinner devices. Many customers are not willing to pay much extra for a mm less thickness. In this case the firm believes it has created a lot of value for the customer, but the customer does not perceive it as value. That difference is capture in the value gap
Customer Incentive to Purchase
Central in the dynamic between value and price is a customer’s incentive to purchase (CIP). Sometimes we refer to the CIP as a customer’s willingness to pay (WTP) for a good or service.
A customer’s incentive to purchase is the difference between the value perceived by the customer and the purchase price.
Note that the customer incentive to purchase is function of the customer only! Neither the value offered by the firm nor the firm’s cost of offer have an impact on the incentive. CIP represents the reason why the customer believes the offer is worth it.
Therefore, no offer is too expensive by itself. It may be expensive given a certain set of attributes or a given situation.
Example: consider you are by yourself on a deserted island. You have a lot of scrap wood but nothing to set it on fire to create a source of heat. A single match is worth a lot of money and you will be very willing to pay a lot of money for the match. However, when returning to your daily life in an apartment with central heating that same match will be worth almost nothing.
In the real world you can expect that a customer will seek to maximize the CIP by comparing the value and price of similar offers.
Surplus Created by Firm
Surplus is the difference between the perceived value and the cost of the offer. It is the sum of the CIP and the margin of the offer.
A key challenge for the firm is to decide how to allocate the surplus created. Increasing the margin will increase the profit for the firm but reduce the customer incentive to purchase, and vice versa. As obligated to its shareholders, the firm should aim to maximize the margin.
Therefore, there is a continuous dynamic between a customer’s aim to maximize CIP and a firm’s aim to maximize margin.
The firm has additional challenge from competitors in the market whose products may offer a better CIP or have better margin. Generally, the firm should aim to offer a larger CIP than the one of the competitor’s best
Conclusive thoughts
The dynamic of value and price is function of the customer’s perception and their ability to capture as much value for as little price as possible. A firm should focus on reducing the value gap, increasing customer incentive to purchase, and increasing the surplus created.
In next posts will talk about how to overcome challenges related to the customer incentive to purchase and value gap.
In this post we outline a set of negotiation tactics you can use during your negotiations. For better understanding, we recommend you to first read the article A Real World Negotiation Strategy Framework.
The negotiation tactics listed below complement the strategy framework in the sense that they may help you execute your chosen strategy. The list is neither comprehensive nor mandatory for success, but simply outlines some options available to you. Based on your situation you may choose to use some of the tactics, or none at all.
Negotiation Tactics of Influence
1. Highlight potential losses rather than potential gains
People don’t like losing and are prone to focus more attention to a potential future loss, especially if the loss appears to be great. Highlighting the potential losses may sway your opponent to be more open to negotiation.
Note that it’s important to not over-emphasize or exaggerate a potential loss. Doing so may come across hostile or humiliating and your opponent may reject your hypothesis.
Example: a video-game development company may be persuaded to support a certain technology if not supporting it means the loss of a significant part of the potential player base.
2. Disaggregate gains, aggregate losses
Building on the previous tactic, it is useful to separate all the gains into separate arguments and aggregate all losses. This makes it seem as if the deal presented has a lot more positive elements than negative. In addition, the large loss looks easier to overcome or prevent.
3. Door in the face
When using the door in the face technique you follow a strong request with a more moderate request. As your opponent rejects the first request, it is more likely that they will approve the second request.
4. Foot in the door
The foot in the door technique is the opposite of the door in the face technique. Instead of aiming for rejection with the first demand, you aim for compliance. Your first request must be very reasonable for the other party to agree with.
Example: an online subscription service may offer you a free trial of one month before asking you to pay a monthly fee.
5. The power of justification
Nothing beats an honest and reasonable request from a trusted party. When the other party believes your request is justified by the information you provide, they are more likely to agree.
Example: when a child needs to use the restroom urgently, you will be able to convince the restaurant owner more easily to allow use of the restroom without purchase.
6. The power of social proof
Everyone knows that social peers can be a great enabler to make a purchasing decision. However, you don’t always need peers to use the power of social proof. Sometimes the suggestion of social proof is sufficient.
Example: when a company claims an online-only product is in high demand and urges you to order quickly, they may choose to limit the bandwidth of the page so less concurrent visitors can access it. As a result, it appears as if the website traffic is very high and thus must be very popular.
7. Token in literal concession
Giving a reward in exchange for an action may get people to give in to your demand.
Example: when signing up for Dropbox, you get extra storage space for sharing the service with your friends.
8. Employ reference points
This tactic combines the leverage of justification and social proof. It is widely used by companies aiming to increase their market share within an industry. Note that it’s important to use reasonable reference points. If the reference point is deemed unreasonable, it may undermine your negotiation.
Example: Xiaomi offers smartphones with similar features for a much lower price than its competitors. It may seem reasonable to spend more than you intended for a smartphone whose value is derived from the reference point.
9. Logrolling
Simultaneously negotiate multiple issues valued by each party differently to trade off concessions. This involves a lot of quid pro quo and complements an integrative negotiation strategy.
Example: you are deciding with your significant other where to go on holiday. You both dislike preparing for the trip. You want to go on a beach holiday and your significant other prefers a city-trip. Instead of negotiation the two topics separately (“Where to Go?” and “Who will prepare?”) you deal with both at the same time. A solution may be to split the vacation time in part beach, part city-trip, and each person prepares their preferred part of the holiday
Defending from Negotiation Tactics
Armed with the negotiation tactics listed above you can prepare for your negotiation. However, you must expect your opponent to also prepare properly. Therefore it’s important to also defend from these tactics influencing your decision making. Below you can find a shortlist of practices that can help you defend.
1. Prepare systematically
As outlined in the negotiation strategy framework post, it is important to prepare your negotiation thoroughly. Before entering the negotiation you need a clear outline of what you want as outcome of the negotiation, what you are willing to give up, and which line you are not willing to cross.
Some items to consider:
Target Point: what do you want?
Reservation Point: what line are you not willing to cross?
BATNA: what are your alternatives and how solid are they?
ZOPA: what would a potential agreement look like?
Bargaining Mix: what elements may be on the table?
2. Create a scoring system
Different elements of the negotiation may be of varying value to each partner at the table. Use a scoring system that determines the value you attribute to each element and keep track of your scoring system during the negotiation. If possible also create a (virtual) scoring system for your opponent.
A scoring system will help you maintain focus on your priorities as well as serve as a more objective basis to determine the outcome of the negotiation
3. Separate information from influence
When receiving information from the other party, be aware they may be trying to influence your decision.
Choose alternate sources to cross-check the information provided and separate genuine information from the influence.
4. Rephrase the offer in different terms
Rephrasing an proposition by your opponent gives you a couple of advantages.
Firstly, it gives you additional time to evaluate the proposition and its merits. Secondly, it forces the other party to reconsider the value of the proposition. Thirdly, it allows you to take or regain control of the negotiation process and dictate the pace.
Last but not least, it helps clarifying the details of a proposition.
5. Appoint a devil’s advocate
A devil’s advocate will help you simulate the negotiation and understand its dynamics before entering the real negotiations. Ideally a devil’s advocate will put you in an uncomfortable position so that you test out different tactics.
A great devil’s advocate will be tougher in negotiations than your actual opponent because they are not an invested party in the outcome.
6. Refuse negotiating under time pressure
Referring back to the negotiation strategy framework, time pressure forces a negotiator to rely on their System 1 thinking. You want to avoid this situation at all cost.
If needed, employ the Go To The Balcony technique to remove yourself physically or mentally from the negotiation
Negotiation Tactics for Weak Positions
Typically speaking, your negotiation position is as weak as your strongest alternative to an agreement. Although it is not recommended to enter a negotiation from a weak position, sometimes it is inevitable.
In this case, the first step is to recognize that your are in this position. Once realized, you can employ certain tactics to still make the most of the negotiation. Note that the success rate for negotiating from a weak position is low and it’s more than likely the other party will succeed. Therefore the tactics outlined below could be considered methods to minimize the damage.
1. Do not reveal you have a weak BATNA
Especially in negotiations where the other party also has a weak best alternative to a negotiated agreement, it is in your best interest to ensure they don’t know you are weak.
It may be helpful to construct a virtual best alternative to inspire confidence during the negotiation.
Note that the best course of action in case of a weak BATNA is to expand and improve your BATNA
2. Leverage the other party’s weakness
In a scenario where you are co-dependent on the other party, it may be useful to leverage the other party’s weakness by offering to help resolve it.
Example: in salary negotiations you may offer your boss to use your professional network to help resolve a problem that is out of the scope of your job description.
3. Leverage your unique value proposition
Focus on what sets you apart from the alternatives.
Sometimes it’s not important to make the best offer, but to make it to the final round of contract bidding. Having an offer that is compelling because it offers something other bidders don’t may be appealing.
If you offer something unique, communicate this with the final customer and educate them. If the final customer appreciate the unique value, this attribute may increase the value of your offer.
Example: in an M&A transaction, remove the agent from the equation to reduce the overall cost of transaction as much as possible.
4. Be honest
If you define yourself in an extremely weak position, it may be useful to give away any power you have by being honest about your situation.
Honesty may increase the consideration of fairness with the other party. The other party may give you a better deal than necessary in exchange for possible reciprocity in other situations.
Example: when applying for a new job position with low salary conditions, you may reveal to your future boss that you will take the job because you need to support your family, even though you consider the salary is too low. In that case your boss may be willing to increase the salary according to their judgment.
5. Increase the scope of negotiation
By presenting the bigger picture to the other party, you may be able to hide your weak position. You can do this by leveraging the power of extreme weakness in case the other party needs you to survive. Also you can cooperate with other people in similar weak positions to form a union against a stronger negotiating party.
Example: you are the primary supplier in the smartphone value chain. Your customer represents 80% of your business, and you supply 60% of the product to your customer. When the other party negotiates for lower prices, you may leverage that lower prices would lead to your company going out of business. In that case, the other party would lose a significant portion of the product necessary to build the smartphone. Looking at the bigger picture, lower purchasing prices may not seem as important.
In this post we talk about the framework for real world negotiation strategy. The content of the post follows lengthy discussions with Frank Gong on the matter.
Expertise and Experience
In the real world there are two key elements to success: expertise and experience. Expertise implies a certain level of proficiency in your job or field, particularly when it comes to understanding the matter in a structural way. Typically you obtain expertise by studying a course or going to school. Experience is the skill and knowledge you build up over the years as you’re practicing in the real world.
Expertise and experience are both important in the real world. They can help you find a solution in a structured way, or come to a solution faster or more efficiently.
While it is advised to gather expertise first, then gain experience in the real world, it is not the only way to be successful. As a general rule of thumb, it’s good to have both. If you are experienced in a certain field it pays to improve your expertise further. If you have great expertise, it’s valuable to return to the field and gain experience through practice.
In this post we will discuss a negotiation strategy shared with me by Frank Gong.
System 1 and System 2 Thinking
Broadly speaking you can separate the way we think in two categories. System 1 thinking is fast, and System 2 thinking is slow.
You can conceptualize System 1 thinking as using your intuition to make a decision in a split second. It requires little to no conscious effort and is largely automatic. You may not even be aware you’re using System 1 thinking! The drawbacks is that it is strongly biased towards false positives and is often distracted by appealing narratives.
On the opposite side, System 2 thinking is slow and conscious. It requires you to focus your attention to the problem and carefully consider the implications. It is more logical and rational, therefore people like to believe they use System 2 thinking most of the time.
In real world negotiation, in particular in the business setting, it is advise to always rely on System 2 thinking processes.
Five Step Negotiation Strategy Preparation
In preparation of a negotiation, there are five essential steps
Define your Target Point (TP), your Reservation Point (RP), and your Best Alternative To a Negotiated Agreement (BATNA)
Improve and expand your BATNA
Determine your opponent’s BATNA
Define the Zone Of Possible Agreement (ZOPA)
Determine the Negotiation Fit
In the next section we will cover each step more in detail.
1 – Target Point, Reservation Point and BATNA
Based on the outcome of a System 2 thinking and analysis process, you should define two key situations that may occur in the negotiation: when to agree and when to walk away. Your Target Point defines what you ideally want from the negotiation, whereas the Reservation Point defines the point you do not wish to cross.
For example, when you are buying new running shoes your Target Point may be $60 for a pair of shoes and your Reservation Point may be $80. If the listed price is $90, you may haggle with the shop owner to lower it to $60. If the shop owner drops the price to $70 you can accept the offer even though it’s not as low as you wanted.
Setting a Target Point and Reservation point helps us override the urge for System 1 thinking to take over. In the example above, it would prevent us from buying shoes we really want for a price that is higher than our reservation point.
To determine your Reservation Point, it is important to determine what is your Best Alternative To a Negotiated Agreement or BATNA. A BATNA is nothing more than alternatives to your negotation. In the example of the running shoes, a simple BATNA is to go to the store next door and look for better priced running shoes
2 – Expand and Improve Your BATNA
The best time to look for a job is when you already have one
Common wisdom as the quote above teaches us that the best antidote to the lack of a good alternative, is to always work on improving or expanding your alternatives. The better your alternatives are, the more power you will have within the negotiation. You have the power to say no, walk away and still create a win-situation.
You can ask a couple of simple questions to work on your BATNAs:
Can you do without any agreement?
What is the cost of walking away from the negotiation?
Are there any alternatives available?
Once you have identified the possible outcomes, it’s important to continue to work on improving them
For example: you have stagnated in your career and are looking to improve this. In first instance you may consider to negotiate a raise and promotion. If you don’t have a BATNA, four things may happen:
Success: you are given a raise and promotion
Partial success: you are given a raise or a promotion, but not both
No success: you are denied either a raise or promotion
Failure: you are let go
To avoid disappointment, or disaster, let’s consider the BATNAs in this situation.
One alternative is to consider looking for employment outside the organization. Applying for open positions on the job market gives you a good understanding and appreciation of your worth on the market. Perhaps you find a job that pays better, that is more interesting, or is closer to home. In this case, expanding your BATNA means looking for other job opportunities. Improving your BATNA means going to interviews and impressing the potential employer.
Another alternative to consider is the worst possible outcome: getting fired. If you have been in a high-paying position and saved up plenty over the years, then maybe it’s not such a bad idea to take a couple months off. However, if you have little savings and a lot of expenses then taking time of is a weak alternative. If you want to expand your BATNA with the option of taking time off, you can improve the BATNA by looking for a second part-time job.
3 – Determine Your Opponent’s BATNA
To know your Enemy, you must become your Enemy
Sun Tzu
An obvious aspect of preparing for a negotiation is to understand the position of your opponent. The best way to prepare is to think about what you would do if you were your opponent. So consider what are their Target Point, Reservation Point and BATNAs.
Thoroughly evaluating your opponent’s BATNAs gives you the advantage of knowing if their are negotiating in good faith. It will also help you determine their possible Reservation Points which will increase your power in the negotiation.
However, even though you can spend a lot of time on the analysis, be aware that you are not your opponent. There will be information asymmetry, meaning there will be things you are aware of that they are not and vice versa. Factors that you deem important may be unimportant for your opponent. Therefore beware of over-valuing information you are able to gather.
4 – Zone Of Possible Agreement
The zone of possible agreement (ZOPA) defines the virtual area between two parties where an agreement can be formed where both parties agree. Within the zone an agreement is possible. Outside this zone, an agreement is not possible. This zone is sometimes referred to as a Win Set.
Typically the ZOPA lies between the reservation points of both parties. In the example of the running shoes, the zone of possible agreement is between $70 (lowest price the shop owner is willing to sell) and $80 (the highest price you’re willing to pay).
$90: Target Point Seller
$80: Reservation Point Buyer
$70: Reservation Point Seller
$60: Target Point Buyer
ZOPA: $70-$80
Considering this example, it is also easy to understand the concept of a win-win negotiation. There’s a clear win for the shop owner for making a sale, and there’s a clear win for the buyer as they own a new pair of running shoes. There is a negotiation surplus
5 – Determine the Negotiation Fit
Within the context of a negotiation, it is important to aim for maximum profit. However, the negotiation usually exists within a broader context that may impact the probability of reaching an agreement. If you pursue maximum profit within the context of the negotiation, you may risk minimizing the probability of the deal going through. In which case you end up with no profit, or worse.
Having a good understanding of the broader context of the negotiation will help you determine the negotiation fit.
In the example of the negotiation for a raise and promotion, the broader context implies that in case of success it is likely you will have to continue to work with your colleagues. Squeezing your boss for every penny in the salary negotiation may leave a bad impression. That may cause your boss to be unwilling to keep you in the loop or not having your back in case a project goes wrong.
Win-Win: Distributive and Integrative Bargaining
To wrap up this post let’s return to point four of the five-step program: the zone of possible agreement. As mentioned, it is possible to create a win-win as opposed to a zero-sum situation in the negotiation. This is the difference between distributive and integrative bargaining.
Distributive Bargaining
In distributive bargaining everything is a zero-sum negotiation. That means the size of the loss of one party is the exact size of the win of the other party.
For example, let’s consider two children who are tasked with dividing 30 M&M chocolates. Any amount higher than half, or 15, for one child is the same amount of loss for the other side. This is a clear zero-sum negotiation. The optimal strategy for this kind of situation is to have one child divided the candy into two groups and allow the other child to first pick the group of choice. That ensures the division of candy will happen in good faith.
Does that mean this situation is always a zero-sum negotiation? No.
Integrative Bargaining
In integrative bargaining we come to a win-win agreement by gathering more information so we better understand the needs and desires of both parties. The size of win of one party may
For example, let’s consider the 30 M&Ms come in 5 different colors distributed equality. Child A loves Red and Black, and is neutral about Green, Blue and Yellow. Child B loves Red and Blue, is neutral about Green, and is allergic to Black and Yellow.
In a distributive agreement each child would have 3 M&Ms of each color. The final result would be that 6 candies are not eating as Child B is allergic to both black and yellow.
In an integrative agreement Child A can choose to give up 3 of their blue candies (which they feel neutral about and the other child loves) in exchange for all of the yellow and black candies (which Child B is allergic to). The final result is that both children will eat more candy.
The main take-away from this article is that negotiations are best done by applying System 2 thinking (rational and logical) and that information gathering and evaluation is your best friend.
“What is business strategy?” is the question that popped up this morning in my daily conversation with Frank Gong. Lacking a sufficiently succinct definition proposed by either Google or Baidu, we set out to dissect the term.
Business
Business is the exchange of the tangible or intangible for a kind of payment. More specifically, it is the selling of a product or a service to a customer. When the demand for a product or service is larger than the supply, it is sufficient to simply have ‘business’. Make the product or perform the service and you will make money. In this case there’s no need for a strategy, let alone putting effort into finding a good strategy.
Example: a friend decided to start his own company to make electronic components with relatively low complexity. He previously made products as a hobbyist and was able to sell them to customers directly as well as a larger distributor. The distributor agreed to sell the products he is working on in his first year of business.
In this example, because the demand is already there it is sufficient to simply have business. Do it, and you make money.
Business Strategy
Sadly, in most markets and industries supply far outweighs demand. In this case, simply making the product or doing the service will not be enough to be successful. You will need a strategy to make it work.
A strategy is a specific plan designed to achieve certain goals. When forming a strategy, the firm must consider three things:
What are the existing and potential attributes of my product or service?
What are customers willing to pay some money for?
Which attributes do we focus on such that we are unique in the market?
Attributes can take many forms, both tangible or intangible. For example, a smartphone has tangible attributes such as screen size, camera quality, battery lifespan, operating system, storage size; and intangible attributes such as privacy, design style, after-sales customer care.
As part of the strategy, a firm must choose which of those attributes to focus on. Focus implies that the firm aims to achieve excellence for that particular attribute. It is in a sense the true north of the firm in this business.
In most cases, it is not sufficient to choose only one attribute. Focusing on only one attribute makes it easy for your competition to copy your focus and you’ll be in trouble. A firm’s unique value proposition is the unique collection of attributes that the firm decides to focus (and not focus) on.
Thus we can propose the following definition: a business strategy defines the unique set of specific attributes the firm chooses to focus on aiming to achieve superior long-term return on invested capital.
Good Business Strategy
In the previous section we talked about business strategy in general. But what sets apart business strategies? Which strategies are bad, good, great, or even fantastic?
This depends on the market.A firm’s goal is to achieve short-term revenue growth and superior long-term sustained return on invested capital. If you achieve the goals, then it means you chose a good business strategy. If you don’t achieve the goals, then it’s a bad business strategy.
Returning to the attributes, we said it’s not sufficient to simply identify those you want to focus on. It’s also important to identify those attributes the market is willing to pay some money for. Achieving excellence in an attribute no one is willing to pay for is a wasted effort and will reflect in poor long-term return on invested capital.
Of course there’s more that goes into achieving success than just having a business strategy with good potential. The business strategy success relies on the execution. A fantastic business strategy with poor execution will fail, but a good business strategy with good execution will bring some success
What’s Not Business Strategy
In the real world often people confuse business strategy with the actions, aspirations or visions of a firm. While these are not part of the strategy, they often support the formulation or execution of the strategy. A couple of examples:
“Our strategy is to expand globally” is not a business strategy, but rather a business tactic in support of the business strategy. Expanding globally only makes sense in the context of making a specific business strategy succeed.
“Our strategy is to be market leader” is not a business strategy, but rather a goal you set as an indication of business strategy success. To be market leader can be the result of a successful business strategy.
“Our strategy is to best understand our customer needs” is not a business strategy, but rather an activity that helps you better understand which specific attributes your firm should focus on. Better understanding of the customer needs will help you choose those attributes customers are willing to pay money for.
