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Management of Technology & Innovation MKTG5603 &
Biotechnology Commercialisation MKTG5604
Workshop 3 Part B: Assessing
Risk Professor Tim Mazzarol – UWA Business School
UWA Business School MBA Program
M Biotech Program
[email protected] MOTI MKTG5603
BC MKTG5604
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Risk Management Basics
Identify risks
Analyse the risks
Evaluate the risks
Treat the risks
Monitor the risks Establish
Context
Source: Schnepple 2006
Hi Tech Venture
Failure to get patents or regulatory
approvals. Laboratory needs 24/7
power and IT, product launch in 3
months.
Product launch needs:
plastic injection parts;
packaging, marketing
materials & distribution
agreement signed.
Plastic injection parts tooling
not finished, awaiting first
samples to validate
production process - (High
Risk)
Schedule design review of
part, tooling and chosen
plastic raw material with
external experts. Draw up
contingency plan for 100%
inspection.
Monitor % yield of production
process once started, tooling
may deteriorate or raw
material quality may vary.
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Technical versus Market Risk
0
10
20
1 11 21
Market
Te
ch
no
log
y
Existing New
Evolutionary Leverage base
RadicalDiscontinuity
Ne
wE
xis
tin
g
Increasing
Risk
Technical Success Factors:
• Proprietary Position
• Competencies/Skills
• Complexity
• Access to External Technology
• Manufacturing capability
Source: Davis et al. 2001
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Technical versus Market Risk
Source: Davis et al. 2001
0
10
20
1 11 21
Market
Te
ch
no
log
y
Existing New
Evolutionary Leverage base
RadicalDiscontinuity
Ne
wE
xis
tin
g
Increasing
Risk
Commercial Success Factors:
• Customer/Market Need
• Market/Brand recognition
• Distribution Channels
• Customer Strength
• Raw Materials Supply
• Environment, Health & Safety
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Technology & Market Risk
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Risk Assessment
• Rank projects using economic or net present
value (NPV)
• NPV (a form of Discounted Cash Flow) can be
used in two ways:
– To make “Go/Kill” decisions at gates based on NPV
“hurdle rates”
• if positive Go, if negative Kill.
– As part of a portfolio review with all projects ranked
according to NPV
• Go projects are at top of the list.
• Other techniques:
– Internal Rate of Return (IRR)
• Value of discount rate that forces NPV to zero
• Project’s ROI%
– Payback Period Source: Cooper (2011)
Assessing the financial, technical and market risk of a project is important in order
to avoid wasting resources on dead ends. It is key to the “Go/Kill” decisions
required in the NPD process.
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Discounted Cash Flow (DCF)
• DCF (discounted cash flow) analysis:
– Recognizes that money has a time value.
– Is a cash flow method not caught by accounting practices
(e.g. accruals).
Source: Cooper (2011)
Example:
• $200m payable in 5 years by Reserve Bank of Australia
• What is it worth today?
• At a Discount Rate of 20%, NPV =
• The Discount Rate depends on the risk:
• Government bond rate
• Share market investment
• Venture capital investment
mm
4.80$2.1
200$5
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Finding the Hurdle Rate
• Normally the Discount Rate used is the
firm’s cost of capital adjusted for the “risk
level” for that type of project.
• An alternative can be to use a discount
rate equal to the lowest rate achieved by
projects of this type within the product
portfolio. – Use the IRR of the lowest-return project of that
type.
– Projects with negative NPV are below the worst
projects of that type in the portfolio and should be
killed.
– Helps to boost up the quality of the portfolio.
Source: Cooper (2011)
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Using Project NPV to Rank Projects
Source: Cooper (2011)
1 2 3 4 5 6 7
Project PV (present value of
future earnings)
Development
Cost
Commercial-
ization cost
NPV (Net present
value)
Ranking
based on NPV
Decision
Alpha $30m $3m $5m $22m 4 Hold
Beta $64m $5m $2m $57m 2 Go
Gamma $9m $2m $1m $6m 5 Hold
Delta $3m $1m $0.5m $1.5m 6 Hold
Echo $50m $5m $3m $42m 3 Hold
Foxtrot $66m $10m $2m $58m 1 Go
Notes:
• Top four projects are Foxtrot, Beta, Echo and Alpha.
• There is a resource limitation of $15m so only two projects can “Go”.
• NPV portfolio value = $115m from both projects.
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Rank Projects using Productivity Index
• Under conditions of resource limitation
the use of NPV alone is too restrictive.
• Use NPV for “Go/Kill” decisions on
projects but the “Productivity Index” to
rank and prioritize them.
Source: Cooper (2011)
Productivity Index =
NPV of the project
Total resources remaining to be
spent on the project
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Productivity Index Project Ranking
Source: Cooper (2011)
1 2 3 4 5
Project NPV Development
cost
Productivity
Index
(NPV/Dev Cost)
Sum of Dev
Costs
Beta $57m $5m $11.4m $5m
Echo $42m $5m $8.4m $10m
Alpha $22m $3m $7.3m $13m
Foxtrot $58m $10m $5.8m $23m
Gamma $6m $2m $3.0m $25m
Delta $1.5m $1m $1.5m $26m
Notes:
• Productivity index used to rank projects until out of resources.
• “Go” projects are now Beta, Echo and Alpha, Foxtrot drops below the line.
• NPV portfolio value = $121m from three projects if Gamma is added this boosts to $127m.
Resource
Limit
$15m
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Risk Analysis with Options Pricing Theory
• DCF / NPV methods fail to deal well with
high levels of risk and uncertainty.
• They assume “all or nothing” decisions
and don’t work well with NPD that has
staged development process.
• As the NPD process moves forward the
project’s risk is adjusted. Options pricing
theory is therefore considered better
than NPV for many NPD situations.
Source: Cooper (2011)
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First Chicago Method
• Based on DCF method.
• Considers the likelihood of the
R&D succeeding.
• Predicts 3 possible outcomes:
– Best Case
– Most Likely Case
– Worst Case
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Decision Tree Analysis
Development
$D
($3m)
Launch
$C
($5m)
$10m
$15m
$30m
$0m $8m
$5m
$ECV
Commercial Success
$PV
Commercial Failure
YES
NO
YES
NO Technical Failure
Technical Success
Notes:
• $ECV = Expected Commercial Value of the project.
• Probability of technical success = 80%.
• Probability of commercial success (given technical success) = 50%.
• $D = Development costs remaining in project = $3m.
• $C = Commercialization costs = $5m.
• $PV = Net Present Value of project’s future earnings (discounted to today) = $30m. Source: Cooper (2011)
80
20
50
50
Expected value before launch =
0.5 x $30m + 0.5 x 0 = $15m Expected value once in development =
0.8 x $10m + 0.2 x 0 = $8m
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T=0
Invest $3m x 4 years T=4, Invest $70m
for commercialisation
T=5
Terminal value
Invest R&D
R&D Success
R&D Fail
0.7
0.3
0.12
0.48
0.4
Best Case
$600m
Best Guess
$100m
Blocked
$0m
Commercialise
$120
At T=4 NPV=
$120/1.2-70=$30m
NPV of R&D = -9.32m
NPV of Project = $-9.32 +0.7*14.47 = $0.81m
Discounted to T=0:
30m/1.2^4=14.47m
First Chicago Method
Source: Steffens & Douglas 2004
=Uncertain
Event
Discount
Rate
Valuation
($m)
15% $3.90
20% $0.81
25% -$1.40
30% -$2.98
40% -$4.90
50% -$5.84
(20% discount rate)
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T=0
Invest $3m x 4 years T=4, Invest $70m for
commercialisation?
T=5
Terminal value
Invest R&D
R&D Success
R&D Fail
0.7
0.3
0.3
0.7
Good Market
Poor Market
Commercialise
Abandon
0.4
0.2
0.4
Best Case
$600m
Best Guess
$100m
Blocked
$0m
Best Case
$600m
Best Guess
$100m
Blocked
$0m
0.0
0.6
0.4
Commercialise
Abandon
$260
$60
At T=4 NPV=
$260/1.2-70=$146m
At T=4 NPV=
$60/1.2-70=$-20m
NPV of R&D = -9.32m
NPV of Project = $-9.32 +0.7*0.3*70.7 = $5.53m
Discounted to T=0:
146m/1.2^4=70.7m =Uncertain Event
=Management
Decision
Decision Tree Analysis (20% discount rate)
Source: Steffens & Douglas 2004
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Sensitivity to Discount Rate
Discount
Rate
Valuation
DCF
($m)
Valuation
First Chicago
($m)
Valuation
Decision Tree
($m)
15% $55.28 $3.90 $8.89
20% $42.12 $0.81 $5.53
25% $32.10 -$1.40 $3.01
30% $24.41 -$2.98 $1.10
40% $13.80 -$4.90 -$1.44
50% $7.26 -$5.84 -$2.94
DCF: all risk is penalised via single discount rate leading to wide range of
valuations vs. discount rate
First Chicago: Discount rate and risk are treated separately, NPV is much
less sensitive to discount rate
Decision Tree: Shows the value of the option to abandon (in this case
under poor market conditions at T=4)
Source: Schnepple 2006
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Risk Management 3 Approaches
Source: Schnepple 2006
1. Keep it simple “Low/Medium/High” only. Higher precision
is not realistic, focus instead on
understanding cause/effect relationships
2. Rate 0…100% using
expert opinion
Most commonly used method, but even the
most qualified experts can be way off the
mark
3. Anchored scales Provide a set scale with precise
descriptions for each value (e.g. from 0 to
10) – reduces spread of ratings by different
individuals
Source: Cooper (2011)
FACTOR Very low 0-10 Very high
1. Strategic Fit & Importance: • Alignment of project with business strategy. • Importance of project to the strategy. • Impact on the business.
0
5
10
2. Product & Competitive Advantage: • Product delivers unique customer or user benefits. • Product offers customer/user excellent value for money. • Differentiated product vs. competitors. • Positive customer/user feedback on product concept (concept test results).
0
6
10
3. Market Attractiveness: • Market size. • Market growth and future potential. • Margins earned by competitors in the market. • Competitiveness – how tough & intense is competition.
0
8
10
4. Core Competencies Leverage: • Project leverage our core competencies & strengths in technology, operations, marketing, sales &
distribution.
0
9
10
5. Technical Feasibility: • Size of technical gap. • Familiarity of technology to the business. • Newness of technology (base to embryonic). • Technical complexity. • Technical results to date (proof of concept).
0
1
10
6. Financial Reward versus Risk: • Size of financial opportunity. • Financial returns (NPV, ECV). • Productivity index • Certainty of financial estimates. • Level of risk & ability to address risks.
0
7
10
Scorecard for NPD Project Selection
Project Attractiveness Score: 36/60 = 60% • Projects scored 0-10 rating scales for 6 factors. • Project Attractiveness score taken out of 100. • Scores >60/100 usually given “Go” decision.
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New Technology Projects are Different
• Financial risk assessment methods don’t
work very well for technology-platforms
and advanced-technology projects.
• Use a scorecard with more strategic and
qualitative criteria to assess risk.
• Strategy drives the portfolio and new
high-tech projects should be assessed
with custom-tailored systems not forced
through the stage-gate process.
Source: Cooper (2011)
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Strategic Buckets “Mercedes Star” Method
Source: Cooper (2011)
1. Business Strategy Fit 0 Score 0-10 10 Congruence Only peripheral fit with our strategy 1 Strong fit with our strategy
Impact Minimal impact no harm if dropped 2 Firm's future depends on project
2. Strategic Leverage 0 10 Propriety position Easily copied no protection 5 Strong protection difficult to copy
Platform for growth Dead end, one of a kind or one off 6 Offers strong plaform for new products
Durability (technical & marketing) No distinct advantage easily leapfrogged 8 Long lifecycle with opportunity for growth
Synergy with other operations Limited to single business area 7 Could be offered across company
3. Probability of technical success 0 10 Technical gap Radical innovation new scientific paradigm 6 Incremental improvement easy to do
Program complexity Highly complex with many hurdles 10 Easy to produce, straightforward to do
Technology skill base No existing technological skills in firm 8 Technology widely practiced within the firm
Availability of people & facilities Must hire and build 8 People and facilities already available
4. Probability of commercial success 0 10 Market need No clear market need identified 5 Large existing market need identified
Market maturity Market is declining 3 Market is growing
Comptetitive intensity Many strong competitors in the market 2 Few competitors in the market
Commercial application skills New company without commercial skills 6 Company already has strong commercial skills
Commercial assumptions High uncertainty of commercial success 8 High certainty of commercial success
Regulatory/Social/Political impact Highly negative 7 Highly positive
5. Reward 0 10 Absolute contribution to profitability (5 year cumulative)
Very weak contribution 8 Very strong contribution
Payback period (guesstimate) Very long 7 Very short
Time to commercial start-up Very long 6 Very short
Total score 113 Maximum score 190
Score/100 59% Project attractiveness total 100
Project attractiveness score 59
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Group Discussion
Working in teams
• Review the project’s technical and
commercial risk.
• Examine the financial returns
using available tools:
– NPV/IRR/DCF
– Decision tree analysis
• Examine project risk using:
– Project attractiveness
scorecards
• How does the project stack up?
– What are the “Go/Kill” issues?
End of Presentation
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