Evaluating Your Idea Financially
Before learning what to be done next, it’s useful to dig more deeply into the economics of a venture. We’ve mentioned that there are many potential opportunities in the world, but how can you determine if an idea is a good one? In this section, we’ll introduce some tools for evaluating ventures. We’ll estimate how much customers are willing to pay, the total size of the market, the level of operating and capital costs, and the cost of capital. A great opportunity is one in which the discounted present value of cash inflows is much higher than the present value of outflows.
Let’s start with a hypothetical venture based on John’s experience in the energy conservation business—let’s call it Motion Alert, Inc. Suppose John has a new idea for a battery-operated, wireless home safety device that detects motion in rooms and notifies the owner. John estimates that he will have to spend $1 million to perfect his design, apply for patent protection, arrange for another firm to manufacture and ship the device, and contract an independent sales organization. He has no employees on his payroll, and he owns 100% of the company.
Based on research and interviews, he thinks the product will retail for $15.00, a price that is significantly lower than the competition. John can buy the devices from the manufacturer for $6.00. The sales organization wants $2.00 for each unit sold and the retailer needs $3.00. That leaves John with a pre-tax profit of $4.00 per unit. He has a personal tax rate of 40%. He prepares a simplified cash flow forecast for his venture, detailed here:
(For this course, we will not expect you to create these financial models, but we will walk you through their use and implications. Creating a model of a venture’s basic business model and cash flows is critical to understand how to select, build and finance a venture.)
As you can see, John has an idea that requires a modest investment ($1 million) and generates attractive cash flows for three years. John assumes that competitors will develop similar products and enter the business, which is why his sales drop to $0 at the end of three years. Competition makes it harder to sustain prices and profit margins.
If we assume that the discount rate (the opportunity cost of capital) is 10%, then the present value of the cash flows is approximately $6 million and the net present value after subtracting the required investment is $5 million. This seems like a very attractive project—if he can pull it off.
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Resources of these articles are: Harvard Business School