Investors will finance technology related projects only if they are convinced that it is in their self interest (Narayanan: 2000). Investors may fund technology endeavors only when such projects are marketable. Narayanan quotes four major financial considerations; project valuation, intellectual capital, financing, and market signaling.
1) Project Valuation
As usual, all projects evolve over a number of stages, from inception to completion to operation. By life cycle of a project, we mean all the activities sequenced over time from the beginning till operations or commercialization as mentioned. The funds required for a project are small in the beginning and are highest during the implementation stage. Project valuation refers to the activities involving estimating the economic worth of a project or a start up.
Many technology firms adopt net present value or internal rate of return in capital budgeting. Net present value (or NPV) is a standard method in finance of capital budgeting – the planning of long-term investments. Using the NPV method a potential investment project should be undertaken if the present value of all cash inflows minus the present value of all cash outflows (which equals the net present value) is greater than zero.
The internal rate of return (IRR) is used by firms to decide whether they should make long term investments. The IRR is defined as any discount rate that results in a net present value of zero, and is usually interpreted as the expected return generated by the investment. In general, if the IRR is greater than the project’s cost of capital or hurdle rate, the project should be accepted, though there are occasional problems in using this rule.
As an investment decision tool, the calculated IRR should not be used to rate mutually exclusive projects, but only to decide whether a single project is worth investing in. In cases where one project has a higher initial investment than a second mutually exclusive project, the first project may have a lower IRR (expected return), but a higher NPV (increase in shareholders’ wealth) and should thus be accepted over the second project. A method called marginal IRR can be used to adapt the IRR methodology to this case.
The IRR method should not be used in the usual manner for projects that start with an initial positive cash inflow, for example where a customer makes a deposit before a specific machine is built, resulting in a single positive cash flow followed by a series of negative cash flows (+ – – – -). In this case the usual IRR decision rule needs to be reversed.
If there are multiple sign changes in the series of cash flows, e.g. (- + – + -), there may be multiple IRRs for a single project, so that the IRR decision rule may be impossible to implement. Examples of this type of project are strip mines and nuclear power plants, where there is usually a large cash outflow at the end of the project.
In general, the IRR can be calculated by solving a polynomial. Sturm’s Theorem can be used to determine if that polynomial has a unique real solution. Importantly, the IRR equation cannot be solved analytically (i.e. in its general form) but only via iterations.
A critical shortcoming of the IRR method is that it is commonly misunderstood to convey the actual annual profitability of an investment. However, this is not the case because intermediate cash flows are almost never reinvested at the project’s IRR; and, therefore, the actual rate of return (akin to the one that would have been yielded by stocks or bank deposits) is almost certainly going to be lower. Accordingly, a measure called Modified Internal Rate of Return (MIRR) is used, which has an assumed reinvestment rate, usually equal to the project’s cost of capital.
A key input into this process is the interest rate or “discount rate” which is used to discount future cash flows to their present values. If the discount rate is equal to the shareholder’s required rate of return, any NPV > 0 means that the required return has been exceeded, and the shareholders will expect an additional profit that has a present value equal to the NPV. Thus if the goal of the corporation is to maximize shareholders’ wealth, managers should undertake all projects that have an NPV > 0, or if two projects are mutually exclusive, they should choose the one with the highest positive NPV.
The assumptions underlying the discounted cash flow method are more or less valued in technology decisions where both the technology and the market are relatively mature. However when either technology or market is in their early stage of development, the assumptions behind the discounted cash flows are seriously violated. As a result, many progressive firms augment traditional discounted flow methods with alternative approaches such as option pricing for valuing early stage projects.
In finance, the discounted cash flow (or DCF) approach describes a method to value a project or an entire company. The DCF methods determine the present value of future cash flows by discounting them using the appropriate cost of capital. This is necessary because cash flows in different time periods cannot be directly compared since most people prefer money sooner rather than later (put simply: a dollar in your hand today is worth more than a dollar you may receive at some point in the future). The same logic applies to the difference between certain cash flows and uncertain ones, or “a bird in the hand is worth two in the bush”. This is due to opportunity cost and risk over time.
DCF procedure involves three problems.
the forecast of future cash flows, b. the incorporation of taxes (firm income taxes as well as personal income taxes), c. the determination of the appropriate cost of capital.
Discounted cash flow analysis is widely used in investment finance, real estate development, and corporate financial management.
Models of option pricing were very simple and incomplete until 1973 when Fischer Black and Myron Scholes published the Black-Scholes pricing model.
The Black-Scholes model gives theoretical values for European put and call options on non-dividend paying stocks. The key argument is that traders could risklessly hedge a long options position with a short position in the stock and continuously adjust the hedge ratio (delta) as needed. Assuming that the stock price follows a random walk, and using the methods of stochastic calculus, a price for the option can be calculated where there is no arbitrage profit. This price depends only on 5 factors: the current stock price, the exercise price, the risk-free interest rate, the time until expiration, and the volatility of the stock price. Eventually, the model was adapted to be able to price options on dividend paying stocks as well.
The availability of a good estimate of an option’s theoretical price contributed to the explosion of trading in options. Other option pricing models have since been developed for other markets and situations using similar arguments, assumptions, and tools, including the Black model for options on futures, Monte Carlo methods and Binomial options models.
(2) Intellectual capital
Because technology includes tacit knowledge, ie, knowledge that is not embodied as physical assets, in many high technology firms the intellectual capital may economically be far more significant than the physical assets. Intellectual capital is a term with various definitions in different theories of economics. Accordingly its only truly neutral definition is as a debate over economic “intangibles”. Ambiguous combinations of instructional capital and individual capital employed in productive enterprise are usually what is meant by the term, when it is used to actually refer to a capital asset whose yield is intellectual rights.
Perhaps due to their industry focus, the term “intellectual capital” is employed mostly by theorists in information technology, innovation research, technology transfer and other fields concerned primarily with technology, standards, and venture capital. It was particularly prevalent in 1995-2000 as theories proliferated to explain the “dotcom boom” and high valuations.
During this period it was often observed that computer code and programmers were bearing a substantial premium when combined in new unproven companies. It is hard to see how this differs from the tulip boom, however, when it would have been just as likely to assign a high value to the seemingly-magical combinations of tulip bulbs and, say, the pots they grew in.
Two fundamental challenges are involved in financing technology projects; adverse selection and moral hazard. Risk can be shifted to another person who is willing to bear it–the speculator. Another way of dealing with risk is by pooling it using insurance. The idea is simple. If one out of 1000 homes will burn each year, and if each person contributes to a general fund 1/1000 of the value of his home, the fund will have enough (ignoring administrative expenses and the question of whether expensive homes are more or less likely to burn than cheap homes) to reimburse those whose homes burn down.
The size of the insurance industry indicates that people are eager to pay to avoid risk. They pay and get nothing if fortune smiles on them, whereas if misfortune strikes, they break even because the insurance should just pay back the value lost in the misfortune.
Because insurance changes the costs of misfortune, and because people choices depend on costs and benefits, insurance should change people’s behavior. They should make less effort to avoid misfortune, and this change in behavior is called moral hazard. For example, if an accident costs a person $1000 but insurance pays $900, the insured person has less incentive to avoid the accident. If the accident costs the person $1000 but pays $2000, the person not only has no incentive to avoid the accident but may have an incentive to seek it out.
Sometimes moral hazard is dramatic. Fire insurance encourages arson, automobile insurance encourages accidents, and disability insurance encourages dismemberment.
The problem of moral hazard also affects government programs that insure people against misfortune. A variety of programs help people who suffer the misfortune of poverty. Aid to dependent children helps people who suffer the misfortune of having children to raise that they cannot financially support. Unemployment compensation pays people who suffer the misfortune of losing their jobs. Food stamps and public housing help the poor. Yet all these programs also suffer from problems of moral hazard. They increase children born out of wedlock, unemployment, and poverty.
Moral hazard is the result of maximizing behavior. A person weighs the costs and benefits of an action, and when benefits exceed costs, he takes the action. This does not mean that if a person has a building insured for $50,000 but only has a market value of $30,000, the owner will necessarily commit arson. There may be costs of violating one’s moral code and of getting caught and convicted for arson. But some people put into this situation will find a way to torch the building because they do not find the cost of violating a moral code very high and they consider the chances of being caught small, and other people will be less careful about avoiding fires. Moral hazard does not require that people intentionally cause the misfortune. If they simply take fewer measures to prevent misfortune, the same outcome occurs.
The problem of moral hazard creates problems both for private insurance and the government. Private insurance tries to keep the insured value of any misfortune less than the value to the insured person. It tries to keep buildings and autos insured for less than their true worth. In addition, it is usually against the law to create the misfortune that you are insured against. Finally, if the problem of moral hazard is too great, there will be no insurance coverage for the misfortune.
The government can and sometimes does take a similar approach. It can give so little aid to those in distress that it provides little encouragement for people to put themselves in the situation, but it then provides little help for those in distress. As it expands a program to provide more aid to those in distress, it also encourages people to put themselves in distress. If people are paid to be poor, some will become poor. If people are paid to have children out of wedlock, some will. If people are paid to be unemployed, more will be unemployed. Thus government programs that act to insure citizens against some misfortunes have a basic tradeoff that cannot be escaped. Greater efforts to help those in need also increase actions that are considered socially undesirable.
The insurance industry can also face problems of signaling and screening. People who buy insurance often have a better idea of the risks they face than do the sellers of insurance. People who know that they face large risks are more likely to buy insurance than people who face small risks. Insurance companies try to minimize the problem that only the people with big risks will buy their product, which is the problem of adverse selection, by trying to measure risk and to adjust prices they charge for this risk. Thus, life insurance companies require medical examinations and will refuse policies to people who have terminal illnesses, and automobile insurance companies charge much more to people with a conviction for drunk driving.
These challenges are particularly acute in the case of start up firms that have to look outside for financing their venture. As a result, the activities during the various stages of a start up are financed from different sources of funds. As external sources of financing are injected into the operations of the company, the outside shareholders may increasingly demand a voice in the running of the company. Sometimes, the objectives of the private equity provider may diverge from the objectives of the entrepreneur; in this case, the conflicts between the two are highly likely. The venture capital process involves an intense company scrutiny by the venture capital providers of the business plan, management team and the request for funds. The venture capitalist tries to attenuate the adverse selection and moral hazard problems through initial scrutiny, terms of agreement and monitoring mechanisms that are placed in the continual evaluation of the start up. (Narayanan: 2000)
The financing of technology projects in the large firms is tied with the budgeting process. Nonetheless, the responsibility for maintaining the innovativeness of a firm to a large extent, will hinge on the success of technology managers in influencing the flow of funds to appropriate projects.
(4) Market signaling
In matters pertaining to technology, signaling becomes a major mechanism by which managers in large firms can provide credible, economically relevant information to outside investors in determining the value of the firm.
The three environmental trends – globalization, time compression, and technology innovation –are influencing the sources of financing used for technology projects. Perhaps the most dramatic development over the past tow decades has been the global growth of venture capital.
Globalization is an umbrella term for a complex series of economic, social, technological, and political changes seen as increasing interdependence and interaction between people and companies in disparate locations. The phenomenon has been noted since the 1980s in the context of sociological study on a worldwide scale.
The term “globalization” is used to refer to these collective changes as a process, or else as the cause of turbulent change. The distinct uses include:
1. Economically and socially positive: As an engine of commerce; one which brings an increased standard of living — prosperity to developing countries and further wealth to First World and Third World countries. This view claims that economic prosperity brings about social prosperity.
2. Economically and socially negative: As an engine of “corporate imperialism”; one which tramples over the human rights of developing societies, claims to bring prosperity, yet often simply amounts to plundering and profiteering. Negative effects include cultural assimilation via cultural imperialism, the export of artificial wants, and the destruction of local society and culture.
Definitions of globalization are almost all highly subjective, depending on the positionality and experiences of the definer. A typical definition can be taken from the International Monetary Fund, which defines globalization as the growing economic interdependence of countries worldwide through increasing volume and variety of cross-border transactions in goods and services, free international capital flows, and more rapid and widespread diffusion of technology. All definitions appear to agree that globalization has economic, political, cultural, and technological aspects that may be closely intertwined.
Narayanan, V. K (2001) Managing technology and innovation for Competitive Advantage, Englewood Cliffs, NJ: Prentice Hall.