“Einstein discovers that time is actually money.” from The Complete Far Side by Gary Larson.
Sooner or later, all decision engineers will come face to face with finance. Someday you will want to get a project approved or maybe you will want to get a business funded. It can be a frustrating experience if you don’t know some simple concepts.
People who study finance in college generally do not think like engineers or entreprenuers. They chose a different major in school for good reason. They think differently than you do. They use a different language. They will bombard you with requests for depreciation schedules and EBIT. They measure dollars to two digits.
Your interactions with the world of finance will be virtually effortless if you are familiar with the following simple concepts:
1) Project evaluations are always comparative. New projects always have to be compared to the best available alternative. Sometimes the best alternative is to leave the money in the bank.
2) Financial evaluations begin with an understanding of free cash flows. When are the checks written and to whom?
3) Net present value of cash flow (NPV) is the appropriate measure to use to compare projects.
4) The appropriate value for a project with uncertain cash flows is the Certain Equivalent NPV. Many financial analysts call this the “risk-adjusted NPV.” (For more about calculating the Certain Equivalent see “Foundations of Decision Analysis,” by Ron Howard and Ali Abbas.)
5) All other things being equal, select the project with the highest Certain Equivalent NPV.
6) The discount rate to use for NPV calculations is a decision. If you are borrowing money then use the interest rate for obtaining loans. If you are cash rich, use the interest rate on your investments.
These assertions are true whether we are evaluating a new product proposal or valuing a Fortune 500 company. NPV of cash flow is the measure of value. It is the gold standard.
In my experience, financial staff are always pleased to see projections of free cash flows and NPV calculations. Sometimes they will want to see the Return on Investment (ROI). This is an easy calculation. ROI is popular, however, ROI tends to bias decisions toward small, fast payoff projects. Large, longer term payout projects are penalized. ROI is not normative like NPV.
If you want to learn more about finance then I recommend a Coursera course. There are many to choose from.
I reviewed an early version of a course by Professor Gautam Kaul. I thought it was excellent. It focuses on two big ideas: the time value of money and the trade off between risk and reward. He presents the ideas as simple common sense.
The course does discuss uncertainty. However, probability is taught from a classical statistics perspective. This is useful for evaluating passive investments. It is not appropriate for the kinds of strategic decisions faced by executives. For strategic decisions we need to address uncertainty directly. For this approach see, Decision Coach’s Guide to the Decision Analysis Process.
Baker Street posts about once a month on topics of interest to decision coaches and decision engineers. If you would like to receive these posts automatically by e-mail, just submit your address here.