Chapter 7 choosing innovation project

CHOOSING
INNOVATION PROJECT
Muhammad Anang Ramadhan
Information System

OVERVIEW [ THE
DEVELOPMENT BUDGET]
Capital Rationing is the allocation of a finite
quantity of a resource over different possible uses.
Many firms use a form of capital rationing in
formulating their new product development plans.
Under capital rationing, the firm sets a fixed research
and development budget (often some percentage of
the previous year’s sales), and then uses a rank
ordering of possible projects to determine which will
be funded. Firms might establish this budget on the
basis of industry benchmarks or historical benchmarks
of the firm’s own performance. To provide a sense of
what firms in different industries spend on R&D.

QUANTITIVE METHODS FOR
CHOOSING PROJECTS
Quantitative methods of analyzing new
projects usually entail converting projects into
some estimate of future cash returns from a
project. Quantitative methods enable managers
to use rigorous mathematical and statistical
comparisons of projects, though the quality of
the comparison is ultimately a function of the
quality of the original estimates. The most
commonly used quantitative methods include
discounted cash flow methods and real options.

DISCOUNTED CASH FLOW
METHODS
Net Present Value (NPV) is the discounted cash inflows
of a project minus the discounted cash outflows.
Internal rate of return (IRR) is the rate of return yielded
by a project, normally calculated as the discount rate
that makes the net present value of an investment
equal zero.
Both methods rely on the same basic discounted
cash flow
mechanics, but they look at the problem from different
angles.

NET PRESENT VALUE (NPV)
To calculate the NPV of a
project, managers first
estimate the costs of the
project and the cash flows the
project will yield (often under
a number of different “what if”
scenarios). Costs and cash
flows that occur in the future
must be discounted back to
the current period to account
for risk and the time value of
money. The present value of
cash inflows can then be
compared to the present value
of cash outflows.
NPV = Present value of cash inflow – Present value of
cash outflows

INTERNAL RATE OF RETURN
(IRR)
The internal rate of return of a project is the
discount rate that makes the net present value of the
investment zero. Managers can compare this rate of
return to their required return to decide if the
investment should be made. Calculating the IRR of a
project typically must be done by trial and error,
substituting progressively higher interest rates into the
NPV equation until the NPV is driven down to zero.
Calculators and computers can perform this trial and
error. This measure should be used cautiously,
however; if cash flows arrive in varying amounts per
period, there can be multiple rates of return, and

REAL OPTIONS
Real options is the
application of stock option
valuation methods to investments
in nonfinancial assets. In “real
options,” the assets underlying the
value of the option are
nonfinancial resources. An
investor who makes an initial
investment in basic R&D or in
breakthrough technologies is, it is
argued, buying a real call option
to implement that technology later
should it prove to be valuable.
Options are valuable when there is
uncertainty, and because
technology trajectories are
uncertain, an options approach
may be useful.

DISADVANTAGES OF
QUANTITIVE METHODSQuantitative methods for analyzing potential innovation projects
can provide concrete financial estimates that facilitate strategic planning
and trade-off decisions. They can explicitly consider the timing of
investment and cash flows and the time value of money and risk. They
can make the returns of the project seem unambiguous, and managers
may find them very reassuring. As noted by Professor Freek Vermeulen,
author of Business Exposed, one of the most common mistakes
managers make in their innovation strategy is to insist on “seeing the
numbers”—for truly innovative products, it is impossible to reliably
produce any numbers. It is very difficult to compute the size of a market
that does not yet exist.13 Furthermore, such methods discriminate
heavily against projects that are long term or risky, and the methods
may fail to capture the strategic importance of the investment decision.
Technology development projects play a crucial role in building and
leveraging firm capabilities and creating options for the future.

QUALITATIVE METHODS FOR
CHOOSING PROJECTS
Screening Questions
As a starting point, a management team is likely to discuss the
potential costs and benefits of a project, and the team may create a
list of screening questions that are used to structure this discussion.
These questions might be organized into categories such as the role
of the customer, the role of the firm’s capabilities, and the project’s
timing and cost.
 Role of Customer ( market, use, compatibility and ease of use,
distribution and pricing)
Role of Capabilities ( Existing capabilities, competitors capabilities,
future capabilities)
 Project Timing and Cost (Timing, Cost factors)

COMBINING QUANTITATIVE
AND QUALITATIVE
INFORMATION
Conjoint Analysis
Conjoint analysis is a family of techniques
(including discrete choice, choice modeling,
hierarchical choice, trade-off matrices, and pairwise
comparisons) use to estimate the specific value
individuals place on some attribute of a choice, such as
the relative value of features of a product or the
relative importance of different outcomes of a
development project. Conjoint analysis enables a
subjective assessment of a complex decision to be
decomposed into quantitative scores of the relative

CONT……
Data Envelopment Analysis
Data envelopment analysis (DEA) is a method of assessing a
potential project (or other decision) using multiple criteria
that may have different kinds of measurement units. Data
envelopment analysis uses linear programming to combine
these different measures from the projects to create a
hypothetical efficiency frontier that represents the best
performance on each measure. It can also consider which
measures are inputs (such as costs) versus outputs
(expected benefits). It then measures the distance of each
project from this frontier to give it an efficiency value. These
values can then be used to rank order the projects or

Chapter 7 choosing innovation project

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