How to Develop a Business Case - Approach, Risk and Success Factors Date Download the entire document at: www.gazhoo.com

Contents Executive Summary Business Case Overview Business Case Development Process Lessons Learned – Risks and Success Factors Business Case Template Overview Glossary Appendix Example Slides Download the entire document at: www.gazhoo.com

Developing the business case involves eight steps. Determine Approach Develop Assumptions Determine Benefits Determine Costs Calculate Financial Impact Determine Non-Financial Impact Perform Sensitivity and Risk Analysis Summarize Findings Desired Outcomes Structure Scope Predict Simplify Clarify Revenue Uplift Cost Reduction Increased Capital Efficiency Operating Expenses Capital Expenditures Cash Flows NPV IRR Payback Changes in assumptions Risk of not achieving targets 1 2 3 4 5 6 7 8 Decision matrix Qualitative descriptions Conclusions Recommendations Business Case Development Process Download the entire document at: www.gazhoo.com

Desired Outcomes

Structure

Scope

Predict

Simplify

Clarify

Revenue Uplift

Cost Reduction

Increased Capital Efficiency

Operating Expenses

Capital Expenditures

Cash Flows

NPV

IRR

Payback

Changes in assumptions

Risk of not achieving targets

Decision matrix

Qualitative descriptions

Conclusions

Recommendations

Define the business case design before collecting data Design the model to be as flexible and modular as possible (e.g., soft-code all assumptions) Use labels and color coding to make the model easy to understand Document the source of all assumptions Build the capability for ‘what if’ sensitivity analysis into the model design from the outset Additionally, successful business case models are flexible and easy to understand and use. Lessons Learned – Key Success Factors Business Case Modeling Download the entire document at: www.gazhoo.com

Define the business case design before collecting data

Design the model to be as flexible and modular as possible (e.g., soft-code all assumptions)

Use labels and color coding to make the model easy to understand

Document the source of all assumptions

Build the capability for ‘what if’ sensitivity analysis into the model design from the outset

Developing the business case involves eight steps. Determine Approach Develop Assumptions Determine Benefits Determine Costs Calculate Financial Impact Determine Non-Financial Impact Perform Sensitivity and Risk Analysis Summarize Findings Desired Outcomes Structure Scope Predict Simplify Clarify Revenue Uplift Cost Reduction Increased Capital Efficiency Operating Expenses Capital Expenditures Cash Flows NPV IRR Payback Changes in assumptions Risk of not achieving targets 1 2 3 4 5 6 7 8 Decision matrix Qualitative descriptions Conclusions Recommendations Business Case Development Process Download the entire document at: www.gazhoo.com

Desired Outcomes

Structure

Scope

Predict

Simplify

Clarify

Revenue Uplift

Cost Reduction

Increased Capital Efficiency

Operating Expenses

Capital Expenditures

Cash Flows

NPV

IRR

Payback

Changes in assumptions

Risk of not achieving targets

Decision matrix

Qualitative descriptions

Conclusions

Recommendations

Several metrics are commonly used to summarize cash flow comparisons among different scenarios. Internal Rate of Return (IRR) The discount rate for which the NPV equals zero IRR demonstrates how high the discount rate has to be in order for the project to have a positive NPV Used to compare the financial impact of two or more options against each other and against company’s internal Hurdle Rate: in general, the option with a higher IRR is preferred and projects should be undertaken if the IRR is greater than the Hurdle Rate Calculate Financial Impact – Metrics: Internal Rate of Return (IRR) NPV = NPV ($ million) Σ n = 0 N = 0 Where: N = Time Periods Illustration: Download the entire document at: www.gazhoo.com NCF n (1 + IRR) n IRR = 40% Calculate Financial Impact 5

Internal Rate of Return (IRR)

The discount rate for which the NPV equals zero

IRR demonstrates how high the discount rate has to be in order for the project to have a positive NPV

Used to compare the financial impact of two or more options against each other and against company’s internal Hurdle Rate: in general, the option with a higher IRR is preferred and projects should be undertaken if the IRR is greater than the Hurdle Rate

A more advanced risk analysis requires performing statistical simulations to determine the expected values of the financial results. More advanced risk analysis involves determining the likelihood or probability that input values and assumptions will change from an Expected Value A statistical simulation (e.g., Monte Carlo) is then used to determine the Expected Value of the financial result (e.g., cash flows or NPV) based on the probability distribution of the input values Perform Risk Analysis Input / Assumption #1 Expected Value of Input Value #1 Expected Value of Financial Output Probability Distribution of Financial Result Probability Distributions of Input Values Input / Assumption #2 Expected Value of Input Value #2 Best Case Scenario Worst Case Scenario Download the entire document at: www.gazhoo.com Perform Sensitivity and Risk Analysis 6 Illustrative

More advanced risk analysis involves determining the likelihood or probability that input values and assumptions will change from an Expected Value

A statistical simulation (e.g., Monte Carlo) is then used to determine the Expected Value of the financial result (e.g., cash flows or NPV) based on the probability distribution of the input values

Advantages: Easily understood Often go, no-go conclusions based on IRR are consistent with the NPV method Conceptually, IRR is like ROI or an interest rate, and is therefore easy to understand by managers Potential beneficial behavioral effects – may incent managers to: Choose projects leading to genuine value creation, when calculated correctly and in the right circumstances How Calculated Significance Advantages and Disadvantages Management Behavior Internal Rate of Return (IRR) The internal rate of return (IRR) is the rate that, when applied to the cash flows of a project, cause the NPV to be zero. The project is accepted when the discount rate is below the IRR and rejected if the discount rate is higher than the IRR. The IRR, when used appropriately, rivals NPV as a financial performance measure. There are, however, major watchouts with this method that must be understood thoroughly by a project manager Disadvantages: When using multiple discount rates in an NPV calculation, decision may be different than when using IRR If the project has both positive and negative cash flows in different periods, it may not be possible to accurately determine the IRR Not easily calculated Potential adverse behavioral effects – may incent managers to: Reject wealth creating projects Accept wealth-eroding projects Using a trial and error method, the IRR that results in a zero NPV in this case is 23%. Using this method, if the 23% IRR is greater than the company’s hurdle rate, the project should typically be accepted Download the entire document at: www.gazhoo.com CF 1 1 + IRR 50 1 + IRR NPV = 0 = CF 0 -100 CF 2 (1 + IRR) 2 50 (1 + IRR) 2 CF 3 (1 + IRR) 3 50 (1 + IRR) 3 + + + + + + Year 0 1 2 3 Cash flow - $100 $50 $50 $50 Example:

Advantages:

Easily understood

Often go, no-go conclusions based on IRR are consistent with the NPV method

Conceptually, IRR is like ROI or an interest rate, and is therefore easy to understand by managers

Potential beneficial behavioral effects – may incent managers to:

Choose projects leading to genuine value creation, when calculated correctly and in the right circumstances

Disadvantages:

When using multiple discount rates in an NPV calculation, decision may be different than when using IRR

If the project has both positive and negative cash flows in different periods, it may not be possible to accurately determine the IRR

Not easily calculated

Potential adverse behavioral effects – may incent managers to:

Reject wealth creating projects

Accept wealth-eroding projects

Revenue Uplift estimates can be derived in several ways. Determine Benefits – Revenue Uplift Top-Down Approach Example (primarily for rough order of magnitude estimates) Estimate percent increase to current market share Use benchmark or survey data (if available) to estimate percent increase in revenues Bottoms-Up Approach Example Estimate percent increases to unit volume increase and/or unit price Estimate impact to both through changing the product mix Old Market Share New Market Share Unit Volume Increase Unit Price Increase Revenue Increase Download the entire document at: www.gazhoo.com Determine Benefits 3

Top-Down Approach Example (primarily for rough order of magnitude estimates)

Estimate percent increase to current market share

Use benchmark or survey data (if available) to estimate percent increase in revenues

Bottoms-Up Approach Example

Estimate percent increases to unit volume increase and/or unit price

Estimate impact to both through changing the product mix