1. Investing in growth:
Decision techniques for
SMEs

2. Contents
• The purpose of decision support
• Opportunity cost, alternative investment,
relevant costs
• Enough about DCF to understand its
weaknesses
• Simple alternatives
• Infrastructure/enabling projects which don’t
have a clear payback

3. The purpose of decision models and
the role of judgement
• The practical purpose of financial decision-
support models is to tell you what a proposed
investment needs to do to justify spending
money on it
• A human being, a decision maker, needs to
decide if the project can perform at or above the
that level. No financial tool can do that.

4. Topics
• Some theory about corporate decision making
• Why it doesn’t work well at SMEs
• Some quick and simple techniques
• What to do about essential investments which
don’t clearly create separate cashflows?

5. Jargon
• We’ll cover some theory about cashflows
• Some shortcut and simple techniques
• We’ll cover ‚contribution margin‛, ‚relevant
costs‛, ‚risk‛ and ‚opportunity cost‛

6. What do big businesses and SMEs
have in common regarding
investment decisions?
• Need to make wise decisions about where to
invest and now much to invest
• Need to set benchmarks to evaluate decisions
• Need to set priorities
• Need to deal with uncertainty

7. The limitations of finance techniques
• Estimated costs and outcomes are crucial to all
finance techniques but they need human expert
judgement
• Not many big innovations and growth
opportunities come from spreadsheets (although
many smaller profitability improvements do)

8. The formal decision-making
‚maturity curve‛
• 0. Gut-feel
• 1. Basic budget and concept of payback
• 2. Choose superior projects from a pool of
alternatives
• 3. Develop cashflows and scenarios based on key
drivers
• 4. Apply multiple methods and share
calculations with third parties to obtain funding

9. Major reasons to use finance
techniques for decision making
• The process of analysis establishes the definition
of a financially successful project
• Helps reveal risks and ways that the project
could fail
• Increases the confidence of third parties in
decision making (and therefore access to
funding)
• Gives targets to measure the performance of the
project along the way
• Genuinely useful in setting priorities

10. Key concepts: Opportunity Cost and
The Alternative Investment
Opportunity cost, and the alternative
You can only spend a dollar once
A decision to invest in a project is always made by
comparing it to the next best alternative
Often we use a ‘theoretical’ alternative (eg ‚compared
to putting the money in the bank‛)
The two concepts are linked: the return from the
next best alternative is the opportunity cost of
proceeding with the investment opportunity (what
you forego)

11. Opportunity costs can be subtle
• If you have $100,000 in the bank, it’s clear that
spending it on a new website means you can’t
spend it on product development
• But if you have $100K equity in your house and
borrow against that to fund the website, you
may think that there is no opportunity cost,
because you didn’t have the $100K until you
decided to do the project
• That’s false. Now you have $100K less equity to
borrow against for an alternative project

12. Key concepts: Relevant cashflows
Relevant costs
When evaluating a decision, we must only consider
the consequences of that decision vs the alternative
(which is often not making the investment)

13. Relevant costs illuminated
• Last month you bought 10 100W incandescent
lightbulbs, which cost $2 each, and $3 a month to
run
• Someone says ‚buy 15W energy savers for $6, they
cost $0.50 a month to run‛
• You say ‚No, that’s silly, I just bought the new bulbs.
I’ll wait for them to fail before replacing them‛
• Bad decision! You save money as soon as you use
the new light bulbs. The purchase cost of the
existing light bulbs is not relevant to the decision to
replace them because it is not affected by the
decision

14. Key concepts: Risk
Risk simply means the possibility of surprise, good
or bad.
Theoretically, all investments turn into cash at
some point in the future. A higher risk investment
means less certainly about what that future value
will be.
The demand for higher risk investment
opportunities is not as great as low risk investment
opportunities, so it costs more to get money for
high risk investments.

15. What is risk?
• Risk means unpredictability.
• A ‘riskier’ investment means you are less sure about how
well it will do. We guess a ‚mid-range‛ return, but it
could do better or worse.
• A ‘risk-free’ or ‘low-risk’ investment will do exactly what
we expect. No nasty surprises, and no pleasant surprises.
• High-risk investments have a place.
• Equity investments (shares) have higher risk because
they are the left-overs (for better or worse)
• Small business owners making investment decisions are
usually facing ‚equity‛ decisions, since they are majority
shareholders

16. Investment alternatives: the theory
• Investment decisions are about comparing
alternative investments which are of the same
risk.
• We start by assuming we are prepared to take a
certain risk.
• We then evaluate our project against a known
alternative of the same risk

17. Some basics about cashflows
• Cashflows are money AND timing
• Cashflows are negative for cash out (investment)
• And positive for cash in
• They show only the changes in cash due to the
decision
• They can therefore include both additional
profits and costs avoided due to the decision

18. What’s needed for perfect decision
making
• Complete accuracy of costs and resulting
cashlows, both in amount and timing
• An alternative investment of the same risk with
a known return
• These are the two major weaknesses of financial
decision-making tools

19. Discounted Cash Flows: The academic
approach to investment decisions
• DCF solves many technical problems. It allows
comparison of projects with different durations,
and projects which requires a one-off investment
with projects which require multiple
investments.
• However, it doesn’t overcome the key
weaknesses mentioned earlier.
• If its weaknesses are misunderstood, it leads to
false confidence and bad decisions

20. DCFs are a professional tool
• DCFs should be designed by a finance
professional. There are many subtle points.
DCFs assume an infinite series of cash flows, for
example. And replacement costs need to be
considered.
• Tax calculations are not obvious and need to be
tuned to the circumstances

21. A checklist to validate a DCF
• Ask what is the basis for the discount rate: it
should be based on next best alternative
• Ask how the final cash flow approximates the
‚infinite cashflow‛ theoretical requirement
• Make sure that further injections of cash needed
to sustain the original investment are included
• You should see scenarios which cover a wide
range of possible cashflows.
• Ask how tax has been treated

22. The ‘time value of money’
• You often hear that DCFs reflect the ‚time value
of money‛ that is, that future money is worth
less than today’s money.
• Bad concept. Too easily confused with inflation.
• Discounted Cash Flows are discounted by a risk
rate which converts future cash to an equivalent
today based on compound interest. It’s a
powerful trick to compare projects of different
duration. Nothing to do with the ‚time value of
money‛ or inflation.

23. DCFs: The key outcome
• A project which as a Net Present Value of zero is
a project which performs exactly as well as the
alternative.
• Negative NPV means you’d be better off not
doing the project, but investing in the alternative
instead.

24. The theory assumes risk is priced
correctly by the market
• Australian government bonds at about 4%
• BHP bonds about 8%
• SME overdrafts about 12%
• Large corporates work out the average cost of
money provided to them by investors (shareholders,
bond-holders) and then they know that investments
in growth have to return at least that amount.
• Then they hope to say to investors: Look, you
thought we were a 14% risk, but our projects
delivered 16% return: we ‚added value‛.

25. What’s the right discount rate?
• This is tricky.
• For small businesses, you’d probably be looking
at rates in the range 20% to 35% before tax.
• Lower rates should be carefully justified by an
especially low risk

26. When to use DCF
• For medium term and large decisions
• Where you have reasonable confidence about the
cashflow forecasts because the new activity is
similar to an existing activity
• Eg investing in a new clinic.
• The discipline of preparing cashflow forecasts
has good side-effects

27. Other simpler techniques
• Payback: how fast before the initial investment is
returned?
• EBIT multiplier: Assume the value of your
business increases $3 for each $1 of sustained
profit you can add

28. Why payback is not popular with
theoreticians
• Payback doesn’t cope with projects with
multiple waves of investment
• It doesn’t compare large and small investments
very well; it may be biased towards big
investments, when several small projects would
be better.
• It ignores compound interest

29. Why payback is still popular
• It’s simple and fast
• It’s not a bad way to rule a simple project in or
out
• While it has big theoretical limitations, it’s also
less hostage to the danger of misunderstanding
the power of assumptions crucial to DCF

30. The EBIT multiplier method
• Many small businesses are sold based on a
multiplier applied to EBIT (between 2 to 5
usually)
• So a project which increases EBIT by $500K
(sustainably) is worth, say, 3 x 500K
• (once again, ignoring tax)

31. The EBIT multiplier method
• If a website costs $100K, what level of extra sales
are necessary for a ‘break-even’ return?
• Using a multiplier of 3, we need $33K of EBIT.
• Assume a EBIT margin of 10%
• So that’s a sales level boost of $33K / 10% =
$330K per year (on top of now). This is very
rough and short-term (good if selling the
business in the next two years)

32. Theory: converting EBIT multiplier to
a discount rate for DCF
• Assume that EBIT is a terminal cashflow of $1
• Assume the value is $1 x EBIT Multiplier
• Assume a certain growth (in line with GDP, say 3%)
• The value of a $1 terminal cashflow is
• V = 1/(r – g) where r is discount rate, g is growth
• V = Ebit Multiplier since the cashflow is $1
• Therefore, r = g + 1/v
• If EBIT multiplier is 4, then r = 28%
• If EBIT multiplier is 3, then r = 36%
• So, discount factors are high for small businesses

33. Other short term decision making
techniques
Contribution margin:
• You plan to spend $100,000 on an advertising
campaign to bring in $200,000 of new sales.
• Estimate the contribution margin: for every $1 of
new sales, what new costs are triggered?
• Assume cost of sales 45% and one temp at the front
desk for three months ($15K)
• Net cash: $200K- $100K - $15K – 45%*200K
• = -$5K
• So no, not convincing.
• Note the use of ‚relevant costs‛.

34. What about ‚enabling‛ or
‚infrastructure‛ decisions?
• All the theory about decision making starts with
being able to measure cash that results from a
decision to invest in something.
• But some decisions are essential yet vague.
• Such as a new IT framework
• This is a good chance to remember to ask the
right question

35. In the case of a new finance system
A key part of the value of the project is that it
unblocks other projects.
So the question is not really whether to invest or
not.
The question is which system to buy.
If the value of the new system is purely enabling,
then we weigh up the speed to implement and the
cost. Unnecessary functionality and complexity
which goes beyond the enabling requirement must
be justified by the return on invesemtne

36. Summary: key concepts
• Opportunity Cost and comparison to an
alternative
Every investment decision is based on comparing
another way to use the money

37. Summary: Relevant cashflows
• When evaluating an investment, we consider
only the cashflows which change due to the
decision

38. Summary: Risk
• Risk is a measure of surprise.
• High risk investments can be large flops or big
hits
• Investors choose a balance of risk
• It only makes sense to compare investment
alternatives which have about the same risk