## Friday, December 2, 2011

### NPV in the Tree

In a recent Inc. Magazine post, an investment Red Frog Events made to build a tree-house in the middle of their office space was discussed. In my experience this is not very common.
Given that we are fresh off evaluating Net Present Value, or NPV, this is a great opportunity to explore utilizing this method in a break-even analysis framework on something very tangible.

“Tree Up” the Factors
For this exercise we will assume that we have used the Capital Asset Pricing Model, or similar mechanism, and through that analysis determined that our required rate of return is 20% reflecting a Weighted Average Cost of Capital at a 40% tax rate. We will assume that a tree-house in an office will have a five-year asset life, with no salvage value at the end, and that it is eligible for three year accelerated depreciation for tax purposes. We also assume that tax losses may be taken in the year they occur. Finally, we assume that the benefits do not grow or decline during this period of time.
Given these assumptions, we can use the Reverse Method to generate the Earnings Before Interest, Taxes, Depreciation, and Amortization, or EBITDA, required to “break-even” on the investment. In other words, earn our required rate of return exactly, so the project, inclusive of the investment outflow, has a Net Present Value of \$0.
For this case, the investment needs to generate an EBITDA of \$39,024 annually (for the rest of this post rounded to \$40,000), calculated as shown:

Investment Benefits
Red Frog identified five areas of benefit: recruitment, happiness, creativity, appreciation, and attention.
Four of these benefits relate to employees, so the next step is to get some information to go into the “number cruncher”.

The Baseline Scenario
Red Frog is in the event planning industry. I googled “how much is the average event planner salary” and got numbers ranging from \$40,000 to \$60,000. So let’s use \$50,000 as the average employee salary. Red Frog has 115 of them.

The Recruiting Benefit – In Full Glory
The tree house is used as an icon of Red Frog’s “creative work environment”, and they receive over 2,000 resumes every month.
What is unknown is how many more resumes they receive due to the tree house symbolism than they otherwise would have, and whether there is a material difference between the two populations (received normally, received because of tree-house) with respect to talent level (i.e. are more talented people inspired by the tree house to apply when they normally would not have? And are they the ones more likely to be hired?).
Note that resolving these unknowns would be a great Big Data exercise for the treasury and analytics group! And then we could calculate our NPV on that basis.

The Recruiting Benefit – Simplified
However, in order to simplify the focus on NPV (this is a blog, not a whitepaper!), we will go instead with the following assumption, that normal recruiting costs are typically 150% of the salary of the position, so in this case would be \$75,000 (\$50,000 x 150%).
At 115 employees, assuming a turnover rate of 5% (higher than some industries and lower than others), they need to fill about 5 positions per year. Dividing our need to generate \$40,000 by 5 is \$8,000 per position filled.
Subtracting this from the \$75,000 average yields \$67,000. This represents about 11% savings.

Feasibility Assessment
Is this a feasible amount to be generated from the tree-house investment? At an average of \$50,000 per year, an employee makes \$25 per hour (assuming a 40-hour workweek). To reach \$8,000, we need to save 320 hours of time (assuming all are paid the same).
Recruitment costs include the following items: lower productivity due to short-staff situations, advertising, time and expense of interviewing, time spent evaluating and deciding, time spent negotiating, and then time and materials related to on-boarding (any HR readers reading this, feel free to add more items in the comments).
Is the spot filled a month earlier? This is 160 hours towards the 320 right there. If we interview either in a series or as a panel, say four are involved for two hours, then each interview saved is 8 hours. Therefore, if we interview 5 less individuals that’s another 40 hours saved.

Pause…Are You Aware That…
…we are discussing the amount of hours required to perform tasks. In most companies labor is a major cost driver. So in the above example we are evaluating the investment in terms of a something big and important to profitability and survivability. Something anyone running the business knows a lot about.
Compare that to combing through the accounting records to figure out what our NPV was. What would be discussed then? Items like how much overhead is allocated to what labor categories? Fixed items that need to be backed out of the variable costs, such as cubicle space, computer terminals, pencils and paperclips in the supply closet, etc. What costs were put into O&M versus capitalized?
Notice the difference? Major, important cost drivers every business manager understands vs. minor allocation and classification issues. Things an operator is not going to intuitively understand very well. Things only an accountant can love (nothing against accountants, only that they are not the ones running the business).

Now Back to the Show
So far, we have calculated 200 hours towards a 320 hour hurdle. The second benefit identified is happiness, which leads to higher productivity.
If the 115 employees are each more productive for 1 hour per year, we have come within 5 hours of meeting our hurdle, with three remaining benefits still to be evaluated.
Based on this (and the boatload of assumptions that went into it), we can say that this appears to be a worthwhile investment.
We might want to do some sensitivity testing or scenario analysis around this investment. What if there is a recession and we don’t hire for 2 years? How much more productive do the employees need to be in order to make this investment pay off? Three hours each. A business unit operator would be able to make a judgment as to whether that was feasible or not.

Key Takeaways
We, as finance, analysis, and treasury professionals, can fulfill our Trusted Advisor role to the business by:
1.      Discussing important value drivers with operations folks
2.      Discuss these items in language they understand and items that are important enough for them to control
3.      Avoid burdening the operations folks with things only an accountant could love, and
4.      Hire an inventory firm to count the number of pencils and paperclips in the office!

Questions
·         Do you routinely discuss the business in terms of major value drivers?
·         Do you focus a large percentage of your time assessing scenarios and sensitivities impacting major value drivers?
·         Do you end up spending too much time with “pencils and paperclips” exercises?