So, you are feeling rather satisfied. Maybe even a tad smugly so. The fiscal year is half over, your team has – through Herculean effort – kept operational costs contained by finding new and innovative efficiencies. And the division is transforming the prioritized list of demands into honest-to-goodness, value delivering completed projects – more or less within forecast. You take a minute to lean back in your ergonomic mesh chair and dare to dream of that day six months from now when you will report to the Executive Suite of Acme Limited that you have delivered within plan and within budget. Life is good!
But then your quiet reverie vaporizes as the dark cloud of bad news – in the form of your scowling analyst – lumbers into your Spartan hoteling workspace and melodramatically prepares to fire her salvo across the bow of your serenely sailing ship of commerce.
“What’s up?” you ask with panache, at least with as much panache as one can squeeze into a two-word interrogative.
“We have just been made aware of a heretofore unforeseen …,”
[she begins in her passive-dripping analyst parlance]
“ … a new … <pause for emphasis>”
[no, don’t say it!]
“LEGAL REQUIREMENT!”
BOOM! And just like that, she has uttered the dreaded words, a phrase that implies that your ethereal musings of Executive Suite remunerative laud and favor are just that: ephemeral, elusive, pie-in-the-sky, and gone. Because we all know perfectly well that the criteria of “legal requirement,” once attached to a demand, trumps every other potential characterization possible, to include the likes of:
“strategic”
or
“Quality Of Worklife”
or even
“WILDLY PROFITABLE IN PERPETUITY!!”
Because we also all know perfectly well that we must operate Acme Limited within the capriciously shifting constraints of regulation, statute, and governmental oversight. After all, we are not a criminal enterprise, right? We must be a good corporate citizen and by so doing, avoid potential fines and penalties.
So, with head-shakes and mutterings all around, you direct the team to initiate an emergency project to satisfy the legal requirement which in effect de-funds the four projects scheduled for the last quarter of the fiscal year, pushing them into the demand backlog for the next FY. Or you contemplate approaching the Executive Suite for more capital funding. Either way, that year-end bonus potential is looking pretty grim. Nothing you can do, right? Well, no. Not right. There is actually something you can do, and that something is to treat the legal requirement like any other opportunity to which you may apply your precious resources. Which is to say, determine the dollar value of your options via financially based risk analysis. Yes, it can be done! Here is a way.
The first step is to extrude from the catch-phrase “Legal Requirement” what the real change to the business environment actually is. If, for example, Acme Limited is regularly transferring its proprietary technology offshore for a joint venture, and Parliament enacts immediate full-spectrum sanctions on the host country with clear and codified criminal implications for failure to comply, it’s pretty obvious that you are forfeiting your bonus potential in favor of the project. However, if the legal requirement is a matter of dancing to the regulatory dirge of Euro-Union, Commonwealth, or local council bureaucracy, you may have recourse under this method. Let’s assume the latter. And so, here we go.
As an illustration, our potential project is going to be a technology solution. So next, we determine the cost to implement the project in terms of cash outflow over the next five years. This is fairly straight forward and something tech teams do regularly. There will be first year expenses to implement the solution, and likely there will be subsequent year’s outflow for licensing, support, maintenance, and additional staffing for the care and feeding of the solution. In our simple example, those costs look like this (expressed in USD):
First year: $100K to implement
Years 2 – 5: $10K annual maintenance fees, plus:
$20K annual internal staff support
(1/3 FTE * $60K average comp/FTE)
Year 4: $20K expected consulting cost for major upgrade
Next, determine the cost of doing nothing. These costs will be avoided if we move forward with the project. In other words, what is the exposure (risk) of choosing to decline to address this “legal requirement?” Here admittedly the numbers get mushy, but more often than not, with research and the right expertise, these values can be reasonably estimated.
So, let’s assume that our due diligence suggests that there is a 20% chance that the company will incur a fine or penalty in each year that it elects to do nothing. Further, the fines, penalties and remediation costs will average $200,000 for each occurrence. We have:
20% * $200K = $40K of risk exposure in each year of our 5-year forecasted “do nothing” period.
Now we address the impact to the company’s Goodwill. Goodwill is an intangible asset on the balance sheet of some companies that represents the value over book value attributable to patents, customer and employee relationships, proprietary technology, and the like – at least that’s what Wikipedia thinks it is. The element we focus on here is the customer. Will the specter of a regulatory fine have an impact on the customer component of Goodwill? If so, this reduction in balance sheet asset can be considered equivalent to cash out. How long will Goodwill be adversely affected? Will this be a single year dip or multiple? A technique I like to employ is to quiz a Goodwill SME (cost accountant, financial analyst, CEO?) to determine the drop due to a worst case scenario, the drop in the best case (least impactful), then derive an average.
Goodwill on the books for Acme Limited is $500,000. The customer component of Goodwill represents 40% of the total according to our SME, and will likely drop by half for two years if a penalty is imposed:
Year 1 20% probability *40% of $500K * 50% = $20K
Year 2 20% probability *40% of $500K * 50% = $20K
PLUS $20K 2nd year impact from Year 1
Year 3 20% probability *40% of $500K * 50% = $20K
PLUS $20K 2nd year impact from Year 2
Year 4 20% probability *40% of $500K * 50% = $20K
PLUS $20K 2nd year impact from Year 3
Year 5 20% probability *40% of $500K * 50% = $20K
PLUS $20K 2nd year impact from Year 4
So the exposure to Goodwill is:
Year 1 $20K
Years 2 – 5: $40K
Next, we go through the same process to determine the damage to the company’s reputation of a regulatory adverse finding. The metric we use to reflect this damage is forfeited marginal profit. Again, it is helpful to enlist an appropriate SME and consider best and worst case scenarios to converge on an average. This “marginal” descriptor is key because just as revenue is offset by the variable cost to produce that revenue, so too “anti-revenue” can have the same offset. Companies produce a good or service. It costs resources to produce that good or service for sale: the cost of goods sold, or cost of services sold. Let’s assume the COGS for Acme Limited is 90%, leaving 10% marginal profit. If we lose $100,000 in annual incremental sales due to the negative publicity of a regulatory slap, the real loss to the equity owners is $10,000, because we did not employ $90K worth of resource cost in that loss. Just like for Goodwill, we can project that loss over multiple years, but for our example, we will assume a single year of loss for each infraction:
Year 1 20% probability *$10K lost marginal profit = $2K
Year 2 20% probability *$10K lost marginal profit = $2K
Year 3 20% probability *$10K lost marginal profit = $2K
Year 4 20% probability *$10K lost marginal profit = $2K
Year 5 20% probability *$10K lost marginal profit = $2K
Now, if we implement the Solution, we will avoid the assessed loses to Goodwill and to marginal revenue. So the multi-year picture of the project costs and the associated avoided losses – or savings – look like this (in USD thousands):
|
YEAR: |
1 |
2 | 3 | 4 | 5 | |
| Costs (negatives) | Implement | -100 | ||||
| maintenance | -10 | -10 | -10 | -10 | ||
| staff increase | -20 | -20 | -20 | -20 | ||
| upgrade | -20 | |||||
|
Costs sub |
-100 | -30 | -30 | -50 | -30 | |
| Savings (avoided losses – positives) | penalties | 40 | 40 | 40 | 40 | 40 |
| goodwill part 1 | 20 | 20 | 20 | 20 | 20 | |
| goodwill 2d year | 20 | 20 | 20 | 20 | ||
| retained marginal profit | 2 | 2 | 2 | 2 | 2 | |
|
Savings sub |
62 | 82 | 82 | 82 | 82 |
Now that we have quantified our pseudo-cash flows for the 5-year period, the final step is to apply a Net Present Value calculation to them.
Net Present Value is the present value of specific future cash flows at a specific discount rate (DR). The discount rate represents the time-value of money, especially the assumption of the impact of inflation on future cash. So applying a discount rate makes future money less valuable than the same amount of money today. Think of it as lost purchasing power due to inflation. So the question becomes, what DR value should you use? Here are some possibilities:
- Recent (say, the last five years) inflation trend as published in many financial sources.
- Inflation forecast (average rate of inflation expected for the next five years) by a trusted SME. Does your corporation have an economist on staff or retainer?
- The corporation’s carrying cost of capital (CCoC). This is the premium paid by Acme in order to borrow funds. It is usually expressed as a weighted average annual interest rate, based on the proportional costs to procure both short-term and long-term debt. Larger corporations know this value; smaller ones may not.
- Modified Internal Rate of Return (MIRR). This value represents a percentage return any investment is expected to meet in order to be considered for capitalization. It includes the carrying cost of capital plus a profit margin based on the company’s goals. Again, larger and more sophisticated businesses set this value and use it as a measure to determine the initiatives and projects in which to invest.
In this illustrative example, I’ve selected option three – the corporation’s carrying cost of capital – and by waving my magic MBA wand, have determined that Acme Limited’s weighted average CCoC is ten percent (10%).
All that is left now is to plug the values into an Excel spreadsheet and apply the NPV formula. In Excel, the formula description is:
=NPV(rate,value1,value2…) Returns the net present value of an investment based on a discount rate and a series of future payments (negative values) and income (positive values).
Notice that the positive values are called “income” in Excel. We derived savings, not income, but the formula works exactly the same. Savings are additional contributions to the bottom line and therefore can be considered a form of income for this analysis.
Value1 will be the 5-year range of negative costs; Value2 will be the 5-year range of positive savings. Thus, the formula in the spreadsheet grid below is:
=NPV(.1,B1:F1,B2:F2)
| A | B | C | D | E | F | |
| 1 | <NPV formula> | -100 | -30 | -30 | -50 | -30 |
| 2 | 62 | 82 | 82 | 82 | 82 |
This formula will return a value of ($9.30) in cell A1 for this potential project. The meaning: if this project proceeds, it will be expected to represent a net loss of $9,300 in today’s dollars. In other words, the value of the costs required to implement the solution is greater than the benefit it will provide, to wit: avoiding losses due to penalties, Goodwill shrink, and forfeited revenue. Therefore, the inference is that you should accept the risk of non-compliance with the Legal Requirement, and deploy your scarce resources toward your programmed demands as originally budgeted for the remainder of the fiscal year. Put the Legal Requirement demand in the next fiscal year’s backlog and let it fight again for prominence amongst that year’s contenders for your resources.
Conclusion:
Raise your hand if you have ever heard this: “We HAVE to do this! If we don’t, we will lose millions and millions of dollars (or Euros, or Yuan, or Brexit Bitcoin)!” Yes! I see your raised hand through my blog-access-activation-of-your-webcam agent! Nice Deadhead T-shirt over there in Johannesburg, by the way. This technique of applying financial analysis to regulatory risk management helps to take emotion and wild conjecture out of the picture and restores some objectivity.
Poor Richards' Capitalist 