Making Finance Relevant

1. Making Finance Relevant Creating Shareholder Value Through Corporate Finance ReengineeringFinegan & Company LLC

2. What Reengineering Does Not Mean • Reengineering does not mean cost-cutting. • It does not mean improving technology to do the same tasks faster. • It does not mean TQM. • It does not mean continuous improvement.

3. What Reengineering Does Mean “the fundamental rethinking and radical redesign of business processes to achieve dramatic improvements in critical, contemporary measures of performance” —M. Hammer, Reengineering the Corporation Closely allied with: • Identifying and exploiting core competencies. • Eliminating hand-offs and bureaucracy. • Empowering employees to make their own decisions. • Identifying the unmet, often unarticulated needs of customers. • Starting with a blank sheet of paper.

4. Why “Reengineering” Degenerates Into Cost-Cutting • The finance functions seem too diverse for comprehensive, radical improvement. • It’s nearly impossible to measure the value created by any particular finance function.

5. To Reengineer:Focus on the Process, Not the Task Problem: The classical tools (or “tasks”) of finance are too slow, disconnected, and one-sided to be of practical value to line managers and stockholders. Consequence: The entire strategic planning process is discredited.

6. Technology is the Essential Enabler Classical FinanceReengineered Finance • Developed to explainDeveloped to monitorinvestor behavior and assist corporate(Shoe-horned into evaluatingbehaviorcorporate behavior) • Mathematically based  Simulation-based(Inherently simplistic) (Comprehensive, potentially realistic) • One set of answers per  Multiple answersassumption set per assumption set(Inherently reactive) (Responsive and proactive)

7. The Proper Objectives ofFinance Reengineering • Improved quality and consistency of business plan assumptions. • Improved relevance and clarity to line managers. • Sustained relevance throughout the year. • Better contingency planning.

8. Don’t Get Distracted • Reengineering is not about cost-cutting. It’s about making planning and reporting processes facilitate better business decisions. Finance processes must be as flexible, responsive and “just-in-time” as the business processes they assist. • For many companies, devoting adequate attention to uncertainty would create far more value, at the margin, than devoting further financial resources to projecting, prescribing and policing “expected” returns.

9. Classic Signs of Disfunction: The Decentralization Paradox Vision Reality • Decentralization and empowerment lead to inconsistent assumptions, benchmarks and objectives. • Decentralization and empowerment lead to improved responsiveness, coordination, feedback and accuracy.

10. Classic Signs of Disfunction: The Project Selection Paradox Vision Reality • Capital costs differ wildly between projects—even within business units. • Line managers forced to forgo projects which, on paper, promise profitable IRR’s. • Uniform cost of capital for each business unit. • Projects selected on basis of rank IRR or EVA.

11. Classic Signs of Disfunction: The Efficiency Paradox Vision Reality • Managers encouraged to pursue marginal product line extensions and efficiency gains, instead of identifying new opportunities. • Managers encouraged to pursue all value-enhancing opportunities, whether from efficiency improvements, downsizing or growth.

12. Defects of the Traditional Financial Planning Process • Can't tell whether the “Base Case” is the mean, mode, median or—more likely—an arbitrary product of negotiation. • Can't tell whether the “Worst Case” represents a 0.01% probability or a 25% probability. • Provides no guidance six months out about how to get back on plan if off.

13. Implications • Capital budgeting is distorted by ignoring asymmetries in the distribution of value drivers.

14. Implications • Valuation efforts are compromised by confusing goals with expectations, modes with means.

15. Implications • Incentive payments are rendered arbitrary by not reflecting difficulty of attainment.

16. Implications • Financing decisions are distorted by not gauging downside risk accurately, and by not evaluating the fatness of “tails.”

17. Implications • Communications between the corporate office and the field are frustrated by not being sensitive to macroeconomic factors beyond the control of management. The relationship between weather and resort attendance means . . .

18. Implications • Communications between the corporate office and the field are frustrated by not being sensitive to macroeconomic factors beyond the control of management. It’s easy to confuse bad luck with bad management

19. The Reengineering Approach:Focus on the Model, Not Point Estimates • Express forecasts of value drivers as verifiable ranges, not point estimates. • Focus attention on how those value drivers inter-relate in the face of uncertainty. • Manage business decisions and expectations on the basis of how aggregate performance measures cluster, given variability in the underlying value drivers. • Make strategic planning proactive and “contingency aware,” and thus useful to guiding investment decisions—not just policing them.

20. The Six Steps of Corporate Finance Reengineering • Assign meaningful (if possible, verifiable) patterns to the key ingredients or “value drivers” of a forward plan. Identify Value Drivers Quantify Relationships Build a better model Identify Sources of Exposure • Posit relationships (again often verifiable) between those value drivers

21. The Six Steps of Corporate Finance Reengineering • Re-compile management's forward plan many, many times, allowing the plan's value drivers to vary randomly. Run Lots of Simulations

22. The Six Steps of Corporate Finance Reengineering • Derive distributions for important aggregate measures. Re-examine the Aggregates

23. The Six Steps of Corporate Finance Reengineering • Base expectations, financing decisions and rewards on patterns in those aggregate measures. Re-evaluate Expectations

24. The Six Steps of Corporate Finance Reengineering • Use subset analysis to guide performance 6-to-18 months later. PlanContingencies

25. The Six Steps of Corporate Finance Reengineering Plan Contingencies

26. Summary of theReengineering Process • Corporate finance reengineering tackles uncertainty by concentrating attention on those components of performance where randomness can be measured historically, and where it is thus easier to generate consensus among line managers as to bounds. • The alternative approach is to assign weights to arbitrary “best” and “worst” scenarios. Although quicker, the approach does not distill from historically verifiable relationships those factors over which management has influence, and is thus more prone to error. It is often impossible to explain the chosen weights to line management, appearing instead to be a black box rationalization.

27. Benefits of Reengineering • Improves the quality and consistency of business plans and financial reporting. • Makes finance understandable by shedding the black box, one answer approach to financial modeling. • Requires little or no statistical training. • Makes fair calibration of bonus plans possible. • Filters out the impact of macroeconomic factors beyond management’s control. • Extends the planning process’ relevance.

28. Implications for Incentives • Measure management's contribution to share value, not the economy's. • The exercise price of employee stock options should be indexed against the stock price performance of competitors. • Cash bonuses should be based on discretionary EVA, not total EVA. • Base expectations on verifiable levels of difficulty. • Price options fairly. • Calibrate bonus plans fairly (a linear award schedule is presumptive evidence of unfairness). • Revise goals and expectations to meet economic conditions at the time.

29. Other Areas of Application • Annual planning and budgeting • Performance measurement and appraisal • Interim planning and target-setting • Capital budgeting and formation • Treasury planning • Stock option pricing • Financial communication • Executive incentive compensation • Acquisition pricing and planning In each of these areas, the framework for value-based planning is established. What is needed now are explicit ways to measure, communicate and address uncertainty in a world where chaos has become the norm.