Choosing Wisely: Navigating Project Selection in a Slowing Economy

As a product leader, the decisions you make every day have a direct impact on your firm’s operating cash flow. Whether it’s deciding between acquisition and organic growth, cloud investment versus on-premises expansions, a SaaS offering versus an embed solution, or simply approving a capital expenditure request, these decisions can directly affect your firm’s valuation. With such high stakes, how can you ensure you make the right capital decisions and invest in the right projects?

Let’s examine the case of Emma, a fictitious head of product in a tech startup. We met Emma previously as we examined how she scaled her team too quickly.

Emma is presented with a business case to acquire TechInnova.ai, a growing startup in the domain of Generative AI with double-digit revenue growth that complements Emma’s product portfolio. With revenue synergy, Emma expects a return of 12% on this investment. Is it a good investment? Does the expected return justify her firm's capital spent? What are the other alternatives and what are the expected returns? How should she factor the recent interest rate hikes in her decisions?

The Cost of Capital

Businesses require funding to generate profits, and the cost of that funding is known as the cost of capital. This cost is based on the expected returns investors demand to compensate for the risk of investing in the firm's debt and equity securities. The more risk associated with a business, the higher the expected returns investors require.

?? Projects that are expected to produce returns higher than the cost of funding are typically considered as worthwhile investments.?

?? The Weighted Average Cost of Capital (WACC) is the most commonly used method for calculating the cost of capital. This approach considers all sources of financing, assigning weights to each source based on its proportion in the firm's capital structure.

?? Investors expect a premium return, known as the Market Risk Premium (MRP), for investing in the market. The 2022 average MRP in the US was 5.6%, indicating that investors expected a 5.6% return on the market, with a lower rate for less risky investments like government bonds and a higher rate for riskier investments. The riskiness of a firm's securities is measured by its beta, with government bonds having a beta of zero (risk-free) and the market having a beta of 1. If a firm is perceived as riskier than the market, its beta is higher than 1. This is the basis to calculate the cost of debt and equity for companies.

Case Study

Emma is excited to expand her portfolio to include TechInnova.ai, with whom she has partnered on multiple projects over the past couple of years. However, before she decides to acquire them, let’s take a closer look at the cost of capital for her firm, the expected rate of return on this investment, and whether this acquisition deal is a good use of Emma's capital.

Let’s start with a simplified picture of Emma's capital structure: 10% of her capital is in the form of debt with a 3.9% interest rate, while the other 90% is from shareholders in the form of debt and equity securities with an expected return of 9.9%. ?? [the numbers in blue are our calculation].

With a 15% tax rate, the WACC for Emma's firm is 9.3%.

The expected return on TechInnova.ai acquisition is 12%. Given that it is higher than 9.3%, an acquisition would likely be a good investment. This analysis simplifies many nuances, and it’s always advisable to consult with your finance team for a detailed analysis.

Macroeconomic impacts on decisions

Given the volatile year we've had, and the expectation of rising interest rates through the first half of 2023, it's important to consider how to adjust your investment decisions. Let's take a closer look at the impact of the interest rate increase over the past 12 months, assuming no changes in capital structure or beta for Emma's firm.

In March of last year, the average rate for a 10-year US Treasury bond was 2.32%, with an average market risk premium (MRP) of 5.6%. However, by February 2023, the 10-year US Treasury rate had jumped to 3.52%, with investors now seeking a 6.76% risk premium from the market. Using these numbers, we can recalculate Emma's firm's weighted average cost of capital (WACC) and see that it has risen from 9.3% to 12% over the last year.

This increase in WACC means that an acquisition that looked profitable last year may now be considered borderline. With the expectation of interest rates continuing to rise in 2023, it's important to reassess the case for acquiring TechInnova.ai.

This situation highlights how external macroeconomic factors can have a significant and unexpected impact on your cash flow, despite your efforts to optimize your investment decisions.

As a product leader, it's crucial to navigate business decisions carefully in this economic climate, taking into account the effects of macroeconomic factors like interest rates on the cost of capital and the expected returns on projects.