In Search Of Returns

The wonderful thing about financial markets is that they help to get funds from people who have them to people who have a productive use for them. In other words, they help to make things more efficient by enabling money to be put to good use.

The problem with financial markets, though, is that more often than not participants insist on measuring everything based on “return on investment”.

Why is this a problem?

Well, return on investment is a measure which is interested in how much cash you will get back, and how quickly. If you assume a fairly conservative required rate of return of 7%, then cash received ten years from now would be worth about half as much as cash received today.

As a result, this way of thinking focuses the mind on short term gains, and encourages us to ignore the future.

A similar problem can occur in a social setting.

The wonderful thing about community organisations is that they can bring people together, and give people with particular talents an opportunity to contribute towards a constructive goal. In other words, they make communities more effective by enabling people to put their talents to good use.

The problem with community organisations, though, is that more often than not the people who lead them insist on measuring everything based on a “social return on investment”.

What does this mean? And why is it a problem?

Well, if you are willing to come with me on this thought experiment and assume that all human life has value. Or more broadly, that all life has value, then we can quickly see how measuring things based on their “social return on investment” can lead to questionable outcomes.

Imagine, for example, that you are the bishop of a Catholic diocese based somewhere in America and a Muslim community based somewhere in the Middle East has recently been bombed by American troops causing a large number of civilian casualties.

This is certainly a human tragedy, but you may be less likely to make a public outcry than you would have been if the affected community were Catholic. In other words, since your actions earn you less social returns, you may be less likely to act.

A focus on financial returns encourages us to ignore the future, and a focus on social returns encourages us to ignore the needs of people who might benefit from our assistance the most.

In either case, by thinking about what we might get from the deal, rather than about how we can contribute, we limit our freedom to act and the chance to make the world an easier, better and more enjoyable place to live.

Case Math

Case Math

(Source: Flickr)

In this post we outline some mathematical concepts that may prove useful for solving consulting case questions.

1. Break Even Analysis:

Relevant when trying to decide whether to launch a new product or invest in a project with high fixed costs.

Break Even Analysis

2. Customer Lifetime Value:

Customer lifetime value is a prediction of the entire future value that a company expects to derive from its relationship with a customer. It is a useful tool for a company that is trying to decide which customer segments to target and how much to spend on customer acquisition.

Customer Lifetime Value

3. Net Present Value:

The NPV of an investment is the present value of the series of expected future cash flows generated by the investment minus the cost of the initial investment.

Net Present Value

Where r = discount rate; CFt = expected cash flow in year t; CFn = expected cash flow in final year; g = long term cash flow growth rate.

4. Perpetuity:

A perpetuity is a constant stream of identical cash flows with no end.

Perpetuity

5. Price elasticity of demand:

Price elasticity of demand is a measure of the responsiveness of quantity demanded to a change in price, and is relevant when formulating pricing strategy.

Price elasticity of demand

If demand is elastic (Ed > 1) then changes in price will have a relatively large effect on the quantity demanded, and total revenue will rise if prices are lowered.

If demand is inelastic (Ed < 1) then changes in price will have a relatively small effect on the quantity demanded, and total revenue will rise if prices are raised.

6. Product life cycle:

The product life cycle is relevant when calculating the expected lifetime revenue of a product.

Product Life Cycle Product Revenue 2

7. Profit Margin:

Gross Profit Margin: Gross profit margin measures how much of every dollar of sales revenue remains after subtracting the cost of goods sold.

Gross Profit Margin

Net Profit Margin: Net profit margin measures how much out of every dollar of sales revenue a company actually keeps. Net profit margin is useful when comparing companies in similar industries. A higher net profit margin indicates a more profitable company that has better control over its costs compared to its competitors.

Net Profit Margin

Contribution Margin: A cost accounting concept that allows a company to determine the profitability of individual products.

Contribution Margin

8. Return on Investment:

ROI is a performance measure that a company can use to evaluate the efficiency of an investment or to compare a number of different investments.

Return on Investment

9. Rule of 70:

The Rule of 70 is a simple rule of thumb that can be used to figure out roughly how long it will take for an investment to double, given an expected growth rate.

The rule can be described by the following equation:

Rule of 70

 

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