Impact of the Risky Situation on Present Value

 An investment that is more risky must offer higher returns (if only potential), than safer investments.  If it did not, why would anyone invest in it? 

One impact on the present value is that the the required interest rate will be increased by the ‘risk premium’, which is the additional rate on top of the risk-free rate.  If the risk free rate was for example 2%, and the risky investment offers a risk premium of for example, 8%, then the total interest rate of the investment would be 2% + 8% = 10%.

The simple formula for present value:

CV = PV (1 + i)^t

needs to be adjusted to include the risk premium:

CV = PV (1 + i + rp)^t

Where:

CV = cash value in the future 
PV = cash value in the present (most commonly known as present cash value) 
i = interest rate of a given time period (for example, the interest rate for 1 year) 
rp = risk premium 
t = the number of time periods to consider

Example: What is the present value of an investment that will give us $12,000 one year from now, if the risk-free interest rate was 2% and the risk premium was 8%?

CV = PV (1 + i + rp)^t  12,000 = PV (1 + 0.02 + 0.08)^1  PV = 12,000 / (1.10)  PV = $10,909

What does $10,909 mean?

1. $10,909 today, if invested for one year at the combined risk-free and risk premium rate would return $12,000 in one year.
2. $12,000 one year from now is worth $10,909 today if a comparable investment is available today.

For the sake of comparison, what is the present value of $12,000 -- to be received one year from now -- without the risk premium?

CV = PV (1 + i + rp)^t  12,000 = PV (1 + 0.2 + 0.0)^1  PV = 12,000 / (1.02)  PV = $11,534

Present Value of Future Cash in a Risky Situation

The most basic way of determining the present value of a future cash flow considers only 3 things:

1. How much cash are we talking about?
2. What is the interest rate that you could invest the cash in if you had it today instead of in the future?
3. How long is the future?  1 year?  2 years?

Why would you be receiving that future cash flow anyway?  Sometimes it’s cash that came from you.  Sometimes it’s cash as payment for services you rendered.  Consider the following three scenarios:

1. You put in $10,000 in a term deposit.
2. You lend $10,000 by buying a corporate bond.
3. You provide a service to a company which now owes you $10,000

In each case, the other party has an obligation to pay you back your money.  Is the chance that you will get paid the same?  It’s almost certain you will get your money back from the term deposit.  Even if the bank collapses, the $10,000 is most certainly covered by insurance.

The corporate bond is at risk if the company that issued the bond goes bankrupt.  How likely this is depends on who the company is.  A bond issued by an IBM is less risky than one issued by a smaller startup.

The company who owes you $10,000 may decide not to pay you at all.

Since the risk of not being paid in these scenarios is not different, there are two key things to note:

1. The value of the future cash flow should not be the same. 
2. You would normally want to be compensated for taking more risk.

The most basic means of computing the future cash flow, as outlined above, is not adequate for computing future cash flows that have a certain amount of risk in them.  The formula needs to incorporate the risk factor.

Present Value of Future Cash

 A thousand dollars in your hands today has more value than a thousand dollars promised one year from now. Why?

There's many reasons, but let's consider three.

First, if the cash was in your hands today, you could place it in an interest bearing facility, such as a time deposit.  In one year, that cash will earn additional money for you.  You could not do this with the thousand dollars promised to you 1 year from now.

Second, if you had the money with you today, any opportunity you come across between today and one year from can be acted upon.  If you don't have that money, you will end up not being able seize the opportunity.  Besides opportunities, you could also experience an urgent need for mpmey, as in the case of emergencies.

Third, for a long as the money is not in your hands, you are under the risk of not being paid your money.  In the case of a seller who sold a thousand dollars worth of merchandise to a buyer, should the buyer end up bankrupt, or for some reason unable or unwilling to pay the  money, the seller would be left with a thousand dollar loss.

So a thousand dollars today is worth more than a thousand dollars promised one year from now.  But how much more?

We can answer the question in two ways.  We can figure out how much a thousand dollars today will be worth one year frpm now. Conversely, we can  figure out how much a thousand dollars one year from now, is worth today.

The method of calculation can be as complicated as there are factors to consider, such as the risk of not being paid, the inflation rate, the possible opportunities to be foregone, and so on.  The simplest and most simplistic approach is to just consider the interest rate by which we can deposit the money if we had it in our hands today. This can be computed using the formula:

CV = PV (1 + i)^t

Where:

CV = cash value in the future
PV = cash value in the present (most commonly known as present cash value)
i = interest rate of a given time period (for example, the interest rate for 1 year)
t = the number of time periods to consider

Book Review of 'All You Gotta Do Is Ask' by Norman Bodek and Chuck Yorke

This is the kind of book that I would normally pick up at a bookstore shelf, flip through, and then return back to the shelf. It covers a topic that feels pretty shallow for a whole book.

The whole book, essentially, is about the benefits of putting up suggestion system within your organisation, and some tips and traps when you do so. The topic of an organisation putting up and maintaining such a suggestion system, to let it benefit from employees' ideas, and to boost their morale, sounds like something that can be covered by a web article or at most, a chapter in a book on continuous improvement.  A whole book on the topic feels like overkill, and I imagined it would contain a lot of fluff to pad it out.

But I noticed something in the blurb that attracted my attention.  The book’s author was Norman Bodek, the ‘founder of Productivity Press.’  As it happens, there are currently two publishers I automatically associate with material worth reading. 

One of them is 'Productivity Press', a publisher of books related to quality control and continuous improvement. They are especially known for introducing Japanese classics on these topics into the Western mainstream.  Although a fan of this publisher for many years, I did not know of Norman Bodek.  (The other publisher is The Free Press).

‘All You Gotta Do Is Ask’ is a simple book.  All it does is provide the motivation to implement a suggestion system, and provide proven tips and principles to make sure it is a success.

The book compares the average American company and a Japanese company which encourages its employees to send in suggestions.  The Japanese company receives anywhere from 50 to a couple of hundred ideas per year per employee. Of course, the latter receives the benefits, often in the range of millions of dollars in savings per year.  Almost literally, a goldmine for that Japanese company.

The book covers a whole range of topics about suggestion systems, including the psychological obstacles such as supervisors feeling threatened by inferiors suddenly realising they too possess a brain, or managers co-opting ideas and presenting them as their own, or employees being unsure what to suggest and therefore end up anxious.

In the appendix, you’ll find examples of actual improvement suggestions.  I was surprised by how mundane some can be. Here’s an example:

Before Improvement: It was hard to get a good grip on the shrink-wrap when trying to pull it off the spindle. 

After Improvement: Used a rag to hold on to the shrink-wrap to (tear) it off the spindle.

Simple as it is, it’s nevertheless an improvement. 

A key message the book continually injects is respect for the employees.  Managers must work hard to protect employees and their sense of self-respect. Ideas must be treated with respect.  This is particularly important because not all ideas will be good, and not all will be implemented.  It is important to balance reality. These are important, yet sensitive points, and the book provides recommendations on how to handle them.

There were some other useful insights.  Bodek and Yorke (the co-author) point out that the best suggestions for improvement are those that involve the suggester's work and how they can improve their own work.  It is quite easy to submit suggestions telling how others can improve how they work.  Such suggestions are useful, but because they impose on others, they are often resented, resisted, and not easy to implement.

The one thing I felt missing, which I think very important, is that the focus of the book was on employees coming up with ideas and solutions on how they can improve their own work. For professionals with a relatively large berth in terms of how they do their job, it feels weird to think about how to improve one's work and then put it up for suggestion. Most just execute their ideas for improvement without seeking (or being required to seek) approval. 

Overall, this is a short, easy-to-read book with good ideas about putting up and maintaining a suggestion system.  It cannot be the last word on the subject, but some of the ideas it presents are essential to a successful system.

Recommended.

Project Management Processes

In Session 10 of Pathways to Project Management (a publication of APM), we find a categorisation of the processes of project management:

1. Processes that define what need to be achieved.  Theses are what may be called problem and goal identification activities.  They are essential to clarify what we are trying to achieve, why we are trying to achieve them, and are they worth the cost involved?  Activities include business case and requirements development, as well as project management strategy and planning. 

2. Processes that plan the work required to achieve what needs to be done.  Once we know what we want to achieve, we need to think about the actual steps that need to be done to ahiceve the work.

3. Processes that monitor the work to ensure it will be done a planned.  Project need to achieve the constraints of scope, cost, and schedule.  It is critical to monitor the progress of the work to give us a good sense of how well we are going according to plan.

4. Processes that control change within the project environment.  These are the scope / budget / schedule change management activities.  All projects can expect change. Also included here are the Risk Management activities, which makes sense because risks are a source of project change.

5. Process that ensure the outputs of the project are fit for purpose.  In other words, quality assurance. It is interesting to compare how this differs from the ‘processes that monitor the work to ensure it will be done as planned.’ Does monitoring that the work is being done as planned exclude ensuring that the work done was fit for purpose?

6. Processes that ensure the outputs of the project are successfully launched in the business / customer environment.  In other words, handing over the outputs for the purpose of using the results of the project.

7. Processes that engage and motivate the stakeholders of the project.  Externally focused communication to ensure support for the project continues.  A project fails when it can no longer find support from its stakeholders.

How does this list compare with PMI’s Project Management Processes Groups?  The PMBOk Guide process groups are more abstract, and are not really at the same level as the Pathways process categories.  Cannot really do a useful comparison at this level.

Pathways	PMBOK Guide Process Groups
1. Define what needs to be achieved	Initiating
2. Plan the work	Planning
3. Monitor the work	Monitoring & Controlling
4. Control change	Monitoring & Controlling
5. Ensure fitness for purpose	Executing
6. Handover	Closing
7. Stakeholder management	Executing

Pushing Is Not Managing

A large multi-hundred-million dollar program, dangerously close to its deadline, is experiencing significant problems.

The final stages of testing reveals a large number of unexpected problems, building a mass of evidence that the product is not ready.  This is an unwelcome threat to the much publicised, long promised completion date.

What is the reaction of management?  Put pressure on those under them, as if the already stressed out workers will work better and more productively by application of pressure.  (If that were the case, then why not put more pressure at the beginning of the project, the middle... In fact, why let up pressure at all?)

Pressure shows up in the imposition of targets: You must deliver X number of tests per day! You must fix N number of defects fixed per day!

Incompetent managers have no conception that a process can only  sustain what it can sustain.  You cannot demand that a 3-lane highway accommodate 5 lines of cars.  Try to do so, and you get a mess.  And to fix that mess, you don’t try to ram even more cars. 

If a process cannot sustain a manager's demands, something will give.  The first casualty of pressure will be openness.  Fear will begin to creep and spread like an invisible fog in the project.  Fear leads to lies.  People will lie to save themselves, including from unreasonable demands.  Lies take the place of truth.  With truth gone, you cannot acquire facts.  Without facts, you lose control. Without control, you cannot manage. 

The managers will get their X number of tests, but they will be rushed and dubious quality.  They will get their N number of defects will be fixed. Some of the defects will suddenly become no longer defects. Some will be fixed  with duct tape mentality.

The manager will get the  numbers they want; these will have little resemblance to reality.  But maybe that's fine.  Maybe all that's needed is to maintain a semblance of success, just enough to get kudos and rewards for a job well done. 

There's always firefighters to put out the later problems.  But pity the people whose money is being burned up.  Pity the truth.

Ride Your Bicycle Forward

Organisations with a merit and ranking system are like bicycles being pedaled backward.

 

In the 1950s, W. Edwards Deming, then a relatively unknown statistician, conducted seminars among Japanese companies as part of the American effort to rebuild that country’s post-war economy.  

In these seminars, Deming reportedly used the process diagram shown below, to illustrate the systemic nature of a business’s processes. 

 

The diagram showed how the various parties: suppliers, production, ‘quality control’ (inspection), consumers, research, and others, fed into each other and back in one grand system of production. 

 

Despite the diagram’s deceptive simplicity, it was conveying a message that is both deep and shallow. It was a shallow message because everyone who knew anything about operations knew what it was showing. Yet the message was also very deep because the diagram confronted everyone by asking why they did not act as if they knew that. 

 

Deming made the point that because these functions depended on each other in a systemic way, they must be managed together, as a single system. To manage these functions separately, as if they were not dependent on each other is a path to institutionalised dysfunction.

 

In our modern world of systems thinking, processes management, and post the chaotic period of the 1990s ‘re-engineering’, the reminder Deming wanted to deliver can feel anachronistic.  Not only does the diagram look old, it feels old.  It would not be surprising if a modern audience today reacted to this diagram with a: 'Duh'. 

 

Duh indeed, because by this time we all should all know that. And yet it seems we  don’t.

 

So what is the big deal about Deming’s diagram?  While no one seriously questions its truth, many big companies – precisely the ones that really need to internalise this message – are still operating the business in a backward way.

 

We can illustrate the situation by imagining we were given a bicycle, and then shown how a bicycle should run, and yet we proceed to ride it backwards. 

 

In organisations where a merit and ranking system pervades, where an employee’s ‘performance’ is annually ‘assessed’ by their supervisor,  employees become forced to consider their supervisor as their most important customer.  Employees have no option but to direct all their actions and energies to figuring out what numbers the supervisor is tracking and make sure they meet those numbers, to the subjugation of other considerations.  

 

Supervisors themselves need to please their managers, and so treat their managers as their customer, always thinking: “how am I going to be ranked?”  The situation goes on -- the managers need to please their vice presidents; the vice presidents need to please their executives; executives need to please the CEO; the CEO need to please the board.  The board need to please the shareholders, often fund managers. Fund managers need to please their bosses, in a grand system of brown nosing.

Nowhere in all this is the poor paying customer, the source of the company’s income.  No, that's not entirely true.  The customer does sometimes pop up now and then, but only to the extent where they complain thereby represent a risk to the merit and ranking of employees, or where they give praise and enhance the merit and ranking of employees, or where they can be used to further please that most important of customers, the person higher up in the organisation.

This backward operation of the forward system cannot be undone without a transformation -- a deep, difficult, transformation that demands sustained struggle.  Initiating this transformation, and even more important, sustaining such a transformation will require an unbelievable level of courage, focus, and determination.  A constancy of purpose.

Organisations who are able to operate their forward systems in the right direction will eventually benefit. Once they do start moving forward, it will be easier and easier, kept in motion by a reformed cultural inertia,  to operate the system, understand it, speed it up, improve it, and even accelerate it.  They will have realised how far, FAR better it is to ride a bicycle forward.