Silver Lining To Management’s Hardest Challenge?

Specialist consultant in capital expenditure management Tony Street maintains that now more than ever, as the recession wanes, a systemised approach to capex appraisal is vital if management is to create true shareholder wealth.

New Zealand’s corporate executives certainly have their work cut out for them in the wake of news that many CEOs received significant pay hikes last year.

Some, like Shareholders Association chairman Bruce Sheppard, have voiced surprise at the rises, which include a reported top up to $5million for Telecom CEO Paul Reynolds. Yet others fear incentive bonuses have been put on hold just when CEOs face their greatest challenge – investing for post-recession growth.

For example, Jarred Moyle of Moyle Consulting says companies should introduce or increase incentive schemes to ensure executives are strongly focussed on results.

I believe there is a way executives can prove they really deserve fatter pay packets and also create economic value to grow shareholder wealth.

In a nutshell, the need is to pay far more attention to detailed, disciplined analysis of capital expenditure projects than has been done in the past.

Failure here can be disastrous, notwithstanding that it is now years since this matter last gained media interest. A 2000 ANZ Bank survey of real wealth growth by 500 leading New Zealand companies based on ERC (Economic Return on Capital) and Economic Value Added (EVA) results revealed that in 1998 alone these companies destroyed $6.5billion in shareholders funds. In 2002, former Comalco CEO Kerry McDonald laid blame on many companies failure to develop robust examination tools, practices and processes. Today this is still the case for many companies when it comes to capex projects.

The post-recession race is now on to invest and expand but few New Zealand companies have a set aside war chest ready to hand. With most having a 20 to 40 per cent gearing, bank borrowing, like raising money on the stock market, will be difficult. So in many cases retained earnings (shareholders funds) will be called on.

A common failure here is to overlook the real cost of committing shareholder funds. Importantly, NOPAT, EBIT and EBITDA don’t account for them and often the “look good” capex business case prepared using such measures has a false bottom line. If, instead, the use of capital resources is accounted for at the true weighted average cost of capital (WACC) rate, then the real cost of capital outlay is seen – and dubious capex proposals are quickly shown up for what they really are.

Management must also avoid the pitfalls of poor analysis. One company pumped $69 million into a new manufacturing plant aiming to achieve a NPV (Net Present Value) of $20 million. It was really sad that the accounting errors were not addressed before commissioning. The NPV should have been just $500K.

How can things go so wrong? Answer: very easily. Just fail to account for capital outlay in the correct period, forget about interest costs during construction and ignore the future cost of capex “must do” improvements and plant replacement. When it comes to capital expenditure, many companies do.

Astute managers know that with a more disciplined and resourceful focus, they can get 15 – 30% better value from their capex programs. They also do a very wise thing : reinvest value gains into additional ‘business case’ capex initiatives – reducing costs and increasing revenues. This has a “double-positive” outcome.

Today, it should be clear that for management to receive its higher pay check with a bouquet and not a brickbat, it must commit to protecting shareholder value.

The big sins, of course, are poorly specified or non-existent return on capital objectives and poor corporate discipline in ensuring that capital is allocated where it can influence required returns.

Capital expenditure decisions are amongst the most important that any company can make. But it is astounding that the process of priority setting and capex appraisal is not often thought of as important enough within corporate NZ to warrant the use of software. With many prospective “must do” capital jobs to rank in order of importance, management needs objective tools to ensure that ‘needs’ are met before ‘wants’.

Spreadsheets are a far cry from providing a capital management infrastructure. They are seldom consistent and are prone to error. Rarely are they audited and often they are unchecked. Seldom are they proactive in guarding against incorrect assumptions and overlooking best outcomes. Shareholders deserve better.

So as the new round of investment for expansion gets underway, let’s hear it for management brave enough to take the risks after having putting effective capex management infrastructures in place. Their most important challenge is to create enduring economic value for shareholders, choosing the winners from among the capex lemons.

For pulling that off, corporate executives deserve all the extra remuneration they get.

Tony Street is a director of Capex Systems Ltd (CSL), a leading capital planning consultancy and software development company. (CSL is not an EVA supplier.)
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