Capex priority setting and corporate values

Every company is owned by shareholders. So the primary value must be to protect and grow shareholder wealth. This set as the priority, it is normal to set up two or three broad categories to rank capex projects, assessing them on discounted cash flow (DCF) criteria such as NPV or IRR (internal Rate of Return).

For example, category ‘A’ can be for “must do” capital expenditure which generates no economic return or a return less than the weighted average cost of capital (WACC). Category ‘B’ covers capex projects needed to achieve a return at least equal to the WACC – such as ‘strategic’ capital expenditure, increasing capacity and the like. Category ‘C’ is for capex projects that have a strong business case and will clearly add value – operational improvements, new business, revenue enhancement, innovation, etc.

Be mindful that Category ‘A’ capex projects provide no additional return. Thus Categories ‘B’ and ‘C’ are left to achieve the all-important enhanced overall return on capital for shareholders the company’s value priority requires. In reality Category ‘B’ contributes little to this goal. Therefore Category ‘C” projects must bear an extra load. Thus Category ‘C’ projects should be required to achieve a return threshold greater than the WACC by a pre-determined margin.

To ensure the company behaves ethically and meets key stakeholder needs, sub-categories could be assigned to the Category ‘A’ “must-do” projects as follows:

-  Occupational health & safety related matters – necessary to maintain a safe working environment
-  Environmental / resource management compliance concerns
-  Regulatory compliance related issues
-  Replacement of assets that have reached the end of their economic lives
-  Projects to ensure product quality/or reliability and/or good service delivery
-  Purchase of current business technology to improve work effectiveness.

Category ‘A’ ‘must do’ capex projects can now be prioritised by requiring team members to allocate their proposals to one or other of these sub-categories. Next objectively prioritise the submissions in order of importance. Now you can use the Capex® Stratagio™ priority setting tools to identify key drivers for each sub-category – thus turning a management art (which could otherwise be subjected to company politics) into a near- exact science.

Obviously capital expenditure programme managers need to understand their company’s philosophy in meeting the needs and aspirations of its various stakeholders. In turn this will impact the priority setting systems used to allocate financial resources to capital expenditure programmes.

True, ‘maximising shareholder value’ can be interpreted negatively as a win-lose paradigm when, in reality, of course, a ‘win-win’ approach is needed. The fortunes of shareholders and stakeholders are inextricably linked and a ‘balanced scorecard’ philosophy that embraces customers, staff, business processes and the environment is vitally important. Investing in and developing employees and avoiding negative environmental outcomes are especially crucial.

But beware. Such a ‘triple bottom line’ philosophy is but a variation of the “stakeholderism” that attempts to take a ‘balanced scorecard’ approach to a shareholder focus – and it is easy to take it too far. Ostensibly, it is a company commitment to environmental and social issues, as if these are distinct and separate from the shareholder-value objective. This framework asks companies to measure their role and report performance against economic, social and environmental standards.

Thus about 10 years ago, the New Zealand Business Council for Sustainable Development pronounced a triple bottom line – economic, environmental and social sustainability. The council’s key aims were:

-  A healthy and diverse ecological system which continually performs life-sustaining functions
-  A healthy and diverse economy which adapts to change, provides long-term security and
   recognises social and ecological limits
-  A social foundation which provides health, fosters participation, respects cultural diversity, is equitable, and considers
   the needs of future generations.

Credible objectives all, and no firm committed to shareholder value maximisation would fail to duly consider them. However, it can reasonably be argued that these standards are of a public policy nature and are really outside the legitimate terrain of the business sector.

Where external shareholder funds are used to pursue such aims, shareholders may well ask whether they should be contributing directly to say, environmental organisations. And how can managers determine priorities amid the conflict between the shareholder-maximisation priority and competing public policy objectives? Further, how can they be held accountable for their decisions?

Under a stakeholder philosophy managers and directors have no principled criterion for decision making, capex priority setting, and evaluating performance and, without such a dominant objective, their company will likely fail against a competitor focused sharply on shareholder wealth creation. It’s fine to preserve the environment and help society but since it is the Government that alone taxes and decides social spending the company should neither usurp nor substitute for it’s role.

Sadly, in a stakeholder corporate culture, management and directors often encounter excessive politicking and game-playing. People promote pet capital projects which are often based on loose criteria. Understandably the culture is unproductive and the business ultimately becomes dysfunctional – lacking the common purpose that a shareholder-value philosophy achieves. It’s as if such companies forget the reason they exist.

By contrast, a shareholder wealth creation culture obliges a company to recognise that its success depends both on ethical business behaviour and on meeting stakeholder needs and aspirations. Thus much attention is paid to customer and staff attitude and satisfaction surveys. Successful shareholder-value companies also strive for a ‘balanced scorecard’ (per Kaplan and Norton, 1992) to deliver shareholder value and understand and instill employee motivation.

If shareholder-value creation is the overriding objective, then managers have a clear sense of what they must do – whereas the broad notion of social responsibility invites them to make political decisions and exercise power for their own social purposes. These conflicting objectives cause confusion and provide excuses for poor management.

Today globalisation of capital markets and ever speedier information flow around the world make it impossible to escape from higher expectations of performance and value by investors.

In conclusion, to quote McKinsey & Co – American consultancy (1997):

“There is overwhelming evidence to support the view that shareholder value should be the explicit goal of all corporations. A shareholder mindset benefits not only the shareholders themselves but society at large, setting in motion the virtuous cycle of value creation, job creation and wealth creation.”