Why Your Project Estimates are Probably Wrong

Transcription

1 From Insight Issue #60 Why Your Project Estimates are Probably Wrong By Ben Noland A new breed of investors have entered into the M&A marketplace over the last several decades have brought with them different mindsets and toolsets that can be applied to capital investments to better predict and manage the probability of success. In this article we will explore ways to improve the success of our projects by utilizing more effective techniques in the capital budgeting process. Capital budgeting is the process that companies engage in to make decisions on projects that have a life span of a year or longer. This process is incredibly important for corporations, and these decisions that impact the long-term asset portion of the balance sheet can be so large that their very success can determine the future of many organizations. Think about it: In most organizations fixed costs are largely a function of industry selection. In addition, the cost of funding or cost of capital for organizations tends to be correlated to the industry they operate in as well. That leaves the strategic choices that a company makes and their corresponding capital investments in programs and projects as the choices that allow an organization to truly differentiate. The process of getting capital projects right, beginning with the capital budgeting process, has a significant impact on value creation for shareholders. Conversely, there is little that can destroy value like failed capital investments (and that includes M&A, expansion projects and the like). In order to increase the likelihood of achieving the anticipated outcome of capital investments, we need to explore how capital allocators can be more effective in their selection of capital projects. To do this, we will take a look at how different allocators, both strategic and financial, go through the process of making capital investment decisions that could include acquisitions or programs and projects. Let's begin by looking at a typical process involved in selecting capital projects, and then we will define different types of projects and consider the specific intricacies of each. When an organization is deciding on a significant capital intensive project, including acquisitions, there are some general steps that take place in the budgeting process. These steps may vary based on the specific organization or level of the manager in question, but the basic steps should be pretty similar. Step One: Generating Ideas. Investment ideas can come from anywhere in an organization. Sometimes clientfacing employees will have ideas that are market driven, or perhaps someone coming from a different organization sees value in implementing a process they know. Generating and managing ideas is often the most difficult, but also the most important, step in the process. Step Two: Analyzing Individual Proposals. This involves gathering data and information required to forecast costs and potential cash flows. Step Three: Planning the Capital Budget. At this step, a capital allocator must organize the proposals that seem to be profitable and consider what fits best from an overall strategic perspective and in what timing. pg. 1 FOLLOW

2 Some projects that seem solid on a stand-alone basis might not look as good when considered in the context of a portfolio. Step Four: Monitoring and Post-Auditing. Here actual outcomes and results are weighed against those that were expected, and any variances would be identified and hopefully explained. As an example, how do cash flows realized compare to what was originally expected? While the general steps are used in most decision models, there are some key differences in the types of projects considered and how much focus is put on each step. To begin, let's take a look at the different types of capital projects as a way to identify the areas of greatest potential risk and opportunity. Replacement Projects. These are among the easiest capital budgeting decisions. If a piece of equipment breaks down or wears out, then the decision to replace it may not require significant analysis. Expansion Projects. These decisions arise when a company decides that instead of merely maintaining existing business, they are going to expand into a new arena. These projects should entail greater analysis than a replacement project. New Products and Services. These projects create perhaps the greatest uncertainty of any capital allocation decision. They are typically more complex and will require more stakeholders. Regulatory, Safety and Environmental Projects. These projects are often required by the government, or some other agency, and as a result the only real decision would be around whether the expense is so high that a company would be better closing a division or shutting the doors altogether. Other. All of the projects listed above would typically be validated through some valuation criteria that demonstrate that the cash flow from the project would exceed the expense. Some projects (such as a CEO buying a new aircraft) might escape any such analysis. As you can infer from the list above, a replacement project might not go through nearly the degree of analysis that a new product or service project would undergo. Considering the above descriptions, it would seem clear that if we wanted to focus on making more effective capital allocation decisions, the most impactful types of projects to focus on would be those that either involve an expansion outside of the current business model or geography or on those that focus on a new product or service. The common trait? Uncertainty. Our focus will be on projects that deal with the greatest uncertainty (risk) -- those that deal with expansion and new products -- and consider the second step of a traditional budgeting process, analyzing individual proposals. Analyzing Individual Proposals There are two widely used methods for coming to an investment decision regarding capital investments: Net Present Value and Internal Rate of Return. Their usage depends on the geographic location; IRR is used widely in non-profits and in Europe, whereas NPV is most widely used in North America. There are others, payback period, discounted payback period, average accounting rate of return and the profitability index. But for our purposes we will just reference the two most widely used. And at the end of the day, it is important to know that they are both essentially ways to understand if the projected cash flows (discounted appropriately) are sufficient to exceed the expected investment outlay. pg. 2 FOLLOW

3 Calculating Outcomes Net present value (NPV) is essentially the value of the inflows minus the values of the outflows adjusted to the time value of money. Most publicly traded companies in the United States use NPV primarily because it's aggressively taught in American MBA programs, so it's what masters of business administration tend to know. Internal rate of return (IRR) is essentially the rate of return it would take to bring a capital expenditure down to zero for some prescribed period of time. Anything that gives you a positive outcome translates to profitability; anything that gives you a negative outcome suggests just the opposite. European companies tend to use a mix of both types of calculation, but with less emphasis on NPV. Calculating Outcomes Net present value (NPV) is essentially the value of the inflows minus the values of the outflows adjusted to the time value of money. Most publicly traded companies in the United States use NPV primarily because it's aggressively taught in American MBA programs, so it's what masters of business administration tend to know. Internal rate of return (IRR) is essentially the rate of return it would take to bring a capital expenditure down to zero for some prescribed period of time. Anything that gives you a positive outcome translates to profitability; anything that gives you a negative outcome suggests just the opposite. European companies tend to use a mix of both types of calculation, but with less emphasis on NPV - See more at: So in a traditional capital budgeting process one would use net present value of future cash flows discounted at the appropriate cost of capital and compare the result to the initial investment and look to ascertain whether the outcome represents a positive net present value. If the present value is less than the initial investment, then the project is rejected. If the net present value of a project is greater than the investment, a project would be eligible for a green light. I say "eligible," because even though a project may appear profitable, an organization would look to consider the entirety of its portfolio of projects to decide which should be undertaken due to considerations of prioritizations or the like. Here is where it gets interesting though. In a traditional model the cash flows are forecasted as a single figure and scenarios are considered one by one with uncertainty of cash flow not really being considered. That is all possible outcomes are not considered simultaneously, and there is not an assessment of the likelihood of getting a positive net present value. Do you see why that is amiss? In effect, the traditional analysis is not wrong; it is simply incomplete. In analyzing a project's net present value, one could have an outcome of a net present value that has a 40 percent chance of achieving that outcome (if also measuring using probability and simulations) and a project would have an 80 percent chance, yet still look the same. We will get into more detail in a moment, but let's take a quick look at the rise of simulations in the capital budgeting process. Some key differences have emerged over the last 20 years or so as a result of the growing power of financial buyers in acquisitions. In the more traditional model of M&A, buyers have been strategic buyers. They have consisted of organizations that are currently in a certain industry and are buying other companies in that pg. 3 FOLLOW

4 industry in an effort to grow a customer base, reduce supply or gain strategic synergies that can reduce cost while driving growth. Now that is a simplification designed to be illustrative, but directionally it is accurate. With the consistent growth of financial buyers -- typically private equity or venture capital firms -- there has been a growing number of buyers without the benefit (or as we often see, a curse -- as expertise can become a blinder) of being in an industry where they are considering making an acquisition. As a result, these buyers who are well versed in financial modeling and are accustomed to using simulations (Monte Carlo simulations as an example) have brought to the space intensive simulations to judge not only the scope but also the probability of an outcome of an investment. Let's consider how this can play out in a typical capital budgeting process. If you recall from above, one of the key components in the determination of net present value is discounting the future cash flows at an appropriate cost of capital (or weighted average cost of capital). While this is typically a risk-adjusted measure of the cost of capital that is used as a benchmark, the caveat (and it is an important one) is that in many analyses the most frequently used number is the company's overall risk-adjusted cost of capital in determining the formula to identify a project's net present value. Why is this a problem? If you recall from the reading above, as an example, a replacement project will carry a significantly different level of certainty than would an expenditure into a new product or service. When a company's overall cost of Monte Carlo simulations are a broad class of computational algorithms that rely on repeated random sampling to obtain numerical results; typically one runs simulations many times over in order to obtain the distribution of an unknown probabilistic entity. Basically, it is a more sophisticated way to analyze the sensitivity of different assumptions and outcomes, providing a more in-depth analysis of probable results. The name comes from the resemblance of the technique to the act of playing and recording your results in a real gambling casino - See more at: capital is used to discount the cash flow of projects under consideration, the results could include the following: Rejecting a profitable project that could create shareholder value that carries a lower level of risk than other projects because the company discounted the project's cash flows too much; Accepting projects that only appear to be profitable because the company did not discount the project's future cash flows enough. There are a number of factors that can impact the true risk of a project. These include: Economic Conditions. Will consumer spending be high or not? Will the economy be in a recessionary stage or expansion stage? Will there be government stimulation? What about inflation? Market Conditions. How competitive is the market? How difficult is entering the market? What are the barriers? Interest Rates. What will the cost of raising capital be moving forward? Taxes. What will the tax rate be in the future? International Conditions. Will there be significant shifts in exchange rates? Are governments in involved countries stable? pg. 4 FOLLOW

5 Sensitivity analysis is used to evaluate the degree of impact that certain variables will have on the desired future outcome. We can use a spreadsheet to understand the dependence of the project outcomes to slight changes in these and other forecasts. We can take it a step further by conducting a more detailed scenario analysis on the impact of certain variables on the project being considered. One of the advantages that financial buyers often have over strategic buyers is the more significant exposure to such tools. For example, the use of Monte Carlo simulations has begun to rise in significance due in no small part to their use by financial buyers in M&A transactions. Monte Carlo simulations are the tools that would be used for analyzing the combined effects of changes in uncertain variables. The risk of a project is actually the risk of its future cash flows. Remember that statement: The risk that is associated with a project is essentially the risk of whether or not the projected future cash flows will be recognized or not. That is why the use of a constant cost of capital number that applies to a company overall can have a significant negative impact on the selection process for which projects to undertake. And better decision making on the front end means less risk on the back end. Now, of course, we all know that even in the best scenarios there are also risks in the execution of a project, but that is still a part of whether projected cash flows are realized. My father was a carpenter, and he always said measure twice and cut once. The way you measure twice in the capital budgeting process is to begin to look at the risk associated with your project statistically with measures like the range of possible outcomes, the standard deviation of outcomes and variation of outcomes, all elements of an effective simulation including Monte Carlo simulations. This added level of analysis is particularly applicable to large capital investments with a high level of uncertainty. By using scenarios and simulations, you can begin to get a better idea of the risk associated with your project, which means you can discount the cash flows more accurately to the actual risk involved in the project you are considering. This will allow for better decisions in the front end, and better outcomes in the future. Measure twice, cut once. Usage or repurposing of this content for commercial purposes is restricted without the express permission of Pcubed. For further information on this article and Pcubed, please contact Linda Lavine, Global Head of Marketing, at linda.lavine@pcubed.com. Ben Noland is a Managing Director in Financial Services NA, and leads Pcubed s M&A Practice in North America. He has over a decade of financial services experience including senior client-facing positions at Lehman Brothers, Prudential Securities and with a large alternative investments firm. At Pcubed Ben is focused on helping organizations deliver their highest strategic objectives, whether it be through merger value realization or other major organizational transformation efforts. Prior to joining Pcubed Ben was an Executive in the Capital Markets practice at Accenture where he was tasked with client account leadership and major change initiatives, including playing a role in the largest merger integration in Financial Services history. In addition, Ben has worked with numerous organizations in helping to drive measurable results through executing strategy more effectively. Contact Ben Noland at ben.noland@pcubed.com. pg. 5 FOLLOW