Better capital allocation decisions: our industry will continue to destroy value if management clings to out-moded models of capital allocation. These examples show a better way.Editor's Note Editor's Note (foaled in 1993 in Kentucky) is an American thoroughbred Stallion racehorse. He was sired by 1992 U.S. Champion 2 YO Colt Forty Niner, who in turn was a son of Champion sire Mr. Prospector and out of the mare, Beware Of The Cat. Trained by D. : Previous articles in this series have dealt with the lack of value creation by the pulp and paper industry The global pulp and paper industry is dominated by North American (United States, Canada), northern European (Finland, Sweden) and East Asian countries (such as Japan). Australasia and Latin America also have significant pulp and paper industries. , the importance of and interrelationship in·ter·re·late tr. & intr.v. in·ter·re·lat·ed, in·ter·re·lat·ing, in·ter·re·lates To place in or come into mutual relationship. in between manufacturing costs and strategy, a process to improve operating performance through primarily intellectual capital, and improving capital productivity. This article extends the discussion on improving performance by discussing some of the risks involved in making capital allocation decisions Capital allocation decision Allocation of invested funds between risk-free assets and the risky portfolio. . As previously discussed, the pulp and paper industry has destroyed value over recent years. The most recent article in this series pointed out that a major problem has been the industry's asset-driven approach to capital allocation, which has ultimately resulted in the acceptance of too many capital projects that have marginal or no positive impact on a firms' long-term value creation (see "Improving capital productivity," p. 60 of the April 2002 Solutions! for People, Processes and People.). Decision makers need to focus on selecting an optimum portfolio of investment projects that will add value at the firm level, rather than focusing on any one asset in isolation. Figures 1-3 illustrate a common situation faced by paper industry companies. [FIGURE 1-3 OMITTED] CAN THIS MILL BE SAVED? A facility is in place, established, and generating cash flow (see Fig. 1). Mill management has proposed a major capital project to update paper machine's technology. They have analyzed several possible opportunities over the past year and have determined that this project is the most promising. The engineers promise increased speed and a better quality sheet. By boosting output, the mill will improve fixed cost coverage; by improving quality, the product will potentially command a higher price. The value proposition looks good (see Fig. 2), The project's net present value (NPV NPV See: Net present value ) is positive; the internal rate of return (IRR IRR In currencies, this is the abbreviation for the Iranian Rial. Notes: The currency market, also known as the Foreign Exchange market, is the largest financial market in the world, with a daily average volume of over US $1 trillion. ) is very high; and the payback period Payback Period The length of time required to recover the cost of an investment. Calculated as: is relatively short. Corporate would be justified in authorizing this project, or would they? To answer that question, management needs to take a step back and look at the project in a total firm capital allocation context, a outlined in the prior article in this series. Figure 3 shows the project's impact on the mill, and the resulting impact on its return on invested capital. Although returns improve at the mill, the positive impact of the project is not enough to turn the mill around. After the project is completed, the mill will still be destroying value. The proforma results indicate that returns will continue to diminish, remaining below the firm's cost of capital and well below its target return on capital. Ultimately, this mill will be targeted for closure or divestiture The breakup of AT&T. By federal court order, AT&T divested itself on January 1, 1984 of its 23 operating companies, which became known as the Regional Bell Operating Companies (RBOCs). due to its underperformance, so investing in it now would not be the best use of capital. A more prudent investment decision would be to use this capital where long-term value creation prospects are greater. In most cases it would make more sense to accept a lower NPV project at a winning facility than a higher NPV project at a mill in long term decline, as shown in Figs. 4 and 5. [FIGURE 4-5 OMITTED] LEARNING TO LET GO A related pitfall pit·fall n. 1. An unapparent source of trouble or danger; a hidden hazard: "potential pitfalls stemming from their optimistic inflation assumptions" New York Times. to avoid is making investment decisions based on the size or significance of past investments (sunk costs Sunk costs Costs that have been incurred and cannot be reversed. ) in the asset. Too often, mills or individual assets that are destroying value are kept running and continue to draw new capital because a major investment was made in the asset in the recent past. It is difficult but necessary to recognize that the project has not worked out as planned. Figure 6 compares a proposed project on a paper machine that recently underwent a major rebuild to two alternative projects at a different facility. [FIGURE 6 OMITTED] If a reasonable effort has been made to restore such a facility to value creation status, and that effort has failed, management needs to consider abandoning the asset and concentrating on where value can be added. The two alternative projects depicted above serve as an example. Accepting the proposed project would not be a wise capital allocation decision. About the author: David Null is associate principal, JP Management Consulting Noun 1. management consulting - a service industry that provides advice to those in charge of running a business service industry - an industry that provides services rather than tangible objects Inc., Atlanta, Georgia, USA. Reach him by email at david.null@poyryusa.com |
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