THE DIRECTOR: Capex scrutiny crucial part of good governance

It should have been winner. Instead company’s $69-million investment in new manufacturing facilities missed the target by country mile. The targeted Net Present Value was to have been $20 million. In the event with all the costs in, the NPV was just $500,000.
It’s just one of many unreported New Zealand horror stories that paint the perils of failing to do robust value analysis of capital expenditure (capex) proposals and business acquisitions. Simple accounting mistakes led to the downfall. Capital outlays were not accounted for in the correct period and interest costs during construction were overlooked. The company also ignored the cost of future “must do” upgrades.
Sadly, such oversights are common among New Zealand corporates. Management and financial officers widely fail to objectively assess the real long-term costs of capital expenditure. So today, more than ever, directors must ask the hard questions management often does not ask itself.
Frankly, profit and loss measures such as NOPAT, EBIT and EBITDA are not enough. They cannot track the true costs of capital expenditure because they ignore the cost of shareholders’ equity. Today, many companies are 20 to 40 percent geared and capex is often funded from retained earnings. And here’s the rub. Management typically assesses capex on “business case” basis, using accounting measures that show lift to the bottom line. However, by failing to fully account for the cost of using shareholder funds, it risks destroying them in the process.
The lesson should have been learned back in 2000 when the ANZ Bank last put companies’ ERC (Economic Return on Capital) and EVA (Economic Value Added) under the microscope. Then Stock Exchange chairman Eion Edgar voiced concern that New Zealand’s 500 biggest companies had destroyed $6.5 billion in shareholder value in 1998 alone. third had not even covered their cost of capital.
In 2002, in his book Corporate Governance and Wealth Creation in NZ, ANZ head of regional investment banking Joseph Healy observed that CEO compensation and incentives are seldom aligned to the creation of EVA for shareholders. Fixing the problem was (and is) top priority, he said, “because performance measures are encouraging executives to build bigger businesses – even if it means destroying shareholder wealth”. Clearly this is fundamental board responsibility.
Healy pinpointed poorly specified or non-existent return on capital objectives and failure to ensure capital was placed where it could produce the required returns. He also identified an unwelcome dominance of ‘compliance based’ accounting and legal control over the rigorous economic thinking, risk taking and entrepreneurial flair needed for business innovation.
In August 2002 NZ Management magazine highlighted the issue in feature entitled How EVA exposes non-performers – Top executives destroy corporate wealth.
Detailing results surveyed by international management consultants Stern Stewart, the article said that “when it comes to creating wealth for the companies that employ them, our top managers are not top performers”.
Martin Concannon, Stern Stewart’s then managing director Australasia, was quoted as saying, “the trouble is that while capital management has become more popular in recent years, many businesses still treat shareholder funds as if they are free”. In the same article Kerry McDonald, Comalco’s CEO at the time, charged that “what’s lacking is effective management infrastructures – lack of commitment to developing the tools, practices and processes that let good managers and leaders achieve the best results”.
Internationally, there is very clear evidence that good corporate governance achieves triple win: it attracts capital; it increases the share price and it can reduce the cost of capital. It is powerful risk management safeguard for shareholders. For example, study by McKinsey & Co surveyed 200 institutional investors. stunning 75 percent said that good governance practices (commitment to shareholder value, majority of independent directors and transparent reporting) were at least as important as financial performance when evaluating investments. It also found that institutional investors are willing to pay premium for good governance – as much as 20 percent.
Having helped many New Zealand corporates over the years, I have identified huge gulf between management and accountants in taking responsibility for implementing best practice systems to ensure an overall return from capex programmes. When preparing capex proposals, the need to evaluate alternatives, test assumptions, fully assess risks and carefully analyse true value often falls through crack in the floor. Management also generally lacks motivation to put in place objective priority setting systems. With many prospective “must do” capital jobs to prioritise, they should have objective systems to ensure that ‘needs’ are met before ‘wants’. It’s pity they don’t because shareholders and lenders would expect that systems – of world-class calibre – are used to allocate their scarce capex resources.
Amazingly, although capital investment is make-or-break decision, management rarely rates it important enough to warrant software to systemise the appraisal process and thus guard against bad investment. The common approach instead is to plump for false economy by knocking together in-house spreadsheets – far cry from providing robust capex infrastructure. Normally built ‘on the fly’, they are prone to errors – as occurred in the example at the start of the article.
The whole point of evaluating capital expenditure investment is to create sustainable shareholder wealth. Directors have fiduciary responsibility, as agents for shareholders, to monitor management’s performance. Should deviations occur, the board is responsible for taking corrective action. Poor or even average performance warrants confrontation. So at board level, social niceties must not take priority over the need for constructive debate and decision making.
A key function of the board is to provide the link between the providers of capital (shareholders) and the company officers who use that capital to create value (management). Shareholders invest their financial resources to gain return commensurate with the risks that they are taking. So directors must bear in mind that their primary objective is long-term prosperity of the company.
Shareholder value focused companies accept the need to outperform the competition through vibrant and sustainable competitive advantage. This needs to be combined with an innovation-based culture which anticipates market changes and rapidly exploits new opportunities. Innovation ensures enduring growth in shareholder value and therefore first-rate strategic thinking is crucial. So board members must realise that strategy and shareholder value is intrinsically linked.
As an example, the graph on page 63 demonstrates spectacular compounding financial impact where company gains 20 percent better value from its $10 million per annum capital spend. It then uses the expenditure avoided to re-invest in ‘business case’ capex with three-year payback periods. By year eight, EBIT increases by almost $5.2 million per annum. This is an example of good growth through capex that magnifies shareholder wealth creation.

Tony Street is director of Capex Systems (CSL) – capital planning consultancy and software development company.

Visited 13 times, 1 visit(s) today
Close Search Window