As trite as it may sound, it is nevertheless true that risk management itself is risk that must be managed well. It also goes without saying that in these fast-changing, difficult days of recession, risk management sits in on every board meeting.
Of course, most directors know that slew of laws compel and shape the performance of their duties. They must also steer clear of the rocks posed by serious business risks. Financial risk; environmental risk; insurance risk; staff health & safety risks; and of course, broader national and global economic risks must be managed.
Yet if nothing is ventured, then nothing is gained. So how can board members deliver effective governance to mitigate risk?
The answer is to take sharp look at the planning framework for allocating capital. Disciplined evaluation and decision making is must. Apples must be compared with apples, not pears; so there needs to be consistent system of capex assessment that evaluates all projects in terms of risk, cost and return.
So, how should an entity’s policy and the framework for allocating capital be structured, and how can it embrace the weighted average cost of capital (WACC)? (For directors unfamiliar with this jargon, WACC is percentage that weights the interest cost of term borrowing against the cost of shareholders equity and takes account of the debt to equity mix. Equity funds usually have much higher interest cost, because market and equity beta factors are added to the risk free rate.)
To ensure scarce capital resources are effectively prioritised, organisations first need system for categorising it based on key drivers. Business rules will define what capital expenditure is (ie, fixed assets with an economic life exceeding one fiscal year); and the rules will set cost threshold for capitalisation. Organisation policy will outline delegated management authority levels for approving capex.
Best practice divides capex into several broad categories, based on returns. Internal rate of return (IRR) thresholds are established for each. IRR represents the rate of return earned by the project itself. It represents discount rate (akin to an interest rate) that equates the present value of future cash flows to the initial outlay.
A software program has been developed for capital expenditure planning, priority setting and appraisal – Capex ValueAnalyser. Let’s suppose that within the preliminary capital budget, number of projects are assigned to an occupational health & safety (OSH) sub-category.
Using proprietary software, the priority setting process is made objective and simple. Decision makers use graphical user interface (GUI) to identify the critical OSH drivers. The first might consider the probability of an OSH incident – from almost certain to practically impossible. The next driver might consider the exposure to the OSH risk – from rare to continuous.
Next, it assesses the seriousness of the consequences, from possible catastrophe to first aid treatment. Another metric could consider the percentage risk reduction targeted by the capex. Finally, the quantum of capital would be considered. The aim is to systematically eliminate health and safety risks through the most efficient deployment of capital resources.
Using this process, capex proposals within every sub-category can be objectively scored and prioritised using driver metrics tailored for each. Board members will have confidence that capital resources have been allocated where they can best reduce risks.
They will appreciate that systemised method of preparing business cases reduces inconsistencies, superfluous information and errors. Proprietary software applications can today provide needed risk management safeguards with their programmed intelligence. In-house spreadsheets on the other hand generally fail their users in this critical area.
When preparing proposals, robust capex management system is essential. The system must include policy and procedures that require involvement of the right staff, disciplines and management, in the correct sequence. For example, tendering systems must require bidders to promote best value outcomes. The tendering system must also manage the risk of anyone accepting facilitation payments in return for favoritism. Directors have fiduciary responsibility to mitigate this risk.
Entities that insist on zero-based capital budgets, allocating funds only into areas of highest need and into projects that offer the best internal rate of return, become winners. Directors benefit because they are able to make capex decisions based on concise information from system that targets risk, returns and value gains, right from the planning stage.
Tony Street is director of Capex Systems, capital planning consultancy and software development company. (www.capex.co.nz
