Recently, I was involved in a discussion about a major strategic investment that a company was contemplating. This investment was a possible game-changer involving the development of an important new business capability.
The key question on the table was: Will the prospective benefits exceed the costs, yielding returns greater than the cost of capital? What could be more obvious?
Two Critical Questions
In fact, assessing investments using the cost of capital, often called capital budgeting, is not obvious at all. It is a process that seems like second nature to virtually all managers, but one which only a few use correctly.
And it is critically important. If you get it wrong, it can lock your company in place, block your most important initiatives and prevent you from getting in front of competitors.
Two key questions lie at the heart of sound investment assessment:
- What is the cost of capital?
- How should I assess the value of investments?
Not So Obvious
Let’s start with the first question: What is the cost of capital? Just look it up in a Finance textbook. It is the weighted average of the company’s cost of debt and cost of equity (with a few minor adjustments). Obvious, right?
In fact, the answer is not so obvious.
This seems like a technical question, but in reality it is a very important management issue because it tacitly determines a company’s asset productivity.
The cost of capital is actually a composite. It is the weighted average of the risk/return profile of the company’s portfolio of investments (ranging from buying new machines to developing new product lines) that together constitute the existing business. This portfolio is comprised of some investments that have a very low risk and low return, other investments that have a very high risk and high return, and many in between.
Related: Think of Your Company as a Portfolio
Contrast an investment in a well-tested new machine to improve the efficiency of an existing process, with another investment to develop a new product line. The former investment has a low-risk profile, and thus is a sensible investment even if it generates returns that are lower than the company’s composite (overall) cost of capital. The latter has a high-risk profile, and thus requires a higher return than the company’s composite.
Here’s the key point: It is wrong to evaluate each investment by the standard of the company’s composite cost of capital – instead the right measure is how its risk-adjusted return compares with relevant investments, those with similar risk/return characteristics, in the company’s portfolio.
As a practical matter, I think of three levels of risk/return: low, medium and high. This makes the task of specifying a hurdle rate (the appropriate cost of capital) much easier.
Strategic vs. Tactical Investments
The second question – How should I assess the value of investments? – is vitally important to a company’s competitive success. The bottom line is that assessing strategic initiatives is fundamentally different from assessing tactical investments.
Tactical investments, which produce incremental improvements to the business, are the appropriate domain for traditional capital budgeting, featuring net present value (NPV) and return on investment (ROI) analysis setting well-understood costs against benefits over time. (Remember that even here, most companies’ capital budgeting processes fail to differentiate between low risk/return investments that warrant a lower hurdle rate, from the high risk/return investments that require a higher hurdle rate.)
In the world of major strategic investments, a different financial assessment process is needed: one that goes beyond simply adding up costs and benefits to also reflect strategic relevance, the prospective cost of capital and the payback period.
Should you make all investments that pass the cost of capital recovery test? I wrote a very popular blog about this: What are Bad Profits?
The heart of the blog was the Investment Decision Matrix.
The essential point is that in assessing investments, profitability alone is not enough – and this is especially true of major strategic investments. The other critical dimension is whether the investment is strategically relevant.
For example, investing in offering a service that is demanded by only a few customers, but not most customers, probably is not strategically relevant and, if so, you should avoid it even if the investment is profitable. On the other hand, investing in a showcase project to discover an important new customer need in your main line of business may well be very worthy in the long run, even if it does not offer immediate returns.
Yet, a simple business case would favor the former investment and discourage the latter. How can this be right?
Consider a profitable investment that is not strategically relevant, which would indeed pass the cost of capital test. What’s really happening is that this situation has two hidden costs that typically do not appear in the business case calculation.
First, an investment in a new service almost always exponentially increases the complexity of the business in unforeseen ways, and this increases the cost structure of the whole business. (In general, increasing the volume of existing business creates arithmetically increasing costs, but increasing the complexity of the business creates geometrically increasing costs.)
Second, an investment of this sort generates an inexorable future demand for more resources. Why? Because top managers generally do not act for purely economic reasons – after all, how can you really estimate the costs and benefits of a service offering five years from now? Rather, at the executive level, they often act to ensure “fairness” – i.e. the executive in charge needs an opportunity to show what he or she can do with this new opportunity. And, it is much easier to start trying to grow an opportunity than to end it because the former is easy to measure, while the latter is difficult because turning it around is “just around the corner.”
These issues are central to growing profitability in a robust, lasting way.
Read more from Jonathan Byrnes about the measures distributors should use when considering investments in Part 2 of this blog next week.
Jonathan Byrnes is a senior lecturer at MIT and author of the recent book, Islands of Profit in a Sea of Red Ink. He is president of Jonathan Byrnes & Co., a consulting company with which he has advised over 50 major companies, medical institutions and industry associations. Contact him at firstname.lastname@example.org.