Expense Management

Forum: Scrap Capital Project Evaluations

At the project level, NPV and IRR analysis is a waste of time.
Roy E. JohnsonMay 1, 1998

In the world of finance, there are few activities more entrenched than capital project evaluations. These evaluations, which rely on net present value (NPV) and internal rate of return (IRR) techniques, keep countless analysts hard at work, while consuming an enormous amount of managers’ and directors’ time.

But in fact, the justification of individual capital expenditures is one of the most questionable activities in finance. Do we really need to be assured that, say, a $750,000 machining center for a $3 billion (in revenues) manufacturing company is economically viable? Or that a $300,000 CAD/CAM system for the engineering department will have a “payoff?” When such investments are put in their proper context, capital project evaluations can appear virtually meaningless — as, in reality, they usually are.

Is this an exaggerated claim? Let’s assume that our $3 billion company has three business units (BUs), each with approximately $1 billion of revenue. Further, assume that the machining center and CAD/CAM investments are in BU 1, which has a strategy of growing at 15 percent per year and offering a combination of high product quality and competitive cost. BU 1, therefore, plans to grow revenue by approximately $150 million next year. Its current-year balance sheet reflects the following for fixed assets:

(Chart Omitted)

This GFA ratio reflects capital intensity — how much capital is required to generate each dollar of revenue. If we determine that the growth strategy will be in line with past experience, then BU 1 will need to invest about $45 million next year — 30 percent of its $150 million in “new” revenue.

Even if the strategy could leverage the existing asset base and require less new capital, we’re still dealing with annual investments of many millions of dollars to support and execute the strategy. Since strategies often require more than one year to execute, the aggregate amount of new capital could be in the $50 million to $100 million range, and perhaps beyond.

So what is the point of justifying the investment in the machining center or the CAD/CAM system? Why drive everyone crazy by requiring elaborate evaluations on relatively small projects that have no useful life of their own, and are only pieces of a much larger puzzle?

The job of management is to put the puzzle together, not to place each piece under the microscope. I’ll bet that many companies performing extensive capital project evaluations have not quantified the shareholder value impact (that is, the NPV/IRR) of their overall strategy. The key points are, if a strategy has value, then the individual projects should have value, since they are part of the strategy; further, those projects cannot, and should not, be separated out for purposes of analysis.

The purpose of value-based analysis — regardless of which metric you prefer (they are all an extension of NPV/IRR concepts) — is to determine value at appropriate levels in the business hierarchy: the company, business unit, strategy, and, possibly, major program. The major program (say, an important strategic or operational initiative) is the absolute lowest level for which value-based analysis should be performed.

BU 1, for instance, may have a major program to enhance product quality that encompasses, say, 10 machining centers (projects) averaging $1 million each plus the CAD/CAM system. At this level, value-based analysis can be relevant — but only if the program is a key building block of a strategy or operational plan.

At the project level, however, NPV/IRR evaluations are a waste of time. Let’s scrap them and spend our time on more productive efforts.

Roy E. Johnson is a partner at Vanguard Partners, a business and financial strategy consulting firm based in Ridgefield, Connecticut.