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In this case the reward is the NPV which shareholders expect from the newly announced project. So

33

as long as investors believe in a project they will give credit for all of its NPV to the existing share-

holders and the share price will immediately rise to reflect this additional value.

386 The three pillars of financial analysis

I suggest, are founded on two mutually inconsistent assumptions. These are

that companies implicitly assume that the marketâ€™s overall size will equal

the true value of all of the companies quoted on the market while individual

investments assume that any investment will not change the overall value of

companies.

So I have shown some possible reasons why companies can be tempted to

attempt to maximise returns rather than value and I have also shown how

the market is likely to be unstable. We now should turn to the â€˜So what?â€™

question. What is the danger of seeking to maximise returns rather than

value? I suggest that this is that some good projects are rejected altogether

and that other projects are not appropriately optimised. I will deal with this

in some detail later in this book as part of my consideration of the CoC and

in particular whether one should add so-called fudge factors to the CoC in

order to achieve the desired return. For the present I must simply ask that

readers accept that the implications of seeking to maximise returns rather

than value can be very considerable.

Now at this stage one might think that the two sirens would tend to offset

each other. My concern, however, is that the two effects can survive together.

Yes, a search for growth does encourage too many projects to be undertaken

while a search for returns might result in some good projects being rejected.

So there is an offset in that growth encourages overspending while the search

for returns encourages underspending. What can happen, however, is that

companies can be misled by the economic signals which they receive from

their investment cases. It can be easy to generate high IRRs on projects that

have benefited from large sunk costs and which get a free ride from signifi-

cant future fixed costs. By contrast, major strategic moves that are studied at

their initiation may well only offer returns of slightly above the companyâ€™s

CoC because they will be showing an incremental IRR which is much closer

to their full cycle IRR. So the pressure to earn high IRRs can result in a bias

in favour of one type of project over another and so the two sirens cannot be

expected always to offset each other. If a company is performing poorly then

raising the required return on projects is not the way to solve the problem as

it may simply make it harder to justify the strategic change which might be

necessary to solve a companyâ€™s underlying problems.

ChAPTer

10

Conclusion

This middle section of the book was started with an analysis of where we

had come from and where we were going. I propose to finish it in a similar

manner. I will use a special diagram that I call a â€˜fish diagramâ€™ to describe the

progress that readers should have made to what should now be skilled practi-

tioner status. I will, through this diagram, explain why the numbers behind

all projects should be considered as being fishy1 and how we can then sort out

the real fishy numbers from those that just look that way.

This section started with a consideration of how to model economic value.

The basic concept was disarmingly simple but the practical application relied

on many factors that had to be got right if we were to be able to trust an

economic model. I suggested that one key aim for a financial analyst was to

remove spurious number noise from the items that senior decision-makers

need to consider. A well-specified methodology would then allow a set of

assumptions to be converted faithfully into the economic indicators. If a dif-

ferent analyst was given the same assumptions they too would produce the

same profile of after-tax funds flows and the same economic indicators.

A typical set of after-tax funds flows can be used to prepare a chart which I

believe sums up how most project people will think about their project. This

is a graph of cumulative present value. A typical chart for a hypothetical pro-

ject is depicted overleaf.

This particular project involves a capital spend of $20m. The spend takes

place over the first two years and there are then assumed to be 20 years of

beneficial operation of the plant. The twenty-third year represents recovery

of residual working capital, etc. Overall the project has an NPV of $7.0m.

Project people tend to think of their project as though it starts from noth-

ing but quickly, money is poured into it. This is why the line of cumulative

present value starts off by going downwards. It hits â€“$17.4m after the first

Readers for whom English is not a first language should be made aware that â€˜fishyâ€™ does not just mean

1

fish-like. It also has an informal meaning of being suspicious, doubtful or questionable.

387

388 The three pillars of financial analysis

10

5

Present Value

0

â€“5

â€“10

â€“15

â€“20

Time

Fig. 10.1 Cumulative present value: the project personâ€™s view

two years. It is not the full capital spend of $20m because of the time value

of money and the working capital benefit of 45 days of payables on all the

spend. Over time the initial investment is gradually recovered and, ultim-

ately a positive NPV of $7m is earned.

The first pillar should have provided the skills to prepare this chart. In

effect, it equipped readers to convert assumptions into an NPV. How, though,

do readers decide what makes a good assumption? Unless we have something

to help us make good assumptions the numbers must be â€˜suspicious, doubt-

ful or questionableâ€™.

At this stage what a decision-maker who had read the standard texts would

probably do is review the assumptions and decide if they were acceptable. The

decision-maker would take comfort in the fact that in this instance the project

had an IRR of 13.3%. This is well above my assumed 9% CoC. So what might

be thought of as the projectâ€™s â€˜safety marginâ€™ over the fateful zero NPV hurdle

would be quite considerable. In this particular case I have calculated that the

NPV is the difference between the present value of inflows of $53m and outflows

of $46m. The sum of these two numbers is more or less $100m so a change for

the worse of 7% would be required in every assumption before the NPV fell to

zero. The projectâ€™s assumptions could be said to have a 7% safety margin.

Imagine, however, the situation where the initial assumptions indicated an

NPV of zero. The project would be at risk of not being approved and the spon-

sor of the project would face a great temptation to see if any of the assump-

tions could be stretched a bit in order to achieve a token positive NPV while

still retaining what seemed to be reasonable assumptions. How easy would it

be to fiddle the numbers and improve the IRR by, say, one percentage point?

I have tweaked the numbers a bit in order to investigate such a situation.

My new base case had an NPV of â€“$0.1m and an IRR of 9.0%. The NPV was

389 Conclusion

now the result of cash inflows and cash outflows each with a present value of

$48m. From this I was able to calculate that in order to get the IRR back to

10% one would need on average to enhance each assumption by only about

one and a half percent. Changes as small as this would be too small to be

resolved by any logical debate. So the reality is that the conventional decision

rule of â€˜invest in all positive NPV projectsâ€™ when coupled with project spon-

sors who are bound to exhibit at least some bias in favour of their project will

become â€˜invest in all projects unless they clearly have a negative NPVâ€™.

Furthermore, the standard approach means that this problem is then com-

pounded by the fact that the decision rule refers to incremental NPVs and

not full-cycle NPVs. The microeconomic logic of this rule is correct but the

strategic implication is that in the case of marginal projects, companies are

encouraged to approve them even though their shareholders should either

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