In courses on business, future managers learn about Net Present Value, Discounted Cash Flow, Return on Investment, Payback Intervals, and other useful concepts that can be used to analyze the attractivenss (or unattractiveness) of potential investments.
But do real, practicing executives actually use these analytical tools the way they are intended? Or is something else going on?
Let me start by saying that one person's analysis is another's pipe dream. Almost all financial analysis is built on assumptions about how things will go in the future. Typically, the bigger the decision, the further into the future these assumptions extend.
In some cases (such as a well defined cost reduction, for example), it is possible to get pretty definitive figures to perform the analysis. If you know that by investing in a new machine, you can reduce the scrap from a particular operation by 8.73%, you can probably compute a pretty accurate NPV for the project. But even here, there are still assumptions that go into the analysis -- future volumes, cost to purchase the machine, installation and debugging costs, etc. The thing that tends to make this type of short range analysis work well, is that none of the assumptions is likely to be too far off of the real outcome.
In such cases, analysis does seem to lead the decision-making process -- in most cases. And analysis tends to dictate which projects are most attractive, and which are the highest priorities.
An acquisition analysis at the other extreme.
In mergers, acquisitions, and joint ventures, the time period for analysis is usually at least five years, and more often ten. And at the end of the analysis period, there is normally an additional critical assumption about something called the "terminal value" of the contemplated investment, that can have a huge impact on overall valuation. Additionally, assumptions about volumes, prices, costs and competive responses are built upon other assumptions, often about a product, market, and/or geography where you have, at best, imperfect knowledge. I picture the financial model of an acquisition as a house of cards, precariously balanced and on the verge of coming crashing down with the smallest disturbance.
Is it any wonder, with all those assumptions, that more often than not, intuition leads analysis when making decisions on this type of investment.
What do I mean by that? Simply that the sponsor(s) of the project FIRST decide that the deal is attractive, and they bend and twist the assumptions to come up with an answer that confirms that answer. Often, the sponsoring executive even tries to craft a convincing argument as to why their assumptions are "conservative" or "worst case," when they definitely aren't. Why? Because the sponsor already covets the deal.
Not too many years ago, I witnessed an extreme example of this related to a greenfield factory. The boss I was working for desperately wanted to build a new plant (this all happened before I arrived, offering me the rare opportunity to critic without having any skin in the game). The analysis used to justify the project had a terrific rate of return and NPV. The board enthusiastically approved the project. And then I entered the picture, and was handed this "developing opportunity."
The problem was, there were a few critical assumptions in the project that just didn't work. For example -- the building, improvements, and equipment ended up much more expensive than what was assumed in the original justification. It was also assumed that volume could be freely transferred to the new facility without a negative impact on absorption at the old one. The most damaging assumption was a huge annual productive improvement -- a staggering 10% per year for five years!
In my experience, the only way to achieve that degree of productivity improvement is to either start at a very, very low productivity level (not the case here), or make some massive investments in tooling and equipment (not budged in this project). As I tried to figure out how I was ever going to deliver on the promises my boss had made for the project, I was continually frustrated by other absurd assumptions made in the initial project -- assumptions that set expectations at an unreasonable level, and would have inevitably led to the project being labeled a "failure" no matter what I did.
How did it get that way?
All of the involved executives were intelligent. And all of them were quite familar with the ins and outs of financial analysis -- perhaps too familar! The problem was, the boss WANTED the new plant. Intuitively, he had already decided it made sense. He and other staff members manipulated the assumptions in the analysis to make sure the overall project showed the kind of return the board would fall all over themselves to approve.
In this case, the high risk assumptions were fairly obvious, and I think the board failed to do its job when it approved the project without really investigating things thoroughly. But I've also seen clever executives bury critical assumptions so deeply in the analysis that you'd have to be a forensic accountant to find them.
The point is: beware. Try to avoid letting your intuition lead your decisions about major investments, and watch out for others who may be trying to slip one past you. 12.1
Other Recent Posts:
- If it Quacks Like a Duck...
- Living with Your Business Autopilot Engaged
- You're a Genius!
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- The Tone at the Top
If you are intriqued by the ideas presented in my blog posts, check out my other writing.
Non-Fiction: NAVIGATING CORPORATE POLITICS
Novels: LEVERAGE, INCENTIVIZE, DELIVERABLES and now HEIR APPARENT (published 3/2/2013)-- note, the ebook version of DELIVERABLES (a prequel to HEIR APPARENT) is on sale for a limited time at Amazon for $4.99.
These novels are all based on extensions of my experiences in the world of corporate management.