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P1: JYSFM JWBK371-Steiners May 4, 2009 15:1 Printer: Yet to come

CAPEX Excellence

Optimizing Fixed Asset Investments

Dr Hauke Hansen

Dr Wolfgang Huhn

Mr Olivier Legrand

Dr Daniel Steiners

Dr Thomas Vahlenkamp

A John Wiley and Sons, Ltd., Publication

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CAPEX Excellence

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CAPEX Excellence

Optimizing Fixed Asset Investments

Dr Hauke Hansen

Dr Wolfgang Huhn

Mr Olivier Legrand

Dr Daniel Steiners

Dr Thomas Vahlenkamp

A John Wiley and Sons, Ltd., Publication

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Published in 2009Copyright C© 2009 John Wiley & Sons Ltd

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Library of Congress Cataloging-in-Publication Data

CAPEX excellence : optimizing fixed asset investments / Hauke Hansen . . . [et al.].p. cm.

Includes bibliographical references and index.ISBN 978-0-470-77967-5 (cloth)1. Capital investments. I. Hansen, Hauke.HG4028.C4C344 2009332.63–dc22 2009011962

A catalogue record for this book is available from the British Library.

ISBN 978-0-470-77967-5 (HB)

Typeset in 10/12pt Times by Aptara Inc., New Delhi, India.Printed in Great Britain by CP1 Antony Rowe, Chippenham, Wiltshire

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http://www.wiley.com


Contents

Acknowledgements ix

About the Authors xi

PART I WHY INVESTMENTS MATTER 1

1 Introduction 31.1 Investments: the forgotten value lever 3

1.1.1 The early bird catches the worm 41.2 A bird’s-eye view of the book content 6

1.2.1 Part I: Why investments matter 61.2.2 Part II: Getting investments right 71.2.3 Part III: Right allocation: Managing a company’s

investment portfolio 91.3 Why investments matter: the importance and structure of capital

investments 101.3.1 The relevance of capital investments 101.3.2 The structure of capital investments 161.3.3 Time dependence of capital investments 211.3.4 The future of capital investments 26

1.4 Summary 27Appendix 1.1: Wavelet analysis: Extracting frequency information frominvestment timelines 27References 29

PART II GETTING INVESTMENTS RIGHT 31

2 Right Positioning: Managing an Asset’s Exposure to Economic Risk 332.1 Preface 332.2 Asset exposure determines the achievable return on an investment 332.3 Five levels of protection determine the asset exposure 352.4 A simple scoring metric to measure asset exposure 37

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2.5 Quantitative asset exposure analysis shows high correlation with ROIC atall levels 422.5.1 Using exposure level analysis for benchmarking 45

2.6 Strategies to reduce asset exposure 472.6.1 Strategy 1: Create public-private, win-win situations in natural

monopoly environments 482.6.2 Strategy 2: Foster regulatory conditions that enable sufficient

investment levels 492.6.3 Strategy 3: Create the right structural conditions and ensure fair

access to scarce resources 492.6.4 Strategy 4: Establish protection for intellectual property 502.6.5 Strategy 5: Achieve a strong commercial position 502.6.6 Strategy 6: Minimize fixed capital costs or outsource asset

ownership (go “asset light”) 522.7 Summary 53

3 Right Technology: How to Optimize Innovation Timing and Risks 553.1 Capital investments in technology innovation 55

3.1.1 Technology analysis 573.1.2 Assess risks 633.1.3 Mitigating technology risks 67

3.2 Summary 69

4 Right Timing: How Cyclicality Affects Return on Investments and WhatCompanies Can Do About It 714.1 How cyclicality destroys value 714.2 Industry drivers of cyclicality 73

4.2.1 Impact of investment lead times 774.2.2 Slow-to-no market growth 784.2.3 High price sensitivity 784.2.4 Investment timing with respect to the cycle 79

4.3 Developing an economic model of cyclicality 814.3.1 A fundamental law of economic cycles 814.3.2 Base parameters of simple economic oscillations 834.3.3 Reaction of cyclical systems to external “excitation” 854.3.4 Economic cycles with more than one player present 87

4.4 Measures to cope with cyclicality 904.4.1 Reaction delay 914.4.2 Reaction strength 924.4.3 “Jokers” that can help beat the cycle 924.4.4 Where no joker is available 95

4.5 Summary 98Appendix 4A: A differential equation for economic cyclicality 98Reference 100

5 Right Size: Balancing Economies and Diseconomies of Scale 1015.1 Introduction: The role of scale in determining profitability 1015.2 Assessing economies of scale 103


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5.2.1 Fixed cost leverage 1045.2.2 Decreasing unit costs 1055.2.3 Equipment utilization/chunkiness of capacity 1065.2.4 Critical size 107

5.3 Determining diseconomies of scale 1075.3.1 Cost elements 109

5.4 Risk elements 1115.4.1 Utilization risks 1135.4.2 Market reaction risks 1155.4.3 Technology risks 1165.4.4 Timing risks 116

5.5 An approach for finding the “sweet spot” 1175.5.1 Scale effect model 117

5.6 Real-life examples 1185.6.1 Automotive industry case example 1185.6.2 Base chemicals case example 119

5.7 Summary 120Reference 121

6 Right Location: Getting the Most from Government Incentives 1236.1 Government incentives: An overview 124

6.1.1 Creating public-private, win-win situations 1256.2 Common types of incentive instruments 127

6.2.1 Subsidies 1316.2.2 Financing support 1316.2.3 Tax relief 1336.2.4 Other types of government incentives 134

6.3 The financial impact of incentives: A modeling approach 1366.3.1 General impact of subsidies 1376.3.2 General impact of financing support 1386.3.3 General impact of tax relief 1386.3.4 Specific impact of incentives on different industries 139

6.4 Geographical differences in incentive structures 1406.5 Managing government incentives 1416.6 Summary 142

References 142

7 Right Design: How to Make Investments Lean and Flexible 1437.1 Lean design as a competitive advantage 143

7.1.1 The lean way: Moving from capital investment projects to a leandesign system 143

7.2 The three dimensions of a lean capital investment system 1467.3 Dimension 1: The technical system 147

7.3.1 Start with project objectives, design princisples, and target setting 1477.3.2 Value engineering and lean tools 1497.3.3 Design optimization 1527.3.4 From the basic design to start of production 1537.3.5 Anchoring tools and practices to formal standards 155


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7.4 Dimensions 2 & 3: Management infrastructure, mindset and behavior 1557.4.1 Project organization and performance management 1557.4.2 Institutionalization and learning 1567.4.3 Adapting the system to local specifics: Project design cannot be

“one size fits all” 1567.4.4 Getting started 157

7.5 Flexibility: Just what customers and the company need and no more 1587.5.1 Macro-level flexibility: modularity in plant design to ensure

flexible, cost-efficient assets 1587.5.2 Midi-level flexibility in plant design: cater for product

portfolio diversity 1597.5.3 Micro-level flexibility in plant design: design for iso-productivity 160

7.6 How to avoid creating a front-page disaster: Anticipating what cango wrong 162

7.6.1 Performance management and decision making 1637.6.2 Tools which every company and project team need to master 1647.6.3 Cross-functional coordination 165

7.7 Summary 166References 166

8 Right Financing: Shaping the Optimal Finance Portfolio 1678.1 Why Financing Matters 1678.2 Three-Step Financing Approach 170

8.2.1 Step 1: Evaluating the investment’s cash flow parameters 1708.2.2 Step 2: Assessing investment risks 1728.2.3 Step 3: Composing the financing portfolio 180


PART III 185

9 Right Allocation: How to Allocate Money Within the Company 1879.1 Key requirements for capital allocation 1889.2 Four models of the corporate center role in shaping the investment portfolio 1929.3 Capital allocation approach for operators and strategic controllers 195

9.3.1 Step 1: Treat special projects as high priority 1969.3.2 Step 2: Allocate remaining capital to business units 1979.3.3 Step 3: Business units distribute capital to individual investments 1999.3.4 Step 4: Implement a capital assurance process 2019.3.5 Improving the “capital allocation key” 2039.3.6 Capital allocation backbone 204

9.4 Capital allocation approach for strategic architects and financial holdingstructures 210


Index 215


Acknowledgements

No book is solely the effort of its authors and this book is certainly no exception. Severalpeople worked closely with us, providing support that was essential to the completion of thebook. Therefore a big thank you to:

Andreas Gupper, Franck Temam, Herbert Pohl, Jorg Doege, Juliane Bardt, Marcus Klemm,Olivier Cazeaux, Robin Schlinkert, Sebastian Serfas, Stefan Buchkremer, Thilo Duckert,Thomas Hundertmark, Ute Roelen, and Volker Jacobsen for helping us develop the ideasand the material that led to the chapters in this book.Colleagues from all around the world who helped us with discussions on specific topics orprovided case examples.Our assistants, Carolin Bindert, Dagmar Kruger, Elif Ebci, Jana Stovesand, and SabrinaMichel, for help in preparing the manuscript and coordinating the flow of paper, e-mails,phone calls and meetings.Our manuscript editors Ivan Hutnik and Jurgen Raspel for their contributions to the clarityand crispness of many chapters.The team at John Wiley & Sons, including Karen Weller, Kerry Batcock and Jenny McCall,for their patience and understanding during the manuscript production process.

Finally, we would like to thank our wives, Angela Vockel, Dunja Vahlenkamp, Gesa Hansen,Petra Steiners, and Virginie Legrand, for their kind understanding and persistent support.

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About the Authors

Hauke Hansen works as a production manager for ASML in Veldhoven (NL). Prior to hiscurrent job he was an Associate Principal in McKinsey’s Dusseldorf office. He served high-tech, logistics and telecom companies and supported several multi-billion dollar investmentprojects. He holds a PhD in physics from the University of Konstanz and was a FulbrightScholar at the California Institute of Technology.

Wolfgang Huhn is a Director in McKinsey’s Frankfurt office. He primarily serves clients inthe high-tech industry as well as in energy. Wolfgang is a member of the Business TechnologyOffice where he leads the industrial sector in Europe and he also leads the European ProductDevelopment Practice. Prior to joining McKinsey, Wolfgang studied electrical engineering andphysics at Aachen and in the UK and obtained his PhD in Physics from the RWTH Aachen.From 1998 to 2000, Wolfgang was the CEO of a VC-backed company.

Olivier Legrand is a Principal in McKinsey’s Paris office. He serves clients in the transpor-tation, steel and aluminum industries as well as in consumer goods and energy. Olivier co-leadsMcKinsey’s global capital productivity group. Olivier holds an MBA from Stanford BusinessSchool.

Daniel Steiners is an Associate Principal in McKinsey’s Dusseldorf office. He serves clients inelectric power and chemicals and is a co-leader of McKinsey’s European capital productivitygroup. Daniel received a diploma in business administration from Munster University and aPhD in management accounting from the European Business School in Oestrich-Winkel.

Thomas Vahlenkamp is a Director in McKinsey’s Dusseldorf office. He serves clients in thecoal, oil, gas, power, and chemicals as well as transportation industries. Thomas is the sectorleader of the Energy and Materials Practice in Germany and a member of the leadership groupof the European Electric Power and Natural Gas Practice. His educational background is inpolymer chemistry. He holds a degree from the Technical University of Aachen (RWTH) anda doctorate from the Max Planck Institute for Polymer Research.

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Part I

Why Investments Matter

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Introduction

1.1 INVESTMENTS: THE FORGOTTEN VALUE LEVER

Much of the current management literature focuses on a limited set of “classical” value levers,such as cost reduction, sales optimization or mergers & acquisitions, thus neglecting anothercore value lever: capital investments (Capex).

That capital investments receive such limited attention is all the more surprising when oneconsiders just how vitally important they are to the economy as a whole and to business inparticular. In 2007, more than $11.8 trillion was spent on capital investments globally – morethan the combined GDP of Japan, China, India, South Korea, and Taiwan (or Germany, France,Italy, Spain and the UK). Not only is the sum invested enormous, but its influence on long-termcompany performance is critical. Since the early 1990s, asset-heavy companies in the S&P500 have increased their average return on invested capital by 3.8 %. Our analysis indicatesthat about half of this increase (48 % ) is related to investment activities (Figure 1.1).

Investments are important not only in optimizing the asset structure of a venture but alsofor enabling the introduction of new products or for introducing structural cost reductions.

Managers know that the value of an investment is not a “given” that results in an inevitablerate of return. A wide range of variables influences the outcome both positively and negatively.Understanding these variables is therefore critical in assessing the likely performance of aninvestment.

The experiences from a range of capital investment optimization projects show that there issignificant value creation potential in optimizing capital investments. Results achieved acrossa wide range of optimization projects demonstrate this potential to be of the order of 15–40 %of the return on an investment. This value potential arises from three core improvement leversfor investments: reductions in the amount of capital invested, acceleration of the productionramp-up, and increases in the operating cash flow during the productive life of an investment(Figure 1.2).

Investment related ROIC drivers1.8

0.9

3.8ROIC change* in focusindustries 1992−2007

0.5 1.5Sales increase effect

0.4 1.4Cost reduction effect

Invested capital effect

• New product investments

• Investments to achieve structural cost reductions

• Capital efficiency increases and investment activity reductions

* Difference between 10-year moving average of revenue-weighted ROIC in 1992 and 2007Source: MCPAT, McKinsey analysis

Investment-related ROIC changes (48%)

Figure 1.1 Drivers of the increase in ROIC, 1992–2007

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ROIC impact*

* Estimated typical impact on a capital investment based on team analyses, expert interviews, and project experienceSource: CI team

Core Investment Phases

Decision and design Execution and ramp-up Life cycle management

Core value levers available in decision & design phase only• Invest strategy

– Why, where, how to invest?

• Invest design– Right positioning to

risk & competition– Right technology– Right time– Right size– Right location– Right design– Right financing

Optimized

Base case

Reduce capex• Improved capital goods

procurement• Capex spend control

Accelerate ramp-up• Aggressive ramp-up

planning• Effective critical path

& project mgmt.• Contractor mgmt.

Increase operating cash flow• Reduced operating costs• Increased yield• Supply/demand matching• Salvage value optimization

0 –15%

Time

Core focus of this book

Value contribution (not additive)15−30%

5 –10%

10–15%

Figure 1.2 Core value levers for optimizing capital investments

1.1.1 The early bird catches the worm

Once a project progresses from the design phase to the execution and ramp-up phase thepotential for optimizing the investment narrows, as much of the cash has already been spent orcommitted. The decision and design phase, therefore, is of critical importance to the perform-ance of any capital investment. This phase provides the largest value creation opportunityfor investing companies. The crucial questions managers are faced with in this phase are, ofcourse, “Where, when and how to invest?”, “How do we design the investment so as to ensurean optimum return?” and “What is the best way to finance the investment?”

The decisions made in this phase determine the boundary conditions for the business assets –and a significant part of its ROIC – for many years to come. Despite the importance of thesedecisions, it is rare to find them managed well from the outset. One of the reasons whycompanies continue to struggle with the design and execution of large capital investmentsis that their often discrete nature makes it difficult for companies to build up and maintaininvestment management competency in-house. A second reason is that, despite the wealth anddepth of material on financial investment valuation and assessment, there is currently littleor no hands-on, practical advice for capital management and optimization written from a topmanagement perspective. To a large extent, managers are left leaning on their own experience,pulling together the best team they can find within their organization.

This surprising lack of practical management advice has been one of the main reasonsprompting us to write this book: decision-makers need the best possible advice to aid them inmaking decisions on large investments. We intend this book to fill this gap and to provide astrategic manual on large fixed capital investments. It has a holistic approach to the topic, onethat is both strategic and practical in its perspective.

In researching this book, we have invested a significant amount of time and effort incollecting and analyzing the information that forms the basis of the ideas that shape it. In thecourse of this work we have made extensive use of the wealth of knowledge and experience

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Average/year 1992−2007,USD billions*

Total investmentsUSD billions/year*, average 1992−2007

593Transport and logistics

480Utilities

347Telecommunications

320Oil and gas

233Chemicals

200High tech

107Automotive

* In prices and exchange rates of 2007Source: Global Insight, McKinsey

100 %

9.3

Totalinvest-ments

75 %

7.1

Otherindustries

Focus industries

2.3

25 %

Figure 1.3 Share of investment of the asset-heavy industries under review1

present within McKinsey & Company – based on more than 500 capital investment-relatedengagements for many of the world’s leading companies. These efforts have contributed tobuilding up the capital investment practice within McKinsey.

We hope not only that this book will be interesting and readily digestible for the readerbut that the ideas within it will serve to sharpen management’s focus on the impact capitalinvestments have on the wellbeing and growth of their companies – whether the companiesconcerned are already leaders in their field, or aspire to become so.

CAPEX Excellence is addressed in particular to the top management of companies whichare based in asset-heavy industries – and especially to managers faced with the challengesof making individual or portfolio capital investment decisions and who are responsible formanaging these capital assets over their entire asset lifecycle (this includes CEOs and CFOs,as well as senior managers in the business planning, financial, management accounting andcontrol functions). We hope CAPEX Excellence will also be of interest to graduate managementstudents, as well as to all those who want to gain a deeper understanding of the core strategicchoices companies face when making and implementing large capital investment decisions.

Throughout the book we use many industry-specific examples, focusing in particular onseven asset-heavy industries (our “focus industries”): Utilities, Oil & Gas, Telecommuni-cations, Transportation & Logistics, Chemicals, High Tech, and Automotive. Together, theseseven industries account for about 25 % of all global annual investments (Figure 1.3). However,this is not to suggest that we think the book’s relevance will be limited to these sectors alone.Other capital intensive industries, such as Steel, Aluminium, or Pulp & Paper, also face verysimilar challenges, so hopefully the insights here will be relevant to these industries too.

Finally, whatever your particular industry, we hope that, as the reader of this book, you willbenefit from our industry and company analyses of what constitutes best practice in capitalstrategy.

1The largest contributors to “other industries” are real estate (24 %) and public and social services (17 %) whichwe do not include as focus industries since they are driven by either private or public players rather than companies.

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1.2 A BIRD’S-EYE VIEW OF THE BOOK CONTENT

CHAPTER HIGHLIGHTS

This chapter is an executive summary outlining the subject matter of all three parts of thisbook for readers who want a quick overview of the contents.

• Part I: The introductory section highlights the importance of capital investments andprovides an overview of investments across the globe, industries and time.

• Part II: This core section covers the major strategic choices in investment decision, suchas where and when to invest and which technology to choose, as well as how to designand finance large capital investments.

• Part III: The closing section places individual investment decisions within the contextof the overall capital allocation decisions companies are faced with when shaping theirinvestment portfolio.

Though we hope most people will choose to read this book from cover to cover, allthe chapters have been designed to stand alone, enabling the reader to study any indi-vidual chapter independently of the others. To aid the reader, wherever appropriate, wehave included references to topics which are covered in more detail elsewhere in thebook.

1.2.1 Part I: Why investments matter

The importance and structure of capital investments

In this chapter we examine how investments are a prerequisite for growth and what determinestheir structure and timing. Today about 20 % of the world’s GDP is spent on capital investments.Eight out of the 10 fastest growing economies have investment intensities well above the globalaverage. The correlation between investment and growth is even clearer in the world’s emergingeconomies, which achieve more than twice the average economic growth with almost twicethe capital intensity.

Not only is investment critical at the national level but getting investments right at thecompany level makes an enormous difference to a company’s value creation. During the last10 years roughly half the S&P 500’s growth in return on invested capital (ROIC) has beenrelated to investment activity.

Investment patterns vary widely between industries. The most investment-intensive indus-tries are Transport & Logistics, Utilities, Telecommunications, and Oil & Gas, followed byChemicals, High Tech and Automotive (the industries which are the primary focus of thisbook).

Investment is also highly cyclical, with a regular pattern of boom followed by bust. Weobserve that – while unpredictable in specific site and timing – industry cycles are far fromrandom displaying clear cycle frequencies around 5, 10, and 30–40 years.

We conclude Part I with a brief examination of why investment volumes are likely tocontinue to grow in coming years, despite any short-term economic problems.

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1.2.2 Part II: Getting investments right

Part II focuses on the strategic choices that companies and decision makers are faced withwhen making investment decisions, and provides a number of frameworks and strategies todeal with these challenges.

Chapter 2: Right positioning: Managing an asset’s exposure to economic risk

We examine how the degree to which an investment asset is protected against economic riskslargely determines its achievable return on investment. The degree of an asset’s exposurevaries: the lowest levels of exposure are conferred by exclusive access to critical resources ora natural monopoly-type situation; the highest levels are derived from leveraging commercialadvantages, such as strong brands or a superior distribution network.

The core of this chapter focuses on the use of an “asset exposure scoring metric”. Thisallows companies to quantify the degree of exposure their investment asset is likely to besubject to. The metric enables the investment to be benchmarked against the expected returnsof competitors or other investments.

We close by examining a number of strategies available to companies for managing theirasset exposure, looking at how companies create public-private, win-win outcomes, or go“asset light” in highly exposed markets.

Chapter 3: Right technology: How and when to invest in a new technology

Technological innovation is a critical challenge for companies. Though no company can affordto ignore technological developments, switching too early can leave it highly exposed. In thischapter we focus on how companies can determine the right timing for making the transitionto a new technology.

We show that the right moment for making such a transition is not, as commonly thought, atthe point when the value created by the new technology exceeds that of the existing technology,but at a significantly later point. The exact point depends both on the degree of technologicalrisk as well as the company’s appetite for risk.

We show how to determine the optimum switching point and provide an enhanced metricfor measuring the value created by investments in new technology.

Chapter 4: Right timing: How cyclicality affects return on investments and whatcompanies can do about it

Cyclicality destroys value and increases the risk of bankruptcy or investment failure. In thischapter we examine the underlying causes of cyclicality in economic systems, how it is drivenby imbalances between customer demand and the available production capacity of the market,and show what companies can do to counteract it.

We examine how the time delay between the point at which companies react to differ-ences between supply and demand and that at which these changes actually happen underlieseconomic cycles. We look at underlying causes of complex cycle patterns and why some cyclesare stronger than others, before examining how price sensitivity and company responses tocyclicality can actually aggravate the cycle.

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In the final section of this chapter we look at the various options companies have forcounteracting cyclicality and how some companies can, in effect, leverage cyclicality to theiradvantage.

Chapter 5: Right size: Balancing economies and diseconomies of scale

In this chapter we show how defining the optimum size for an investment requires the iden-tification of the investment “sweet spot” – the point at which diseconomies of scale begin toexceed economies of scale.

It is commonly understood that the economics of fixed costs improve with larger productionvolumes. We enlarge this discussion of scale effects to include, among other issues, a look attechnical scaling laws, and how the “chunkiness” of capacity additions impacts higher capacityutilization.

While scale effects are often incorporated into the assessment of large investment projects,diseconomies of scale are almost always neglected. In consequence, companies often under-estimate complexity costs, loss of flexibility, and the increasing risks associated with largeinvestments. We show how this leads to a bias favoring assets that are larger than the optimumsize.

We suggest a structured approach to assessing diseconomies of scale that takes into accountscale costs as well as economic risks associated with scale increases. We consider a widerange of cost and risk effects, such as increased logistics costs, supply chain limitations, andincreased management complexity.

Chapter 6: Right location: Getting the most from government incentives

Government incentives can have a significant impact on the longer-term returns of an invest-ment and are often a major consideration when deciding on an investment’s location. Often,however, there is very little transparency about the range of incentives available and the con-ditions attached to them. In this chapter we shed some light on the various categories and typesof incentives that are available.

To help companies identify the incentives that are appropriate to their business case we pro-vide a general framework which classifies the structure of the various investment instruments.We also provide an overview developed through an international screening of the incentivesinstruments available around the world.

We examine the impact incentives have on the business case in terms of their cash con-tribution and provide a simple framework to help investors select the appropriate types ofincentives.

Chapter 7: Right design: How to make investments lean and flexible

In this chapter we show how lean thinking and principles can be extended from operationsinto investment design. We illustrate how this can enable investors to carry out the executionof investment projects in a time-efficient and resource-efficient manner, overcoming many ofthe limitations typically found in production plant design.

This approach, rather than focusing on a single investment, puts in place a standardized“investment system” which enables the company to bring the new capacity to market fasterand at lower cost while increasing the asset’s flexibility. This flexibility is necessary to copewith changing customer needs and short product lifecycles.

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The outline of the investment system includes a look at the technical set of tools andpractices, the required management infrastructure, and an outline of the required mindsetsand behaviors. We discuss the main elements of a lean investment system in terms of definingthe project objectives, design principles, and project targets, and how the design processshould be optimized at the macro-, midi- and micro- levels, according to the lean principlesestablished in the design phase.

Chapter 8: Right financing: Shaping the optimal finance portfolio

The composition of the financing portfolio is often critical to the longer-term success of aninvestment project. In this chapter we discuss how the project’s financing can be made costeffective while maintaining the liquidity throughout the early stages of the project necessaryto ensure that the repayment schedule can be met.

We examine how banks are currently at an advantage in negotiating finance due to theirability to assess and mitigate risks. This enables them to achieve very high profitability inproject finance. Companies can learn much from their approach.

We show the importance of developing a thorough analysis of the likely cash flow curve overthe project’s lifetime. This will produce a good understanding of the project’s assumptionsand interdependencies.

We look at how to assess all the project’s risks and to quantify their potential impact,identifying which can be mitigated and which cannot. This understanding will give companiesan advantage in negotiating the project’s finance.

Finally, we take a brief look at the composition of the finance portfolio and how costs canbe balanced with repayment flexibility at an adequate level of confidence.

1.2.3 Part III: Right allocation: Managing a company’s investment portfolio

Although there is not a one-size-fits-all approach to selecting the right investment portfolio,in the third and final part of this book we develop some guidelines to portfolio developmentbased on the “best practices” of successful companies.

We show how such companies have four common characteristics in their capital allocationapproach: 1) the alignment of capital allocation to their strategy; 2) the use of clearly-definedmetrics and processes; 3) the adoption of mechanisms to avoid conscious and unconsciousdistortions in decision making; and 4) processes to ensure close collaboration between thecorporate centre and the business units in compiling the investment portfolio.

We discuss how in a multi-divisional company the capital allocation approach is depen-dent on the role and involvement of the corporate center. In this regard, we illustrate thedifferences between “strategic architects”, “financial holdings”, “operators” and “strategiccontrollers”. Taking these differences into account, we propose two different approaches tocapital allocation.

TECHNICAL INSERTS

Throughout this book we will include inserts which cover some of the more technicalaspects of our work. The content of these inserts will provide more details about themathematical and analytical background to the results being discussed in the main text. Itis not necessary for the reader to understand the content of these inserts in order to be ableto follow the line of thought in the main text.

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1.3 WHY INVESTMENTS MATTER: THE IMPORTANCE ANDSTRUCTURE OF CAPITAL INVESTMENTS

CHAPTER HIGHLIGHTS

In this introductory section we provide an overview of the relevance and structure of capitalinvestments at the company, national and global levels. We investigate the drivers of nationaland company growth, provide a comparative overview of investments across regions andindustry sectors and analyze investment behavior over time to reveal the underlying trendsand causes of investment cycles.

The intent of this section is to provide the reader with a fact base to serve as a backdropfor the specific strategic choices discussed in the later chapters. Whilst reflecting someof our analytic work on capital investments, in contrast to rest of the book it is largelydescriptive in nature.

1.3.1 The relevance of capital investments

Capital investments matter for business for obvious reasons: they are a prerequisite for enteringnew businesses, fuelling future growth, and allowing sustained production. Beyond this, capitalinvestments are also a main driver of economic performance at the macroeconomic as well asthe microeconomic level:

• Economic growth and investments go hand in hand. Macro-economic analysis shows asignificant correlation (∼70 %) between economic growth and investment in the top 30most significant economies.

• Investments drive business value creation. Within the last decade companies have been ableto significantly increase their return on invested capital (ROIC). We estimate that for the topcompanies worldwide (taken from the S&P 500 index) more than half their recent ROICgrowth is related to investment activity.

• Investments drive company growth. An analysis of 25 of the top companies from the S&P500 worldwide reveals ∼70 % correlation between growth and investment intensity. Thisconnection between investments and long-term company growth is also supported by fun-damental microeconomic considerations.

Investments are a core driver of economic growth worldwide

In 2007, a total of more than $11.8 trillion – 23 % of the world’s GDP – was spent oninvestments. When analyzing the changes in GDP for the 30 countries with the largest GDP,we find a correlation of up to 69 % between changes in the GDP growth and the gross fixedcapital formation – a surprisingly high correlation given the wealth of factors that influenceeconomic growth (Figure 1.4).

A word of caution is in order, however: investment and growth are rather like the proverbialchicken and egg: it is difficult to distinguish what is cause and what is effect due to themultitude of interdependencies between the two. It is interesting to note, however, that GDPgrowth precedes investment activity, not the other way around as one might expect. One reasonwhy this might be the case is that a large fraction of a nation’s private and public investmentsis typically spurred by economic growth, rather than the other way around. Also important in

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CAPEX Excellence - Startseite · FM JWBK371-Steiners May 4, 2009 15:1 Printer: Yet to come vi Contents 2.5 Quantitative asset exposure analysis shows high correlation with ROIC at