Improving the capital project allocation process

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  • Identification, Prioritization, and Alignment of Initiatives The real benefit from the Initiative Mapping process come from allocating resources to initiatives that most directly affect its ability to achieve the strategy. Without prioritization, all initiatives continue as usual, with no alignment to strategy. The task here is to create a “screen” to be able to determine strategic initiatives from nonstrategic initiatives.
  • Improving the capital project allocation process

    1. 1. Improving the Capital Project Evaluation Process AFP Annual Conference 2006 Jim Robertson Director, Corporate Planning & Performance Management October 17, 2006© 2006 James A. Robertson, Jr.
    2. 2. Agenda• Structuring Discount Rates: A Practical Perspective • COC • Business Risk • Project Risk• Capital Allocation • Linkages to Strategy • Portfolio Optimization• Summary
    3. 3. Objectives• Make decisions about future investments based on the fundamental economic principle that value is created by earning more than the cost of capital. – Focus on cash investment and return • “It’s cash flow that counts, not how you count it” • “Until a business returns a profit greater than its cost of capital, it operates at a loss” Drucker – Use net present value and payback as key financial decision criteria for all investments. • Provides a common financial measure for comparing investments across the company. – Use discount rates that reflect risks specific to BU’s and project types – Allocate capital to strategic priorities• Rationale – Investor expectations for future value • NPV measures the incremental value an investment adds to the company – Better understanding of the financial impact of strategy – Increased visibility into business for top management – Improved expense control
    4. 4. Discount Rate = COC + Bus Risk + Project RiskDiscount Rates Have 3 Components Corporate Required Rate of ReturnDiscount Rate: Cost of Capital: Business Risk: Project Risk: The minimum rate of returnThe rate used to The average cost of The minimum rate of required for a specificcalculate the NPV a firm’s debt and return required on the project. The hurdleof all expected equity capital. entire portfolio of rate should take intoinflow and outflows capital projects. The COC equals the account the corporateof an investment rate of return that a At a minimum, the required rate of return = company must earn + acceptable rate of +/- plus any project in order to satisfy the return should equal specific risks. The demands of its the cost of capital. hurdle rate is used to owners and creditors compare with a project’s internal rate of return.  At the corporate level, the returns for the entire portfolio of capital projects should exceed the COC in order to create economic value.  At the BU level, the return on an individual project may be less than the discount rate depending on the BU strategy.  Hurdle rates may be higher than the required rate of return depending on the likelihood of the project being completed as planned and generating the results which were used to justify the investment. Hurdle rates may be differentiated across BU’s or project types
    5. 5. Discount Rate = COC + Bus Risk + Project RiskBusiness & Project Risk Methodology Business Unit Business Risk – Management Project Risk – Predictability – Competitive FactorsRisk Defined: Risk Points Completion: Likelihoodof a project beingcompleted as planned. Risk COC Outcome: Likelihoodthat project will generate +the results which wereused to justify the Corporate COCinvestment. = Discount Rate Specific to BU and Project Type
    6. 6. Discount Rate = COC + Bus Risk + Project RiskCost of Capital Methodologies: CAPM• Cost of capital is first of 3 components in the discount rate: average cost of a firm’s debt and equity capital.• Defined – Cost of equity is a function of risk-free rates, plus a premium to reflect the extra risk of an investment – Premium is the historical difference between the risk-free rate and the rate of return of the stock market as a whole multiplied by an number reflecting volatility of the stock (beta)• Advantages – Used for over 40 years essentially unchanged – Accepted broadly in industry as the standard measure of cost of capital• Disadvantages – Lack of empirical data proving this rate is used by the market to discount a company’s projected cash flows to a present value. – Market risk premiums are assumptions and vary by firm (e.g., Goldman equity premium is 350 basis points, Accenture uses 500 basis points) – Beta is a historical measure, and not a forward looking measure of a the risk to the future cash flows of a company. – Many bankers and executives find beta an unreliable estimate of a stock’s risk: • 1998: before Steve jobs returned, Apple cost of equity of 8% vs. IBM 12%
    7. 7. Discount Rate = COC + Bus Risk + Project RiskNon CAPM Approaches: Market-Derived Capital Pricing Model• Defined – Cost of capital reflects three types of risk: • National confiscation risk: country policies (e.g. confiscation, inflation = Government bond rate for a given time period • Corporate default risk = premium above corporate bonds that corporations pay • Equity returns risk = traded prices of equity options which reflect best market estimates of future price volatility.• Advantages – Theoretically appealing as a better solution than CAPM • Incorporates market’s best estimate of future price volatility instead of using historical data. – Discount rates can be more intuitively realistic than CAPM rates• Disadvantages – Methodology created by Pacifica Strategic Advisors – Not widely accepted – Lack of empirical data proving this rate is used by the market to discount a company’s projected cash flows to a present value.
    8. 8. Discount Rate = COC + Bus Risk + Project RiskNon CAPM Approaches: Empirical• Defined – Discount rates used by the market to discount expected future cash flows of a company. – Rates can include both market and company-specific rates – Examples include Cash Flow ROI and Warranted Value model by HOLT/CSFB, Attive Research (formerly Callard & Madden).• Advantages – Empiric evidence that these rates are used by markets, both US and international, to discount future cash flows. – Applies equally to all companies regardless of business model or asset intensity.• Disadvantages – Variety of different approaches, most tied to proprietary valuation models. • Maintenance of market and company-specific data requires significant expertise and resources to continually update data on market and company discount rates. – Approaches less applicable to early stage/fast growth companies – Rely on unique methods of projecting cash flows that require involved calculations: • Requires focused corporate staff training • Implementation issues.
    9. 9. Discount Rate = COC + Bus Risk + Project RiskApproach• Adopt CAPM to calculate the Corporate cost of capital. – Update semi-annually to reflect changes in risk-free rates and beta. – At some point evaluate empirical approaches.• In high growth companies, you will miss the boat by debtating whether a project exceeds the COC by 1 or 4 points – This is what happens in mature companies in mature industries where the major opportunity for value creation is in improving profitability.• Focus on implementation
    10. 10. Agenda• Structuring Discount Rates: A Practical Perspective • COC • Business Risk • Project Risk• Capital Allocation • Linkages to Strategy • Portfolio Optimization• Summary
    11. 11. Discount Rate = COC + Bus Risk + Project RiskBusiness & Project Risk Methodology Business Unit Business Risk – Management – Predictability Project Risk – Competitive FactorsRisk Defined: Risk Points Completion: Likelihoodof a project beingcompleted as planned. Risk COC Outcome: Likelihoodthat project will generate +the results which wereused to justify the Corporate COCinvestment. = Discount Rate Specific to BU and Project Type
    12. 12. Discount Rate = COC + Bus Risk + Project RiskQualitative evaluations drive quantitative risk modifiers to cost of capital • Identify risk factors which differentiate the likelihood of a project being completed as planned and generating the results which were used to justify the investment – Business Risk: Differences between BU’s – Project Risk: Differences between types of projects – Determine weightings for Business and Project Risk • Business Risk 70% • Project Risk 30% • Qualitatively rate BU and Business Priority Area risk and assign risk points. BU Risk Points BPA Risk Points Low Risk 0 0 Mod Risk 10 4 High Risk 20 8 • Quantitatively translate total risk points into a modifier which is added to Corporate COC to calculate a discount rate specific to BU and Business Priority Area. • Discount rate applied to any project capped at 220% Corporate Cost of Capital. Total Risk Points Discount Rate 0-3 16% 3.1-6.0 19% 6.1-9.0 22% 9.1-12.0 26% 12.1-14.9 29% 15.0-17.9 32% 18.0 + 35%
    13. 13. Discount Rate = COC + Bus Risk + Project RiskBusiness Risk: Factors • Business Risk is the second of 3 components in the discount rate, and measures the risks of: – Completion: Likelihood of a project being completed as planned. – Outcome: Likelihood that project will generate the results which were used to justify the investment. • Business Risk is specific to a business unit within the company and how its risks of compare to other BU’s (relative), not other companies (absolute): – Internal: Management (Completion) – Internal: Predictability (Completion, Outcome) – External: Competitive Factors (Outcome)
    14. 14. Discount Rate = COC + Bus Risk + Project RiskBusiness Risk: Management• Right Leader – Strategic vision and ability to get team enthusiastic – Teambuilding skills – Enabler – Industry experience – Commitment to and practice of management development• Right Direct Reports – Top notch skills and experience – Business acumen – Ability to motivate – Ability to delegate• Right Team – Trust in senior management team by employees – Team coherence and experience together
    15. 15. Discount Rate = COC + Bus Risk + Project RiskBusiness Risk: Predictability• Key Metrics: actual vs. plan/approved forecast• P&L: actual vs. approved forecast• Meet deadlines• Understand customer requirements and how these rapidly change• Impacted by BU and corporate business processes and ability to measure and forecast key metrics and business results. – For example, strong confidence in forecasting process can increase certainty in a forecast and reduce the risk of making future investments.
    16. 16. Discount Rate = COC + Bus Risk + Project RiskBusiness Risk: Competitive Factors • Competitive strength: – Degree to which BU leads the industry: Is it #1 or #2? – Gaining or losing market share? – Degree of reliance on external partnerships (positive/negative potential impacts) • Pricing Stability – Degree to which BU is woven into competitors’ business model and process – Barriers to entry – Competition basis: price, quality, reliability – Contract length • Smart competitors or dumb competitors • Rate of change – Customer needs – Products – Technologies – Product obsolescence
    17. 17. Discount Rate = COC + Bus Risk + Project RiskBusiness Risk • Risk factor weighting Management 50% Predictability 25% Competition 25% Total 100%
    18. 18. Discount Rate = COC + Bus Risk + Project RiskBusiness Risk: Risk Points Risk Factors Internal External Competitive RISK Management (50% Predictability (25% Advantage (25% POINTS Weight) Weight) Weight) (Weighted) Rating Points Rating Points Rating Points BUSINESS UNIT Division A BU 1 Low Risk 0 Mod Risk 10 Mod Risk 10 5.0 (1) BU 2 Mod Risk 10 High Risk 20 Mod Risk 10 12.5 Division B BU 1 Mod Risk 10 Low Risk 0 Low Risk 0 5.0 BU 2 Low Risk 0 Mod Risk 10 Low Risk 0 2.5 BU 3 Mod Risk 10 High Risk 20 Low Risk 0 10.0 Division C Mod Risk 10 Low Risk 0 Mod Risk 10 7.5 0 Corporate Functional Area 1 Low Risk 0 Mod Risk 10 NA 2.5 Functional Area 2 Low Risk 0 Low Risk 0 NA 0.0 Functional Area 3 Low Risk 0 Low Risk 0 NA 0.0 Functional Area 4 Low Risk 0 Low Risk 0 NA 0.0 (1) .50 x 0 + .25 x 10 + .25 x 10 = 5 Risk Points
    19. 19. Agenda• Structuring Discount Rates: A Practical Perspective • COC • Business Risk • Project Risk• Capital Allocation • Linkages to Strategy • Portfolio Optimization• Summary
    20. 20. Discount Rate = COC + Bus Risk + Project RiskProject Hurdle Rates: Factors • Project Risk is the third of 3 components in the discount rate, and reflects the likelihood of a project being completed as planned and generating the results which were used to justify the investment. – Certainty of Completion. – Certainty of Outcome • Identify risks specific to the nature of the project and how its risks of compare to other types of projects.
    21. 21. Discount Rate = COC + Bus Risk + Project Risk Project Hurdle Rates: Risk Points PROJECT TYPE 1.0 Market 2.0 Productivity & 3.0 Quality & Development Cost Improvement Reliability 4.0 Facilities 5.0 ITRating - DraftCertainty of Completion High Risk Mod Risk Mod Risk Low Risk Low RiskCertainty of Outcome High Risk High Risk Mod Risk Low Risk Mod RiskRisk PointsCertainty of Completion 4.0 2.0 2.0 0.0 0.0Certainty of Outcome 4.0 4.0 2.0 0.0 2.0Total 8.0 6.0 4.0 0.0 2.0
    22. 22. Discount Rate = COC + Bus Risk + Project RiskBusiness & Project Risk Matrix: Total Risk Points PROJECT TYPE 1.0 Market 2.0 Productivity & 3.0 Quality & BU Risk Development Cost Improvement Reliability 4.0 Facilities 5.0 IT Points BUSINESS UNIT Division A BU 1 13.0 (1) 11.0 9.0 5.0 7.0 5.0 BU 2 20.5 18.5 16.5 12.5 14.5 12.5 Division B BU 1 13.0 11.0 9.0 5.0 7.0 5.0 BU 2 10.5 8.5 6.5 2.5 4.5 2.5 BU 3 18.0 16.0 14.0 10.0 12.0 10.0 Division C 15.5 13.5 11.5 7.5 9.5 7.5 Corporate Functional Area 1 10.5 8.5 6.5 2.5 4.5 2.5 Functional Area 2 8.0 6.0 4.0 0.0 2.0 0.0 Functional Area 3 8.0 6.0 4.0 0.0 2.0 0.0 Functional Area 4 8.0 6.0 4.0 0.0 2.0 0.0 Project Risk Points 8.0 6.0 4.0 0.0 2.0 (1) 5 Business Risk Points + 8 Project Risk Points = 13.0 Total Risk Points
    23. 23. Discount Rate = COC + Bus Risk + Project RiskUsing Risk Points to Calculate Discount Rates • Total BU + Project Risk Points used to calculate a Risk Rate Modifier which is applied to Corporate COC. – Highest discount rate allowable is 220% of Company COC. • Discount Rate Table: Total Risk Points Risk Rate Modifier VRSN COC Risk COC Discount Rate 0-3 0% 16% 0% 16% 3.1-6.0 20% 16% 3% 19% 6.1-9.0 40% 16% 6% 22% 9.1-12.0 60% 16% 10% 26% 12.1-14.9 80% 16% 13% 29% 15.0-17.9 100% 16% 16% 32% 18.0 + 120% 16% 19% 35%
    24. 24. Discount Rate = COC + Bus Risk + Project RiskBusiness & Project Risk Matrix: Discount Rates PROJECT TYPE 1.0 Market 2.0 Productivity & 3.0 Quality & Development Cost Improvement Reliability 4.0 Facilities 5.0 IT BUSINESS UNIT Division A BU 1 29% (1) 26% 22% 19% 22% BU 2 35% 35% 32% 29% 29% Division B BU 1 29% 26% 22% 19% 22% BU 2 26% 22% 22% 16% 19% BU 3 35% 32% 29% 26% 26% Division C 32% 29% 26% 22% 26% Corporate Functional Area 1 26% 22% 22% 16% 19% Functional Area 2 22% 19% 19% 16% 16% Functional Area 3 22% 19% 19% 16% 16% Functional Area 4 22% 19% 19% 16% 16% (1) 13 Total Risk Points = 13.0% Risk COC + 16% VRSN COC = 29% Discount Rate
    25. 25. Discount Rate = COC + Bus Risk + Project RiskDistribution of Discount Rates Appears Reasonable Distribution of BU and Corporate Discount Rates 14 # of BU/Project Combinations 12 10 8 BU & Corporate 6 BU Only 4 2 0 16% 19% 22% 26% 29% 32% 35% Discount Rate • BU & Corporate distribution appears reasonable – Standard distribution – BU projects have more risk than corporate projects, and also has a standard distribution • Opportunities to make investments in a broad range of risk categories
    26. 26. Agenda• Structuring Discount Rates: A Practical Perspective • COC • Business Risk • Project Risk• Capital Allocation • Linkages to Strategy • Portfolio Optimization• Summary
    27. 27. Strategy Focused Organization 2. TRANSLATE STRATEGY 1. MOBILIZE CHANGE THROUGH TO OPERATIONAL TERMS EXECUTIVE LEADERSHIP • Create a corporate scorecard • Create a climate for change  Strategy Map • Create the Leadership Team  Measures • Create the vision and strategy  Targets • Create team accountability  Initiatives • Change the culture 3. ALIGN THE 5. GOVERN TO MAKE ORGANIZATION STRATEGY STRATEGY A CONTINUAL TO THE STRATEGY PROCESS FOCUSED • Create business/shared (VSS) • Link budgeting and planning to services unit scorecards ORGANIZATION strategy • Create sub-business/shared • Conduct Strategy Review Meetings services unit scorecards • Actively manage initiative portfolios 4. MOTIVATE TO MAKE STRATEGY EVERYONE’S JOB • Communicate the strategy • Align HR Programs to strategySource: Balanced Scorecard Collaborative
    28. 28. Using VPM to Manage Strategy Execution Longer Term (3-5 year) View Shorter Term (Annual) View Vision Strategy and Map Resource Mission Objectives Measures Targets Initiatives Milestones Accountable Budget Alloc Financial • Grow high- • % revenue • ‘04 xx% F1 margin from high- To provide top-notch healthcare to our • ‘05 xx% margin Be the community hospital of choice service F2 services • ‘06 xx% Customer • Provide • Customer • Develop • Survey drafted • Mkg. • $ xxxx • ‘04 xx% personalized satisfaction organization- by 6/04 Team C1 • community care survey rating ‘05 xx% wide survey • ‘06 xx% • Keep patients • Service level • Electronic • Complete by • Dept. Chairs • $ xxxx Internal P1 informed spot check • ‘04 xx% notes project 2004 P2 rating • ‘05 xx% • All patients • ‘06 xx% logged in Learning • Provide • % new • ‘04 xx% • Learning • Deadline • HR • $ xxxx technology technology • ‘05 xx% assessment met Committee & resources used by staff project L4 • ‘06 xx% Strategy “Leadership” Tactics “Management”Source: Balanced Scorecard Collaborative
    29. 29. Resource Allocation: Where the Rubber Meets the Road Strategic Objective Each objective is measured to track performance and facilitate strategic discussion. Measu re Each measure receives a target to determine the level of performance required to succeed. Target Each Objective is supported by initiatives (activities, projects, and resources) to ensure that the organization is capable of delivering on the targets that underpin the objective. InitiativesSource: Balanced Scorecard Collaborative
    30. 30. Internal People & Financial Customer Knowledge Perspective resources Partnering Objectives performance management development developmentSource: Balanced Scorecard Collaborative Price performance Integrate and align People and change Individual and team Sales and customer Focused technology Perfect manufacturing Economic value added Strategic competencies Pick the winners globally Customer sensitive culture Create new market demand sev t a ti n t nerr u C i i i ng se der t ne m r uc o P i e r Be the lowest cost producer y ge art s s ekr a mgn g e m t t i r E sr e nn w e h hi wr e n r a P i t t t e nac rr uh dna L & Wdna ces se R i not ac fi t ne d s dee n y il a u Q i i i t m e es uac t oo r o c o p y il a u Q il r f r t n ot a u m o e R i l r f se tili ca / not az l a cr e mm c VS i f i i i o o p gn kcart t n a p m c r e m t s u C r i i l o o s p hsr e n r a p PV ml e d S i t / a i objectives serving no 2 initiatives n a hc e u av n t ne m c na hne T i l i e I not a ne ml p m P OCS i t e i mA b CS B e dacsac po eve D / l no s v e a c nu m m C i i t i o se tili ca not a m o er a s A i f i r f i t ne m gl a y ge art s T ni t I v o p m ssec o p kr o w r par c S r i r e m r go pt ne m v o p m d e Y a r e r i l i e dar gpu se tili ca F i r e C. g mn ser AN 20009 OS f i I s mt sys t r e px E e ml p mt ne m o eve d s d a w R e i/ pl r e s not ac nu mm cl a bo G i i o l sli ks c ge art s gn n ar T l i t i i Managing Initiatives Can be a Demanding Manual Process No initiatives 9 initiatives for this objective for 1 objective
    31. 31. Agenda• Structuring Discount Rates: A Practical Perspective • COC • Business Risk • Project Risk• Capital Allocation • Linkages to Strategy • Portfolio Optimization• Summary
    32. 32. Imperative to Improve Ability to Allocate Capital and Other Resourcesin Complex Environments▪ Business models are becoming increasingly complex. – Acquisitions, geography, customer needs – Clear and concise linkages between strategy, financial plans, and daily operations is key to executing a growth strategies▪ With many opportunities for investment, the more important it t becomes to use standardized, enterprise-wide processes that allow initiatives & projects to be identified, evaluated, and ultimately managed across BU’s and geography. – Optimize investments across BU’s – Move towards real-time planning • Need for ongoing evaluation and reallocation of resources to respond to the competitive environment
    33. 33. Comprehensive Initiative Management Demand to Completion Corporat Corporate Mission & Strategy e Strategy Corporate Objectives Initiative Management Portfolio Demand Measures & Mgmt Management Program Management Targets Stratex Project Management Non Project Specific Resource Management Resources• Provides direct link between strategy & projects • Standard financial baseline, track spending and• Executive visibility/dashboard to all portfolios, resources programs and projects • Consolidation capability of all programs and projects• Single portfolio/program and project repository • Captures investment regardless of GAAP classification• Standard and consistent processes, expense/capital methodologies and flowcharts at the macro levels • Standard of project performance and linkages to strategy across the company for resource allocation
    34. 34. Demand and Portfolio Management OverviewDemandManagement Approved New Product Approved Existing Approved Infrsastructure Product Ideas Ideas Ideas Idea Prioritize & Approve 1st Gate Approval Business Ops Council Approved Proposals Proposal Review High Level Approve Refine Estimates/ Business Business Case Submit for Case Planning Architecture & Standards Board Manage Portfolio Costs, Budgets, Benefits Develop Portfolio PortfolioPortfolio Options ScenariosManagement Resource Supply vs. Demand Steering Approved Committee Projects Approval Value vs. Risk Risk Value
    35. 35. Demand/Portfolio ManagementDemand/Portfolio ManagementEnter Proposal for New ProjectCapture Estimated CostCapture Estimated ResourcesDrive the Evaluation ProcessProvide Visibility through a Real Time DashboardOut-of-the box templates to capture projectproposals, value and risk rating,processes, business case, ROI and more.Templates can be configured to captureinformation unique to customers.
    36. 36. Demand/Portfolio ManagementEnter Proposal for New ProjectCapture Estimated CostCapture Estimated ResourcesDrive the Evaluation ProcessProvide Visibility through a Real Time DashboardConfigurable scoring criteria to evaluateproject proposal values and risk.Adjustable weights for each scoringcriteria.
    37. 37. Demand Management: Portfolio Programs and Projects
    38. 38. Portfolio Management: Scenario Analysis
    39. 39. Portfolio Management- Identifying Projects to Fund based onRisk/Reward Profile
    40. 40. Budget Summary Views by Portfolio Scenario
    41. 41. Agenda• Structuring Discount Rates: A Practical Perspective • COC • Business Risk • Project Risk• Capital Allocation • Linkages to Strategy • Portfolio Optimization• Summary
    42. 42. Governance Process - Not the Tool - is Key to Managing Initiatives • PMO Director, PMO – Strategic, centralized – Process ownership Portfolio Managers – Project Managers report functionally to PMO – Aligned to business by portfolio Program/Project Mangers • Governance Organization – Enterprise Portfolio Hierarchy Business Analysts – Steering Committee – Membership formalized • Key functions included Governance – Align BU – IT – Process Board • Business Relationship Approval Authority Managers • Standards Committee Project Review Board (PRB) Prioritization, Budget, Technical, – Governance Staffing and Schedule Review – PLC Project Life Cycle (PLC) Teams EXECUTION
    43. 43. Strategy Focused Organization 2. TRANSLATE STRATEGY 1. MOBILIZE CHANGE THROUGH TO OPERATIONAL TERMS EXECUTIVE LEADERSHIP • Create a corporate scorecard • Create a climate for change  Strategy Map • Create the Leadership Team  Measures • Create the vision and strategy  Targets • Create team accountability  Initiatives • Change the culture 3. ALIGN THE 5. GOVERN TO MAKE ORGANIZATION STRATEGY STRATEGY A CONTINUAL TO THE STRATEGY PROCESS FOCUSED • Create business/shared (VSS) • Link budgeting and planning to services unit scorecards ORGANIZATION strategy • Create sub-business/shared • Conduct Strategy Review Meetings services unit scorecards • Actively manage initiative portfolios 4. MOTIVATE TO MAKE STRATEGY EVERYONE’S JOB • Communicate the strategy • Align HR Programs to strategySource: Balanced Scorecard Collaborative

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