“Investment decision is crucial in this heated economic environment”: Ronnie Peiris

 Ronnie Peiris

It is important that Boards, the CEOs, the decision-makers, project managers and CFOs and heads of corporate finance are girded appropriately to penetrate the veil of bias by challenging the underlying assumptions and/ or presumptions by asking the uncomfortable questions about their existing businesses, and the current business models. Decisions will have to be made by applying the appropriate evaluation techniques. To do this, they must have a practical understanding of the strengths and weaknesses of different techniques of evaluation and be “street smart” in avoiding the common pitfalls which normally beset the logic of the decision. Most importantly, they must learn how to deal with the bias of “forceful” bosses

•  Avoiding the pitfalls and confronting the biases

The Daily FT met up with Coach, Mentor and Consultant Ronnie Peiris, to understand the contents and context of the workshop he will be conducting on ‘Capital Budgeting – the Investment Decision’ on 2 November at the Cinnamon Lakeside (www.ronniepeiris.com). He highlighted the following based on his 45+ years’ experience in projects ranging from $ 1 billion to $ 5 million in his previous positions as the Group Finance Director, John Keells Holdings PLC, and the Managing Director (before the Finance Director), Anglo American Corporation, (Central Africa) Ltd. and Board Member in large corporations. Following are excerpts.

Q: Given Sri Lanka’s current economic situation, who will invest now? So, why this workshop?

Sri Lankan corporates, State Owned Enterprises included, slowed down, and deferred capital expenditure, starting February 2020, with the advent of COVID-19. Since mid-2021, the economic crisis arising out of food shortages created by the fertiliser fiasco, lack of foreign reserves, fuel shortages and high inflation caused by an excessive printing of money, exacerbated the situation, and has paralysed the minds of the leadership in the corporates and in Government re-investment. As a country, Sri Lanka cannot continue with such a mind-set. We must come out of the mess through a better system of governance, effective monetary and fiscal reform, and tighter financial control. And, I am positive we will. 

As stated by Martin Luther King Jr.: “Even in the inevitable moments when all seems hopeless, men know that without hope they cannot really live, and in agonizing desperation they cry for the bread of hope.” If we do not plan for our future with optimism, an optimism born not out of fantasy, but born out of “what is possible” through rigour and discipline, we will be left far behind by the rest of the world and our competitiveness, even in the areas where we have unique advantages, will get further eroded. We must review, and renew, our production/delivery capability, and capacity, through well thought out, keenly debated, and closely monitored Capital Expenditure and Investment. This is urgent. This workshop will educate the attendees on the critical issues which they must consider, and be on the look-out, in approving project investment. The smart organisation can thrive in chaos without being unethical.

Q: Why is the ‘Capital Budgeting – The Investment Decision’ so crucial?

The ‘Capital Budgeting – Investment Decision’ is, perhaps, the most important decision taken by a board and top leadership given the significant amount of funds involved, the often-long gestation, its relative irreversibility, and the impact on share price.

The primary responsibility of a board and top leadership of a company is to maximise shareholder/investor wealth by increasing the current price of shares and consequently the market value of the shareholder’s/investor’s stockholding. In a stakeholder model of governance – I do not like the word “maximise” – so, let us say “optimise.” Accordingly, in an ideal world, managers would make all positive – Net Present Value (NPV) investments. In fact, they should only make positive – NPV investments.

Whether it be constructing a new factory, launching a new product or service, evaluating the merits of an acquisition, or establishing a new process, corporates place great reliance on their Capital Budgeting techniques and governance process in making these high-stake decisions. A quick study of the Sri Lankan stock market and annual reports reveals little meaningful correlation between Capital Expenditure and growth in Capital Expenditure with Return on Invested Capital (ROIC). The study shows that many organisations struggle to achieve consistently positive results. Often, the main contributor to this situation is the ‘bad investment’!

Q: Investment evaluation in practice – what are the flaws and pitfalls?

Given that most companies have pre-established goals and priorities and do take reasonable steps to inspire a shared vision and motivate their employees, the non-achievement of project goals, even during normal periods of operations, and the good times – pre-COVID, may seem rather strange.

Whilst there is overwhelming evidence to show that top management, and, to a lower degree, the board, are not perfect servants and/or agents of the shareholders/investors, the evaluation of capital projects is fraught with many errors, these being;

• Focusing on accounting results. Top management is keener on the optics of published results than on the underlying “real” value creation. It pursues projects which are likely to show “investor exciting,” accounting-based Earnings per Share (EPS) and Price to Earnings Ratio (PER) than projects with high net present values.
• Personal aggrandisement. Limited resources are spent on projects which just exhibit individual power rather than providing benefits to the citizens and society in an economically viable manner. The Mattala Airport, Hambantota Stadium and the “Nelum Kuluna” are just a few examples. Even the Hambantota Port – was it carefully conceptualised and was its economic viability keenly debated?
• Recognition and reward schemes. Short-term incentives, often encourage the adoption of short-term projects than long-term projects which give better returns to investors/stakeholders. In such an atmosphere, the long-term is sacrificed for the short-term gain.
• Utilising Internal Rate of Return (IRR) over Net Present Value (NPV). IRR may not lead to optimal decision making when evaluating mutually exclusive projects and/or projects with different patterns of cash flow over time.
• Forecasting cash flows. Typical errors include;
• Discounting accounting profits rather than cash flows
• Recognition/treatment of working capital
• Ignoring incidental costs and incidental profits
• Discounting absolute cash flows rather than incremental cash flows
• Over/under estimation of sales, cost of sales et cetera
• Recognising sunk overheads. Must recognise only additional expenses
• Ignoring salvage value or ignoring decommissioning costs
• Inconsistent treatment of inflation
• Ignoring the effects of taxation
• Non recognition of opportunity costs
• Recognition/treatment of sunk costs
• Non-separation of investment and financing decisions
  
   
• Using an inappropriate discount rate. For example – is it appropriate to use the firm’s current Weighted Average Cost of Capital (WACC) to all projects irrespective of degree of risk?
• In the current context – where there is high inflation, how should cash-flows be treated – Nominal, Real or Constant? What opportunity cost of capital should be used?
• Using standard approaches for capital projects despite significant differences in risk and other features.
• Failing to account for economic reactions. Example: will the entry of a competitor result in a significant erosion of the estimated profitability of a new product in the medium to long term? 

Q: What is this undue haste for capital expenditure?

The COVID crisis forced most firms to reset their capital expenditure plans. Regardless of whether business has grown, slowed, or experienced closures, or prepared for a return to something approaching normalcy, all firms and their capital projects are undoubtedly affected by the crisis. The availability of materials and labour has decreased. The airline, travel, hospitality and restaurant industries in Sri Lanka has suffered since the Easter bombings of 2019, followed by COVID-19 and now the foreign exchange crunch. Physical distancing measures have disrupted the operations of construction sites and fabrication yards.

Freeing up cash by deferring planned capital expenditure has been the immediate, and spontaneous, response to this situation. We are about to enter a tax regime which we have not been used to. I have, personally, experienced it during my stay in Zambia. I know the challenges we faced and the re-inventing we had to do. In this light, there is an urgent need to review the existing portfolio. We have to look at everything very differently. It is essential, and critical, that leaders identify the projects which promise the largest potential and the projects which are not essential in the anticipated future. Which project gives the biggest bang for the buck? Processes need to be upgraded to meet the new dynamics of business. The Capital Budgeting – Investment Decision has never been more important.

Q: You talk about human bias in investment evaluation – please elaborate.

 Capital budgeting/planning decisions are not only negatively affected by the errors highlighted before, but – are often affected by biases. 

Our own experiences, and behavioural sciences, suggest that individuals, particularly at senior levels, are often biased and allow such biases to override the logic of technique and science. Such individuals unduly influence the project evaluation process through their “gut feel” optimism of certain courses of action over other courses favoured by the majority, their over reliance on specific pieces of information and “the so-called experts” and their view of the project through a narrow, and blinkered, lens. 

Boards, CEOs, decision makers, CFOs and Heads of Corporate Finance must focus on data and not just narratives and gut feel. Investment decisions frequently suffer through “expert bias.” Decision makers are loathed to challenging the expert. For example, the Head of Marketing knows what the customer wants; the Head of Information Technology insists on a specific solution; the Head of Production is adamant in buying a particular type of plant and equipment et cetera. Yes – it is acknowledged that these persons have been employed for their expertise. But the top management team, and other decision makers must know the art of challenging these opinions. 

Q: What will be the key takeaways?

In this context, it is important that Boards, the CEOs, the decision-makers, project managers and CFOs and heads of corporate finance are girded appropriately to penetrate the veil of bias by challenging the underlying assumptions and/or presumptions by asking the uncomfortable questions about their existing businesses, and the current business models. Decisions will have to be made by applying the appropriate evaluation techniques. To do this, they must have a practical understanding of the strengths and weaknesses of different techniques of evaluation and be “street smart” in avoiding the common pitfalls which normally beset the logic of the decision. Most importantly, they must learn how to deal with the bias of “forceful” bosses.

The workshop aims to deliver all this. While capital budgeting is the key topic, there will be some discussion on responding to the emerging challenges.