So we recently had the latest example of capital investment catastrophe to add to an already prodicious list. Well perhaps it’s really just an extension of the whole Eurstar and Eurotunnel saga but what is termed HS1 (or Hifgh Speed 1) – the train line from St Pancras to the Kent coast) is yet another reminder of how poorly these huge infrastructure projects are evluated at their inception.
What we were taught
When I look back to when I was a student I remember being somewhat ducious of discounted cash flow – Net Present Value and Internal Rate of Return. I would never dispute the need for projects to generate a return but it seemed, at the time, that the use of discount rates (to take account of the time value of money) were the be-all and end-all of investment appraisal. But over recent years the FTSE100 has generated nothing by way of a return. And time and again we are reminded just how flaky predictions about the future prove to be. It makes you ask ‘what was ever wrong with ‘pay-back?’
And over the longer term these discount rates do have a big impact when applied to assess project viability. It’s easy (and simplistic) to look at inflation rates of sat 3-4% and suggest that the time value of money is no big beans
. But projects are not free to finance and this has to be taken into account.
And I’m not suggesting any link between discounted cash flow and the under-performance of HS1 but on a broader point I do think that too often in investment appraisal, people lose sight of the fundamentals. Because in all the cases I can recount, and there are a few, it is the fundamental assumptions that underpin any investment return calculations that have been found wanting.
Passenger numbers for HS1 are apparently one thrid of what was predicted back in 1995 and two-thrids of what was later predicted in 1998. The ferry companies were supposed to simply sink (well financially at least). Is that not just plain naive?
Estimates of passengers are not some ‘financial tweak’ applied to already solid data. No, passenger numbers are, I would suggest, just about as fundamental as you get.
Corners cut in project appraisal
But this practice of paying too little attention to the fundamentals is not, I believe, all that unusual. I recall going to a meeting with a prospective client where I was asked to explain the comapny’s investment appraisal criteria. It was ‘discount rate central’
. From memory, it was something like a 10% rate that was to be applied to cost saving projects; 12% for evaluating marketing initiatives to existing customers and 15% for projects marketing to entirely new customers. But there was nothing aimed at helping people assess the real merits of their proposals so that these discount rates would be applied to the right numbers.
It struck me at the time how easily, in the wrong hands, you could have these arbitrary discount rates do the heavy lifting for you in the appraisal process. Excuse yourself from looking at the fundamenbtals too closely, but if it gave you the right answer after you adjusted for the time value of money, it must be a good project.
Of course I’m talking here, not about hguge infrastructure projects with sophisticated evaluation frameworks but of much smaller scale business investments. But I fear they often share an unbdue optimism at the outset which is never born out in reality.
In a case some years ago, admittedly far more straigthforward than most, the owner of a small shop was considering a £50k refurbishment
. He wanted the answer in English (that is, not NPV, not IRR) but in terms he could understand. I did the calculations and told him he would need 21% higher sales to pay for the investment. The answer was expressed in exactly the terms he needed it.
When I read an ICAEW report some time ago based on surveying companies with successful track records in capital investment, there were several points worthy of note. One that jumped out however was the willingness and desire of successful companies to quickly jump on those projects that were not working out as hoped and do what it took to get them back on track fast. They seemed acknowledge and embrace the unforeseeable.
With HS1 and other huge projects in the offing, where taxpayers will continue picking up the tab for years to come, perhaps it’s this ability ‘to just do what it takes’ to deliver on the original project proposal, that is the missing link. And for financial trainbing I think we need to place more emphasis on how we get to the basic numbers in the first place and how we identify and analyse the likely risks, including what we would do to mitigate their respective impact.