This is a part of a three piece article series. We hope that you will enjoy the series.
“We only do high NPV projects.

“We want to maximize the value from our capex plan.

“Only projects with short paybacks get approved.

“Our business’/mill’s ROCE is higher than our cost of capital.

Have you ever heard any of these comments in your company?

Then this is for you because your company keeps making value destroying capex decisions, and you do not invest where you actually will create additional cash flow.

In this white paper, we describe how companies apply their capex process, and how universities teach us to make capex decisions, lead to massive capital destruction. Almost all companies in all industries evaluate capex decisions in basically the same way.

It is tempting, as a reader, to think that your company’s capex management process avoids the traps we will discuss. CFOs, VPs of Strategy, and individuals responsible for the capex process often react like that. This is a defensive reaction and not helpful to any company, its CEO, or its owners. If you, or those responsible for these decisions, are not open to necessary changes to your capex process then someone else within your company will soon learn from our descriptive articles and solutions and bring the inevitable changes necessary to your company. Only change will lead to improvement.

Since June of 1994, we have studied how capexes affect mill performance in real life. Our work has

centered mainly on the pulp and paper industry, but we have also worked in other industries and the issues we have encountered are universal to capital-intensive companies. Our customers are primarily located in North America, but also in Europe. We have helped more than 500 mills/plants since 2004 when we more focused started to implement our Asset Strategy projects.

How today’s capex process leads to massive capital destruction is easily understood when visualized the way we do here. This text will change how you, as an experienced decision maker within a capital-intensive company, view your decisions. We will give you something to think about and something you have to act upon now.

Contact us: contact@weissenrieder.com or ph +46 31 761 07 30

1.0 What Really Creates A Short Payback?

1.1 The everyday capex situation

For the purposes of this paper, all examples will be of mills/plants in the pulp and paper industry. However, all principles, ideas, and concerns may be applied to any capital-intensive industry.

Imagine a mill/plant, See Figure 1-1 below.

The mill, in our example, has been making money (cash flow, net after capexes) at a certain level historically (A). Here illustrated as a normalized straight line, but it is volatile in reality. We can assume the mill will continue to make money in the future at this level. Again, normalized at this specific level.

At some point, the mill is likely to come to the Head Office and say: “Sure, we can continue to make money at this level, but to do so, we need to fix this quality issue that we have. Customers are complaining more and more often.”

Now, look at Figure 1-2. To fix the issue the mill needs to invest in a solution, and the mill – following instructions– does the math on this situation. If they make the capex, they will continue to make money as expected (the straight full green line); if they don’t, they will follow the dashed green line. The difference between these two lines is often referred to as the “delta.” The mill compares the delta to the capex amount (green down arrow) and calculates an NPV, IRR, or Payback.

We assume here that all data is correct (i.e. what the mill assumes for the future is what later comes true). Our experience is that the industry really doesn’t have much of a data issue. That is not why things go wrong.

So far so good. The NPV/IRR/Payback is correctly calculated. NPV of 15 and a payback of 18 months in this case and the company is likely to go ahead with the decision. It makes sense.

Three months later, Figure 1-3, the mill again approaches the head office saying, “Sure, we will make money at this level, but to do so we need to fix this cost issue that we have.”

Again, they do the math on this new situation and come up with the benefits of project No 2. This pattern will continue month after month, year after year, with additional projects. Figure 1-3 represents the mill’s capex plan, in this case, 10 future capex projects from “Today.”

1.2 Misunderstanding the value of a capex project

The sum of all individual capex projects’ NPV in the capex plan is 200. Now to something that is interesting: The 200 in value (USD/EUR/GBP/DKK/…) is totally unrelated to the value of this mill. There is no mathematical connection whatsoever.

Look at figure 1-4. Each capex project’s value is determined by the delta created between the green full line and the green dashed line – here the red area – adjusted for the capex outlay.

How is the value of the mill determined in Figure 1-4? Take the full green line (which also takes into account the annual capex level) and discount it to today (same discount rate as for the capexes). That is more or less how most of us would do it, for instance when calculating the fair market value or when looking at an acquisition. We get an NPV of the mill but again, that is disconnected from what-ever the value of the capex plan. There is no connection. The capex plan can say whatever it says – and still be correctly calculated.

Another way of viewing the issue is to look at each project’s delta (the area between the full and the dashed line). The deltas for the projects overlap each other. In other words, the company “mortgages” the value of the mill over and over again for each capex request.

Look at another example, Figure 1-5.

In about 80% of our projects, we have at least one mill that, going forward into the future, will have a zero-cash flow or less. Here, that mill (Mill C) is illustrated below our original Mill B that we have chosen to keep in the figure for comparison purposes.

Question: What is the Total NPV of Mill C’s capex plan if Mill C has the same projects as Mill B? After thinking about it for a while, it can only be 200. So, we have a mill with a zero or negative value, but with a capex plan that – if implemented – has a value of 200. But the capex plan will not change the value of the mill, it will still have a zero or negative value.

Why is this?

Well, the NPV of a capex is not at all determined by the level of the green full line. The value of a capex is determined by how quickly the green dashed line falls (and the capex amount, and the WACC).

Our third mill (Mill A) is now added into Figure 1-6.

Mill A is a high performing mill, with close to state of the art technology.

What is the value of Mill A’s capex plan in this case, assuming the same projects the value will still be 200?

So, we have three mills – performing very differently – but who may present identical/similar opportunities/needs.

“This is theory,” some might say. We understand objections based on the simplification of things in the above presentation.

However, this isn’t theory. This is reality, it is just that there are other situations than the three represented here, making the capex process even more difficult to control and manage. We have seen many situations in the more than 500 mills/plants we have studied that would need their own illustration, but in order to make our point, we do not need to get more complicated than this. Some readers may be thinking, “Our company is different, this does not happen here, we evaluate things differently.” In our experience that is not the case; rethink. If we were face to face with you, we would answer any comment, question or concern you would have – believe us, we have heard them all over the decades, but it is difficult to cover all in this text.

1.3 Actually, reality is worse.

Getting back to our example, the next logical question is, “How does a company distribute capital between mills that perform differently?”

We claim that in reality the three capex plans for Mills A, B, and C will not have similar values. They will differ significantly and in the “wrong” direction. See Figure 1-7.

If our first mill (Mill B) has a capex plan NPV of 200, then Mill C is likely to have a capex plan value of 400 and Mill A 100. Why? Simply put, Mill C is further away from state of the art technology. In a delta calculation Mill C has have more catching up to do for each questioned piece of equipment. The gap in the delta calculation will be larger creating a higher NPV/IRR or shorter payback, illustrated by Mill C’s dashed blue lines. The dashed lines will fall more quickly in Mill C, creating a larger value in the capex plan. Mill C will also have more projects. Not only projects 1-10, but 1 and 1b and 2 and 2b, and so on. The mill has more needs. The capex plan’s value, therefore, increases even more.

In contrast to Mill C, Mill A will have a smaller gap to state of the art technology. Mill A’s dashed line will fall more slowly, creating a lower NPV/IRR or longer payback. Also, Mill A will have less needs (hence fewer capex proposals), all resulting in a lower “NPV total” in the capex plan of Mill A.

Where is a company likely to invest if it has a capital restraint?

Will it chase the longer paybacks in sustainable mills or the shorter paybacks in mills that do not seem to be very sustainable? We will discuss this in detail later. For now, it is sufficient to keep this question in mind.

And where is a company likely to invest if it has a “hurdle rate”, “discount rate” or “required rate of return” higher than the actual capital cost? A beloved child has many names.

Companies have a fondness for setting requirements above the capital cost (the Weighted Average Cost of Capital) in the NPV calculation (or IRR reference), because they believe they add an extra buffer, and they will get their money back quicker. It adds safety, they believe. But all that leads to is that even more capital is allocated to business units (plants, mills) with capexes having short paybacks. You’ll find those in the low B’s in Figure 1.6 (p.11). So, that behavior leads to lower company cash flow: value destruction. Their intentions are good, the result is bad. Especially since really good capexes that extends company sustainability and long term competitiveness have paybacks in the range 4-8 years – and those are excluded in the capex process.

The term “payback” is, by the way, truly misleading. It is not about that. When does one see the money return in Mill C? Never. The company keeps investing in “short payback projects”, but the mill’s cash flow is still zero or less. The money is gone. The calculated payback simply never happens – even if assumptions turn out to be true in the future.

So, we seem to have a situation where companies’ capex plans indicate that a company should invest where they are not making much money. This is bad enough, but it gets worse. The thing is, that individual mills will not even present the capex plans to the head office that aim at maximizing the company’s long term cash flow. How would they even know how to do that? They don’t have the bigger picture, only the picture of their individual mill.

It gets even worse than that because the mill will not even supply the head office with the capex plan that aims at maximizing the long term cash flow from their own mill. Mills will suggest the capex plan that ensures mill sustainability, not maximized long term mill cash flow.

This can be debated, of course, but one proof is the following:

In North America and Europe at least 15% of all mills within the Pulp and Paper industry should be closed within 5 years (if maximized company cash flow is to be achieved throughout the industry). Realistically, mill managers will not come to the head office with the following message: “We have analyzed all our options, and I, as a mill manager, can only come to the conclusion that in order to maximize cash flow you should run us for cash for 3 years and then shut us down.” Again, individual mills aim at sustainability – they are probably doing the right thing when doing so. Sorting out where and when to invest from an ongoing consolidation perspective is something that is not their responsibility, nor should it be.

Interested in reading article two?

“The tail wags the dog – how tactical capex decisions run company strategy”