Risk Quantification in Capital Project Evaluations-A Case Study

Focusing on what really matters Amid resource constraint issues and aggressive, free cash-flow targets in 2003, a strong focus on profitable growth has emerged as a critical direction for corporate Canada. As a result, companies continue to focus on spending restraint to improve their profitability, decrease financial leverage, and prioritize scarce resources.

But given an unprecedented call for capital discipline, companies must now apply much greater rigour and scrutiny to their capital investment decisions to truly yield success. This extra scrutiny is needed to ensure that all expenditures arc on-strategy and display the right financial characteristics.

Unfortunately, many companies today place little, if any, emphasis on risk assessment and quantification. As a result, these companies spend money on projects for which:

* The true financial merit is uncertain;

* The underlying key drivers of the business that dictate the economics arc unclear;

* The uncertainty surrounding a given financial valuation and margins of error are not clearly evaluated; and

* The qualitative factors and their impacts to the financial conclusion are not apparent.

The intent of this case-study overview, therefore, is to illustrate how basic risk assessment methods can be applied to capital project analysis. While this article is based on an actual transaction, certain information (including names) has been altered to protect the confidentiality of the parties involved.

Case overview

Thompson Corp. (Thompson), an Alberta-based company, is a well-established IT services provider offering systems integration, IT management, and business process outsourcing services, with vertical expertise primarily in the government and health sectors.

Although Thompson has a strong reputation in Western Canada, the company's long-standing accounts are facing mounting attacks from large, global competitors-competitors with the sufficient scale, scope, and capital to offer integrated solutions to customers of all sizes and across many industries. (Margins have become increasingly vulnerable to the competitive pricing strategies adopted by these large players, which include the practices of accepting lower bill-rate work and using fewer subcontractors. Their scale also allows large competitors to use their relative size, track record, and distinctive value-add proposition to gain a larger share of clients' IT wallets, thereby taking market share from small to mid-sized players.) Given Thompson's vulnerability, the company's strategy is to protect existing accounts with a combination of pricing and service, and to expand its revenue base through new vertical and market penetration.

The opportunity

Kent Corp. (Kent), a medium-sized financial services company, provides a wide range of financial products and services-from corporate banking to retail-in Ontario. To lift profitability to a more sustainable footing, Kent is seeking to improve efficiency by outsourcing its customer billing functions to an IT services company. Through a registered financial planning process, Kent selects Thompson as a potential vendor. The opportunity? Thompson would make a significant upfront investment to finance the implementation of a state-of-the-art, customer billing management system and, in return, Kent would enter into a long-term customer billing services outsourcing contract with them.

To evaluate the deal's financial merits and to identify focus areas for due diligence and key deal points for final negotiation, Thompson performs the following analysis:

1) Financial valuation

Below are various financial techniques used in the valuation analysis of the Kent contract.

Note: Relying on a single financial metric is a common mistake made in capital project evaluation. While the following financial measurements are each important individually, no one approach or technique is ever sufficient to support a yes or no decision. Instead, the information derived from these types of analyses must be blended to determine a deal's overall viability.

a) Net present value (NPV)

The NPV is the present value of all cash flows in the project. By itself, a positive NPV means a deal is accretive to shareholders. However, when there are competing projects with similar NPVs, other financial measuresmust be reviewed in order to determine a deal's overall attractiveness.

Based on a 15-year discounted cash flow, the Kent contract is valued with an NPV of $9M, using the Thompson weghted-average-cost-of-capital (WACC) rate of 9.5%.

b) Capital efficiency ratio

This is a ratio of NPV ÷ the present value of capital expenditures to show the amount of value (or loss) to the company as compared to the amount of capital invested. Essentially, the capital efficiency ratio indicates the net return per dollar of invested capital. If two projects generate the same NPV but have different capital efficiency ratios, the one with the higher capital efficiency factor is considered the superior investment. The capital efficiency ratio for the Kent deal is 14.5%.

c) Discounted payback period

The payback period is the number of years it takes before a project's discounted cash flows equal the initial capital invested. The shorter the payback period, the faster the project is able to pay back its investment. Thompson requires that all invested capital be recovered within three years, but the discounted payback period for the Kent deal is calculated at approximately twelve.

d) Internal rate of return (IRR)

The IRR is the discount rate needed in order For the NPV to equal zero. Generally, a company will move forward on a project if the IRR is greater than the opportunity cost of capital (also known as the WACC). However, regard should be given to the risk level associated with any given project; and in that respect, the greater the level of risk, the higher the IRR needed to justify going ahead.

The overall IRR for the Kent contract is 11%.

2) Sensitivity analysis

Using a "tornado" diagram, which shows the relative sensitivity of NPV to each variable in a project, a sensitivity analysis is performed to show how variations in the underlying key assumptions affect the concluded NPV, thereby re-focusing executive attention on a deal's most critical uncertainties. For each key driver, a low, base, and high value is tested, holding the other variables at base levels. The variance created to the base case NPV is then observed.

Interpreting the tornado results

As shown in the diagram above, the assumption about headcount reduction causes the greatest variance to the NPV: 29% of the total. At 40% headcount reduction the NPV is $7M, and at 60% the NPV is $11.5M. These low and high rates, compared with an overall base-case NPV of $9M, create a total potential variance of approximately $4.5M.

The selling, general, and administrative expense item (SG&A) is the second major contributor to the NPV's variance. By adjusting the SG&A by 1% up or down, the NPV moves up or down by $1.2M, resulting in a total potential variance of 16%.

The four key contractual provisions round out the top six contributors to NPV variance. In total, approximately 85% of the total variance is driven by these six variables.

3) Risk identification matrix

The risk identification matrix presented above plots the key value drivers against the assigned degree of risk, and the corresponding impact to the NPV as per the tornado diagram. As identified in the top right corner, the drivers with both the highest degree of uncertainty and the greatest impact to the base-case NPV are: (i) employee costs (headcount reduction); (ii) SG&A; (iii) termination for convenience (T4C); (iv) termination for individual services; (v) First Nations clause; and (vi) non-performance clause.

Blending the analyses

Despite having an IRR (11%) that exceeds the WACC (9.5%), and despite producing a positive NPV of $9M, the feasibility of a 12-year payback period is highly questionable-by any standards, but especially so given Thompson's requirement that invested capital be recovered within three years.

Furthermore, because the average capital efficiency ratio of comparable contracts is approximately 30% versus the 14.5% for Kent, the net return for each capital dollar spent on the Kent contract is greatly inferior to the average deal.

Among other key drivers, the financial success of the Kent contract hinges on the realization of a 50% headcount reduction, which at the time of analysis is still considerably uncertain. Moreover, if only a 30% reduction is achieved, the business case will become a break-even proposition (i.e. NPV [asymptotically =] $0). The uncertainty around this and other critical drivers brings into question whether the 1.5 points above the WACC are enough to justify this deal.

The analysis also suggests that if Thompson does decide to execute on the project, a tactical plan must be developed to address the top six identified risks. For instance, the uncertainty of headcount reduction could be reassessed with greater rigour through a phase II due diligence plan. As well, outside experts could be engaged to assist the project team in systems analysis. And the contract could be structured to include a six-month "grace period," providing Thompson with six months to ensure that all of Kent's normalized business operating costs are identified. Another tactic could be to adjust revenue for costs not previously disclosed.

So, does Thompson execute this deal?

Based on the overall findings in this financial valuation, the Kent project seems marginal at best. Nonetheless, Thompson decides to move forward with the project. Why? Because in addition to financial considerations, Thompson executives have deliberated on the strategic, or qualitative, rationales for pursuing the project. Specifically:

* How important is it for Thompson to penetrate a new (i.e. financial services) vertical?

* How strategic is it for Thompson to gain traction in a new (i.e. Ontario) market?

* Could the contract provide an effective hack-door strategy to significantly cross-sell other Thompson services to Kent and its subsidiaries?

* Could this be viewed as a valuable defensive play to prevent major US competitors from stealing Canadian market share?

* And most importantly, could the capital invested in the Kent project be considered a platform to pursue other customer care and billing outsourcing contracts in Ontario or other provinces?

To Thompson, these perceived qualitative benefits add a substantial strategic value component to the projects financial valuation. For example, as an effective platform to pursue other business process outsourcing contracts, the analysis turns from a single contract valuation of $9 million to a going-concern valuation ranging from $50 to $90 million, in which the initial Kent contract is viewed as an "anchor tenant."

Based on their go-to-market strategy, Thompson has determined that there will be layers of value over and above the stand-alone Kent contract valuation. A detailed financial analysis of the Kent deal as a platform for additional businesses is beyond the scope of this paper, but for illustration purposes, the chart below highlights the total potential platform value for such an initiative, with additional business coming from selectively targeted accounts in other provinces.

In essence, regardless of the valuation amount, additional contracts will allow Thompson to sweat the upfront capital assets more effectively, thereby improving the overall economics of the Kent deal and escalating the project assessment from marginal to strategic.

As this case study demonstrates, companies contemplating capital projects must use comprehensive risk assessment methods in order to make sound investment decisions. Without a thorough assessment, Thompson Corp. would likely have missed an excellent opportunity.

By David C. Lam, CA, CBV

David C. Lam, CA, CBV, advises on new business opportunities and strategic initiatives at TELUS Corporate Strategy and Business Development. For their contributions to this article, Lam thanks Marco Tomassetti, CA, CBV, of Capital West Partners, and Marissn Cho, CA (Ontario), of PricewaterhouseCoopers Ltd. Tomassetti provides mid-mnrhet financial advisory services in Vancouver, and Cho provides advanced economic modeling and strategic analysis in Ottawa.

Copyright Institute of Chartered Accountants of British Columbia May 2004
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