Evaluating Capital Investments in a Tight Market

Auto Focus: Evaluating Capital Investments in a Tight Market
MiBizWest • 2001
by Jim Gillette

The 1990s were a boom time for capital investment in the auto industry. Flattening vehicle sales in the U.S., tightening credit conditions and profit margins under pres­sure from price reduction demands have signaled the need for greater caution in making asset investments. Fortunately, there is an analytical tool, “real options,” that can help component suppliers more clearly value new capital investment proposals. First, let’s look at the current market situa­tion.

Automakers share of total capital investment shrinking

Recognizing that vertically integrated (in­ house) component operations would continue to yield sub-par returns, auto makers have been systematically pushing responsibility for capital investment outward to their independent suppliers. The chart Suppliers’ share of capital expenditures (see graphic on this page) illustrates that, for the three most recent years for which consistent data is available, suppliers have shouldered an increasing por­tion of the investment burden.

On the one hand, this is a positive trend for suppliers. In the long run, investment leads to strong financial returns, increased productivity and an improved competitive position by building barriers to entry. Firms that have the means to invest in critical capabilities demanded by their customers can, in essence, preempt their less capable competition from gaining access to new component programs. Examples might in­clude the ability to machine metal parts to higher levels of precision, the ability to paint in addition to injection mold plastic parts or having multiple process operations.

In the short run, however, higher operat­ing leverage resulting from elevated fixed costs can lead to greater risk of financial distress during downturns in product de­mand. It has also become painfully apparent that some sectors of the automotive supply industry currently have significant excess capacity, exacerbating price-reduction de­mands. There is evidence that financial prob­lems are increasing. During 2000, credit downgrades of auto companies and auto suppliers by Standard & Poors outnum­bered upgrades by a four-to-one margin.

Credit conditions have tightened

After enjoying relative loose credit for most of the 1990s, conditions began to tighten markedly in 1999. (See Percent of large U.S. banks tightening credit graphic on this page).

All of this has made it critically impor­tant that suppliers exercise a great deal of care in the analysis of and commitment to new capital acquisition.

Traditional investment decision models do not capture reality

Discounted Cash Flow (DCF), the calcu­lation of net present value or comparing an investment’s internal rate of return to a firm’s cost of capital or “hurdle rate,” has been the investment analysis tool of choice for the last four decades. In many cases, DCF works just fine.

However, DCF falls short in two impor­tant respects. First, in laying out a forecast of future cash flows resulting from an in­vestment, DCF fails to provide a clear frame­ work to include potential growth opportuni­ties. Suppliers, for example, are often asked by their customers to make large capital investments to service a marginally profit­ able program in hope that follow-on work will ultimately raise financial returns. Us­ ing the standard DCF framework, quantify­ing the likely payoff from such growth opportunities is difficult if not impossible.

Second, DCF analysis does not capture the benefit of continuous management in­ put over the life of a project. Traditional analysis is unable to model the benefits derived when management recognizes that a project is veering off course and is able to take corrective action. In other words, good management has value that is not reflected in the initial analysis.

Real options analysis

Most business people are at least vaguely familiar with options traded in securities markets. Call options give the holder the right to buy a security (e.g. share of a company’s stock) at a fixed price at a future date while put options give the holder the right to sell a security at a fixed price. Options contracts are widely used both for speculation and to hedge risks. Pricing mod­els were developed about 30 years ago by Fisher Black, Myron Scholes, (the famous Black-Scholes model) and Robert Merton.

Work has progressed over the past 20 years that now allows us to apply these option pricing models to real (that is, physi­cal versus financial) asset investment. Fear not, there is no need to delve into arcane mathematical models to understand and benefit from the concept.

Some examples

Carefully examined, most capital invest­ments will have several real options at­tached that create value over and above that measured by discounted cash flows alone. When analyzing a potential investment, the more options you can build in, the greater the value of the asset. Here are some ex­amples:

  • Growth options. I’ve already men­tioned that the potential for future business opportunities creates value.
  • Abandonment options. Traditional in­ vestment analysis implicitly assumes that you are obligated to continue production for the full, originally assumed life of an asset regardless of how unprofitable it might turn out. In the auto industry, due to contractual agreements, this may often be true. But, if you do have an out, an abandonment option, to sell or discontinue the use of an asset rather than continue losses, there is addi­tional value to be recognized.
  • Flexibility options: Flexible machin­ery, flexible assembly lines, flexible vehicle platform configurations, etc. achieved wide­ spread acceptance in the 1990s. In a world where consumer tastes change frequently and where product design cycles are con­stantly shrinking, the ability to run multiple products in the same facility creates value. Flexibility may cost more at the outset, but its value can more than offset the cost.
  • Delay options. Given the current en­vironment in the North American auto in­dustry, promising capital investments for the long run may not be feasible to imple­ment in the short run. The ability to delay investment (again, not always a choice for a component supplier) is of value. A corol­lary to the option to delay is the option to stage investment. That is, do you really need to build and equip that new 100,000-square-foot plant immediately, or can you do it in stages over time to meet customer demands as they arise in the future?

 

There are more, but I’ve run out of space. The important point is that real options can add value to a capital expendi­ture under consideration by enhancing the opportunity for management to act. Careful consideration of available options not only brings to light the value of an asset investment over and above that measured by traditional DCF techniques, but serves to lower risk in today’s difficult environ­ment.

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