Strategic Investments

Injecting a value-creation focus into EG’s planning and performance review process would make a big difference. Ralph also knew he needed to make changes in the way the company looked at major spending proposals.
To evaluate capital spending, EG had been using discounted cash flow analysis for at least five years, as had most other companies. This was fine, but Ralph saw two problems. First, capital spending was not linked tightly enough to the strategic and operating plans for the businesses. Because of this, capital spending proposals were out of context and difficult to evaluate. Second, EG had been using a corporatewide hurdle rate to assess capital investment proposals. From the restructuring review of EG, Ralph knew that each of the EG businesses involved a different degree of risk, so the hurdle rates for assessing capital investments should be different, too. To make matters worse, the hurdle rate was too high, having been set in an attempt to smoke out unrealistic operating projections. The result was an ineffective capital spending process. Ralph figured that many investments that earned about the cost of capital were being passed up because they did not meet EG’s extremely high hurdle rate. On the other hand, major capital investments were not evaluated as closely as they should be since the whole process had degenerated into a numbers game about assumptions. Ralph intended to tie capital spending closely to strategic and operating plans to ensure that its evaluation was realistic and fact-based. He would also ensure that the finance staff developed appropriate hurdle rates that would differ by division to reflect the relevant opportunity cost of capital.
Ralph knew that one of EG’s biggest problems had been the evaluation of acquisitions. He knew they had paid too much for the Woodco acquisitions in the 1980s. In the restructuring review, he had seen the impact of paying too much on the company’s share price. Fortunately, as CEO he would have direct control over the decision to pursue acquisitions. He would insist that when proposing an acquisition, the relevant operating manager and CFO do a thorough valuation analysis based on cash flow returns for the transaction. He would not make the mistake his predecessor had of believing that just because he could make the accounting earnings and dilution figures look good in the first year or two of an acquisition, it made sense from a value standpoint.
To Ralph it was really quite simple. Either the cash flow value to EG’s shareholders of an acquisition would be higher than the price EG would have to pay, or Ralph would not make the acquisition. And he believed that value could be assessed much more systematically than in the past.
First, EG management would evaluate the target’s business on an ”as is” basis, just as the team had done for EG. Next, management would use the restructuring hexagon approach to identify improvements that could be made to the value of the company on a stand-alone basis. The management of the target company might or might not be capable of making these improvements on its own. Third, EG management would evaluate the potential for synergies with other EG businesses on a systematic basis. These synergies would be evaluated in concrete terms for their impact on value. Finally, EG management would think about the strategic options the acquisition would create. These would be difficult to evaluate and value, but could nevertheless be important. For example, an acquisition might give EG an option on a new technology in one of its businesses, or access to a new market, both of which could have substantial value under the right conditions.
Armed with this information, Ralph would be much better able to evaluate the logic of any acquisition, certainly much clearer than EG management had ever been. He would know how much EG could afford to pay. Equally important, he would know more specifically what to do with the business after it had been acquired. Before entering negotiations, Ralph would also have his team assess the value of the target to other potential acquirers; in this way he could be sure that he would not enter into a fruitless bidding contest or end up buying the company at a price higher than he needed to. He certainly did not want to fall into the trap of giving all the potential value of the candidate to the selling shareholders. After all, why should EG do all the work and the sellers receive all the rewards? Acquisition proposals would be subjected to a new test. EG management would no longer presume that the best way to pursue a new business idea was by acquisition. Ralph would ensure that management considered entering a business in other ways, such as through a joint venture. Such approaches might be alternatives to the ”big bang” acquisitions that seem like easy solutions at the time, but afterward cause endless problems for the company’s stock market performance.