Posts Tagged ‘loan’

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.

Ralph was convinced that one of the main reasons EG had gotten into trouble was a lack of focus on value creation in developing corporate-level and business-unit plans. Likewise, evaluations of the performance of the businesses had only a vague focus on value. Ralph firmly believed that it was the responsibility of all senior managers to focus on value creation. Ralph would ensure that company plans included a thorough analysis of the value of each of the businesses under alternative scenarios. He would also make sure that EG used the restructuring hexagon approach on an annual basis to identify any restructuring opportunities within EG’s portfolio.
This new focus on value would also require some changes in the way EG thought about its corporate strategy. For the next year or so, EG had to focus on restructuring. In the longer term, Ralph would need to develop a plan for sustaining EG’s advantage in the market for corporate control. To do this, he would need to better understand the company’s skills and assets and in which businesses they would be most valuable. Most important, he would have to ensure that the value of these skills could be identified in terms of higher margins, growth rates, and the like before building action plans around them. Too often, Ralph was convinced, EG had done a perfunctory analysis of its capabilities and entered businesses without a clear idea of how and why EG would be a better owner and able to create value for its shareholders. As a first step, later in the year Ralph would establish a task force to compile an inventory and do an analysis of EG’s skills and assets compared with its competition, as well as ideas for new businesses EG might enter.
At the business level, EG’s new focus on value would require some changes too. The restructuring review had pointed out a number of specific strategic and operating actions that the various business managers would need to take. Beyond this, management in the business units would need to think differently about their operations. They would need to focus on what was driving the value of their businesses—whether it was volume growth, margins, or capital utilization. Everyone was accustomed to focusing on growth in earnings, but what would matter in the future would be growth in value and economic returns on investment. Sometimes this would mean foregoing growth in the business that would have been accepted in years gone by. At other times, managers would have to get more comfortable with the idea of reporting lower earnings when investment in research and development or advertising with a longer term payoff made economic sense. Ralph knew that these changes would be difficult for his management group, because it had not been encouraged to think this way in the past. To help bring about change, he decided to share with the management group the results of the corporate restructuring analysis and to develop a series of training seminars for senior division management about shareholder value.