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Beneath the surface

It wasn’t a quick fix.

This CapEx process would have to be rebuilt from the roots up.

It wasn’t just the approval process that was wrong. It was deeper than that.

The business didn’t think about capital the right way. And that wasn’t going to change until I could get the finance team thinking about it properly.

The team was starting to listen. They quickly realized that change was coming. The shambolic CapEx committee meeting, and the equally bad capital budgeting session, were behind us. (Covered last week if you missed it).

We’d set the CapEx envelope at a level I was comfortable with. $80m for the year. More than half of that would be maintenance CapEx. The rest would be deployed into carefully selected expansion projects.

This was not a big number for a business of our size. Our competitors had much deeper pockets in the short term. So the growth capital we did have was gold dust. We had to pick wisely.

On the screen in the meeting room was our CapEx pipeline. This was the full ‘wish list’ from the business. One row per project. You know the drill. The total was 5x the budget we had. Picking the right projects was crucial.

The spreadsheet was sorted on the IRR column from biggest to smallest.

The VP of Finance was driving the meeting:

“After your feedback, we have been through and vetted the financial returns for each project. Or most of them at least. I propose that we select our growth projects based on their IRR. We will work down the list from the biggest IRR down. Until we have fully allocated our pot for the year.”

He looked up at me for a response.

This is progress from where we had been a few weeks ago. But still light years from where I wanted to be.

IRR is important. But it’s not my preferred financial metric for CapEx (more on what is later). But there were more fundamental flaws in the approach…

There wasn’t a single non-finance person in the room.

While we weren’t formally signing off on the projects, we had 5x more projects than money. So the decisions we made would determine where we spent our time and resources.

That was not a finance only decision. This discussion should have been in partnership with the COO and Divisional Presidents at a minimum. And probably even the CEO.

It was becoming clear just how disconnected the finance team was from the business.

Something told me this wasn’t just a ‘CapEx problem.’

CapEx vs. Crapex: Spotting the Winners

This is week 3 of a five-week series breaking down the CapEx playbooks for CFOs:

• In week 1, we discussed what matters most when thinking about CapEx

• Last week, we defined the ‘CapEx envelope’ and set the size of the total capital budget

Now you know what size your CapEx envelope is, let’s talk about how to put your envelope to work. This is where we decide what has a shot at opening the envelope.

Note: we are STILL not formally approving projects at this stage (that comes next week). We are deciding which projects should be fully evaluated.

Why is that important?

As we discussed in week 1 of this series, there are a huge number of variables in a CapEx proposal. Approving a CapEx is not like playing chess, where the whole board is visible, and you just need to calculate the perfect move.

You are playing poker. There are cards are in play, that you cannot see. For example:

• Execution risk

• Market conditions

• Input prices

• Future demand

• Etc

Every serious CapEx proposal does need real evaluation. A great business case. Validation. Review. (We’ll talk more about the precise steps next week.)

That is a LOT of work. And … you might do all of that work, just to find out that the project isn’t right.

So before you set to work fully evaluating a CapEx proposal, you need a way of sifting the good ideas from the bad ones. Sorting the CapEx from the CrapEx.

Then you can commit time and attention to evaluating the projects that have a fighting chance.

The Open Envelope

This gives the business a paradox to solve. How do you know which projects are worth the effort of a full business case and which are not, without going through the evaluation process?

You need to keep a list of pipeline projects with a priority status attached (I call this is the ‘open envelope’):

• High - likely this project will be approved

• Medium - possible it could be approved

• Low - unlikely to be approved

If you get this right, you should have allocated approximately 80% of your envelope to projects marked high, and 40% of your envelope to projects marked medium (expecting that you’ll do half of them).

Your high projects should get 80% of the evaluation resources and attention. Your medium projects should get 20%.

What that resource is depends on the size and shape of your finance team. In a small team - that could be your own time as CFO. In a large finance team with a lot of capital spend, you might even have CapEx dedicated business partners.

The key is to make sure you don’t waste time or effort on low-priority projects. You don’t want to discard them altogether. Today’s low priority, could be tomorrow’s high. So keep them, and have a cadence for keeping the status up to date.

Remember, at this 'open envelope' stage, you're not making final decisions, you're simply triaging where you’ll focus your efforts. Projects marked ‘High’ still require rigorous business case validation later.

The Role of Maintenance Capex

Before we talk about how we prioritize individual project, we should talk again about maintenance CapEx.

As we said last week, maintenance CapEx tends to have a priority role in capital allocation, as it’s essential to protect current cashflows. For this reason, there isn’t just one CapEx envelope but two: one for maintenance, and one for growth.

And it’s important to get clear early on which projects are maintenance CapEx and which are growth.

Because you’ll need to police it:

The financial return bar is lower for a maintenance CapEx project. So the bar for meeting the qualitative definition of maintenance CapEx needs to be high.

The precise definition will depend on your business and the specific exposures you have to maintenance capital.

It won’t take long for the business to work out that the maintenance CapEx envelope is a safe space. Where the demands for a return are less intense.

This will inevitably lead to parts of the business arguing their project belongs in the ‘easy envelope.’

The most common example is an operator/technician arguing a machine is at the end of life, so they can push for an upgrade. IT upgrades, health and safety, fleet overhauls, regulatory & compliance are other examples.

These are all great ways for businesses to disguise new investments as maintenance CapEx.

You need clear rules, and a policing process to ensure projects hit the right envelope.

And the smaller you can make the maintenance CapEx envelope (without risking the business) the more you can allocate to projects which drive growth.

Let’s talk about growth CapEx…

Growth CapEx Investment Matrix

So, how do you decide which projects are high, medium, or low priority? Well, like the rest of the CapEx process, it’s art AND science.

Let’s start with the art.

You need a system for quickly parsing project ideas into a 2x2 grid based on its likely financial attractiveness, and strategic fit (is there anything you can’t put on a 2x2?)

Firstly, let’s define the two axes:

1. Financial attractiveness: what is the expected financial return? At this stage, a simple cash return on cash investment is fine (expressed as a %)

2. Strategic Fit: is it core to strengthening or expanding a competitive advantage? Does it enable growth and efficiency, or is it defensive?

Now let’s dive into each of the four boxes:

🤩 (High Financial Attractiveness/High Strategic Fit): These are the projects that are in the middle of the dartboard. They advance your strategic plan and they deliver a great return. Projects that sit here are always worth the time and effort for you, your team, and the business.

🤑 (High Financial Attractiveness/Low Strategic Fit): These projects deliver dollars but aren’t necessarily core to your strategy. A typical example is an investment in efficiency initiatives or non-core real estate plays. These projects have an important tactical role, because, used well, they can provide more financial firepower to reinvest (and grow future CapEx envelopes).

‼️(Low Financial Attractiveness/High Strategic Fit): These are the problem children. They are important to support because they are part of advancing a wider strategy. But the payback is unclear or speculative at best. Or maybe, just not there at all. Capacity expansions (with untested demand), pilot projects, innovation hubs, new geographies, etc. This box is where the ‘game of poker’ is hardest, especially for finance folks. There are more words and fewer numbers.

💩 (Low Financial Attractiveness/Low Strategic Fit): It doesn’t return capital and it’s not strategic. And it doesn’t have the protected status of maintenance CapEx. Anything down here isn’t worth your time. Pushing as much as possible into this box (without killing what could be a good project) is the key.

Triaging Growth CapEx Ideas

So, how do you efficiently triage your project list and get them in the right part of the grid?

You need someone (or a small group of people) who understand the business well enough to propose a score for strategic fit and financial attractiveness for pipeline projects.

At this stage napkin math/logic from a trusted source is ideal. These people will typically sit in growth/strategy, FP&A, or operations. In smaller businesses, this will be the CFO or even the CEO. The scoring can be as simple as high/low (like above), or 1-5 if you want/need something more sophisticated.

This will help you decide which projects are high, medium, or low priority. And therefore which projects make it into the ‘open envelope’ and which do not.

At this stage you should also ensure you also assess execution risk. A strategically perfect project with high returns means nothing if the business can't deliver it.

Use your exec (or CapEx committee in larger businesses) to align on ‘what is strategic.’ This quick triage process is art, after all. And all art is taste. So ensuring you, the COO, CEO, etc (and their teams) agree on what the strategic priorities are is vital.

Trading off tactical projects (good financial but poor strategic) with strategic projects (poor financial but good strategic) is often where the toughest decisions are made.

The strength and duration of your balance sheet will influence how much you are able to ‘indulge’ in projects with slower payback.

Having reached this point, you should have a series of projects that are deemed worthy of spending valuable time and resources.

Now we need to put these projects to the real test. We can no longer settle for napkin math, and we need to start understanding the real fabric of the cashflows underlying a project.

Financial Metrics

Next week, we will dive into the financial diligence on a capital project as part of the actual approval process.

For now, we need to touch on the best financial metrics for comparing projects. Let’s start with some of the greatest hits:

Net Present Value (NPV). You know this one. The discounted values of future cashflows. It’s theoretically beautiful. But on its own, it’s not much use. The maxim you were taught in college (that if NPV is > 0 you should do the project) doesn’t hold up in a world where you have more projects than capital. And you ALWAYS have more projects than capital. Plus, it doesn’t help you decide between two projects with the same NPV.

Internal Rate of Return (IRR). Another classic. The discount rate at which NPV is zero. IRR is a great tool for investors, comparing pure financial risk and return across different asset classes. It has some value in a CapEx setting, as a sort of time-weighted percentage return on investment. But you don’t get any sense of the scale or size of the project.

Cash Return on Investment (CROI). I like the simplicity of this measure: how much cash will this project generate at maturity (annually) divided by the cash needed. People understand it. But it ignores the time value of money and the maturity curve of a project. So it is too simple for this stage.

There is Return on Capital Employed (ROCE) and Economic Value Added (EVA) but I don’t think they work well for isolating the incremental effect of individual projects. They have their value, but not here.

There are two financial metrics I like best for evaluating CapEx:

1. Payback period. Everyone understands it. It takes X months to get your money back. It’s particularly good in a cash-constrained business where capital rationing is most important/difficult, and where downside protection is important. There is a ‘discounted payback’ alternative, but I prefer the simplicity of raw payback period.

2. Net Present Value Per $ Invested. What I like about this is that it captures the best of NPV and IRR into a single metric. You have the time value of money captured, but also a sense of return on capital invested. I.e. If you invest $1 you can expect $2.50 of NPV back. If I had to pick a single metric to rank projects on, it would be this one.

To be clear, there is no right answer on metrics - it will be business dependent. To some extent, they all have a role to play. But I do believe you need 1-2 primary metrics for CapEx that the business can understand and adopt.

Having selected payback period and NPV Per $ Invested, we can plot this on a bubble chart (where size of bubble = size of investment):

The color of the bubble represents the quality of return. Simplistically:

• Hard return: proven payback (automation and cost removal investment, proven rollout programs)

• Soft return: speculative payback (new markets, capacity expansion, unproven demand, or untested payback)

One is not better than the other, but the bet is different. With a ‘hard return,’ you can be more confident in the outcome. The distribution is tighter.

With a soft return project, the outcome distribution is wider. But often the upside is greater too i.e. a breakthrough into a new market could 10x NPV.

Soft return projects are harder to appraise. So I tend to look at the cashflow profile of a base case and reasonable worst case. Then ask myself what is the likelihood of each scenario.

The gap between the base case and the reasonable worst case is the execution risk. This is a simple way of bringing probabilistic thinking in. All without having to consider an infinite range of possibilities.

Allocating to the Open Envelope

You might think that you simply fill your CapEx envelope working from bottom right to top left on the bubble chart above. And that’s the right principle. But there is still strategic fit to think about (as well as the risk attached to the cashflows of the project). Also our appetite for soft vs hard return will depend on our broader risk appetite and balance sheet.

So while we are now getting more scientific, we will need to be in lockstep with the business, the CEO, the COO, (and well beyond) in ensuring we are aligned on what is in the envelope and what is not.

Practical Issues

In practice, evaluating projects is not a static process where your projects all line up neatly at the start of the year. Projects appear and progress at different speeds.

And business is dynamic. It can mean being ready to rush a project through the process quickly. It can also mean culling a project you’ve done a bunch of work on - even if your triage process was good

And don’t forget CapEx spend can (and often, will) straddle years. Meaning a single project might touch more than one envelope at once. For example, a $10m project that needs $7m this year and $3m next year. If you approve that project today, you are also committing to a future CapEx envelope (which carries a different opportunity cost). These decisions can quickly become multi dimensional.

Capital Committee

I’m not a fan of exec sub-committees in business. They slow things down and create jobs and bullsh*t.

But… capital committees (chaired by the CFO, COO or CEO) do work. CapEx creates so much work inside the business. Having a small group of senior people who can set clear direction on priorities and make decisions on the CapEx envelope is important.

More on the role they play next week.

Net-net

With the tools above, you should be able to decide which projects should have a place inside your CapEx envelope and which should not.

The next step is to start formally approving those projects to start work. That’s what we will cover next week.

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