There has been a great deal talked and written recently about investment projects - particularly in light of the government’s decision on what to do with the partially-built HS2 rail project on which they have already spent over £70bn.
Even that figure was at 2019 prices, so with the surge of inflation in the intervening period, that could easily now be £85-90bn or more. But when you take all of the politics out of it, there are lessons to be learned for any business from this fiasco.
In both economics and accounting, the word ‘investment’ means spending on something today which is expected to produce a measurable ‘return’ over an expected period of time in the future. This differs from ‘consumption’ which means spending on something that will be used up almost immediately. Hence building a large extension to your shop is ‘investment’, whereas repainting your existing shop would be considered as a simple expense. The former is often referred-to as ‘Capital’ because the cost will create an asset on your balance sheet, while the latter is usually referred to as ‘Revenue’ because it will simply be charged to this year’s Profit and Loss account under ‘Repairs and Maintenance’ or suchlike.
Some investment may be discretionary – you want the bigger shop because it should increase your future sales and (hopefully) profits; whereas some may be essential – your underground tanks are 25 years old and leaking, and the local authority will not renew your petroleum licence unless you dig up the forecourt and install new tankage.
The basic rules of planning any investment (at least those investments which don’t involve politics…) are relatively simple and logical. First define your project: what do you want or need to achieve, and over what period of time? The shop extension would be about increased profit, perhaps over the next 15 years; the tank replacement would be about staying in business until the last oil-based car is off the roads.
The second step is where the calculators and spreadsheets appear: how much will you need to spend ‘today’ and how much ‘return’ can you expect over the projected pay-back period? The third step is to compare the projected return that you’ve just calculated against any other return that you might make over the same period for the same initial outlay. It’s what the economists like to call ‘Opportunity Cost’: if you were to put the £500k that you’ve earmarked for the shop extension into a simple no-risk deposit account for 15 years and the expected return from doing that was close to your expected increased profits over the same time frame, why bother with all of the hassle (and uncertainty) of building, just put the money into the bank and opt for the quiet life.
In principle that sounds simple enough, but usually this is where it all starts to go wrong. As in the HS2 example, badly, even grotesquely wrong. The problem is that we’re considering things which by definition relate to the future; and in the absence of reliable crystal balls or time-machines, that means uncertainty. It means making assumptions which look perfectly reasonable today, but might seem completely unrealistic (with the benefit of 20/20 hindsight) from the perspective of 2035 or 2040.
Stuff happens! Nobody 10 years ago predicted the economic and social changes following on from the Covid19 pandemic, just as one very obvious example; nor in the middle of that pandemic did anyone (seriously) predict the disaster of ’Trussonomics’ and the resulting hike in interest rates just a year ago.
A well thought-out, detailed spreadsheet calculation of costs and returns prepared when inflation rates were 2% per annum (or less) and base rates were at 0.1% (March 2020, in case you’d forgotten), looks wildly wrong when inflation is at 10% (or higher) and base rate is at 5.25% - and of course, the bigger the initial investment sum, the more extreme the resulting divergence from reality.
The normal way of trying to anticipate this is to prepare several versions of the business plan with different values for the key financials, both higher and lower: projected revenue, costs, interest rates, etc - which in economists’ jargon is often called a ‘sensitivity analysis’. The resulting calculations should show the potential outcomes from a wide range of possible scenarios – but even the most sophisticated analysis can’t overcome another issue when it comes to investment decisions. Human nature.
The problem is that generally people want to develop their bright ideas into new projects. The person who had the idea is usually convinced it will work, and is excited to start it; the people who might be doing the work are keen for new business, even the people who might be lending the money for the whole thing can have their own reasons for really wanting to proceed with the deal. Show them all a bunch of projections which range from ’Dead Certain Success’ to ’Don’t touch it with a barge pole’ and in many cases they concentrate on the one closest to what they already believe or want to believe – something which psychologists call ‘confirmation bias’. Anyone who looks at the figures independently and warns against choosing the most optimistic scenarios tends to be dismissed as ‘negative’ – a naysayer – and ignored.
The history of investment projects of every type is littered with contractors who submit bids for the work at completely unrealistic, low prices. Either their own finance people haven’t costed the work properly, or they’ve been ignored in the rush to get new business. Remember Carillion?
Imagine you’ve started your shop redevelopment and halfway through the main contractor tells you that they can’t possibly complete the job for the amount you’d agreed to pay them. Either pay more immediately or find someone else to take on the rest of the job – which would amount to the same thing. Or that a site survey failed to reveal major contamination under your forecourt until digging had started; suddenly you’re faced with a new, possibly major, cost which wasn’t included within your project financial calculations at all. Stuff happens. Which is why a good investment analysis will include sizeable provisions for ‘contingencies’ – things that might crop up during the project which nobody could really foresee at the start – and those provisions can make the projected costs look much higher and therefore the projected returns much lower. Which again is why they are often minimised or ignored.
The sensible route for anyone investing in a major new project is to do your calculations properly, put in a wide range of realistic possible values, and then get objective, independent, advice from someone who understands the financials but has no vested interest in actually being involved with the project beyond that – and actually listen to their opinion before committing to anything.
