Is it worth the wait?

A company decides to invest in, say, an additional production line if the expected profit exceeds costs. In other words, the expected rate of return must exceed the company’s cost of capital. That is the theory, at least: fifty years ago.

In practice entrepreneurs have known for quite some time that the threshold to invest is markedly higher. According to a survey by former US Secretary of the Treasury Lawrence Summers CEOs discount project cash flows at rates amounting to three times the weighted average cost of capital!

Inversely, companies terminate loss-making projects only — and correctly — when revenue is far below (variable) costs. Textbook investment theory apparently deviates from entrepreneurial practice. Which crucial issue has been ignored?

Uncertainty rules the world and the impact of uncertainty on the investment threshold cannot be overestimated. Sunk costs raise a significant hurdle: set-up costs usually cannot or only partially be recouped when a project takes a turn for the worse.  As a result, inertia in decision-making, keeping your options open, is often optimal. The majority of investments are not “now or never” decisions. It is worth waiting; all in good time.

Deferring decisions applies to loss-making ventures as well where, paradoxically, greater uncertainty can be an advantage: there is, objectively, a larger probability that the project may still end up in the black! The investment model that replaces the classical orthodoxy, can calculate when it is best to pull the plug.

The expected rate of return does not only have to cover the actual cost of capital but additionally the opportunity cost of not waiting longer, of losing flexibility. As soon as the investment is a fact, management loses flexibility, “options”. The true cost of investment is precisely because of this constraining of degrees of freedom (much) higher than the classical WACC.

Waiting can be advantageous, as it preserves options and avoids risk. The company that can wait may profit from future favourable commercial or financial evolutions. The downside of the trade-off is the foregone profits during waiting.

Orthodox investment theory does not take into account the “time value” of waiting, and the fact that the future is inherently uncertain. Each investment is deemed an isolated, now-or-never decision. As soon as the project appears profitable “intrinsically”, it ought to go through. The theory ignores management’s flexibility to address uncertainty.

State of the art investment science allows one to estimate the value of waiting. It determines true thresholds and the optimal timing of (dis)investment. The outcomes confirm the intuition of experienced managers: decisions must be deferred as long as waiting is valuable. The more sunk costs, the higher the uncertainty in an investment project, the less investing should be rushed, or vice versa: the longer unprofitable projects must be kept alive. One should not pull the plug unless chances of returning to profitability no longer outweigh the current losses.

In 2002 Belgium’s National Bank investigated the impact of uncertainty on the investment behaviour of the country’s industrial corporations. Indeed: more uncertainty in the expected net profit and sales lowered the profitability of investment (but only when the outlays were largely irreversible). On the other hand the probability of investing improved to the extent the company made more profit, in the process accumulating a liquidity buffer against uncertainty.

Investment policy is again a dynamic process. The traditional static decision criterium where net present value becomes positive or negative, is replaced by a zone of inertia around that point. In the zone the previously made decision simply remains valid. A project for example only obtains the green light when the expected return exceeds the inertia zone upper limit, and a project is terminated when returns sink below the lower limit.

Thanks to that innovative insight investment decisions are no longer undone if and when economic circumstances change compared to the situation when the decision was made. Consider the following example.

A power plant runs on fossil fuels. Management considers — temporarily or forever — to switch to renewable energy. The expectation is that fixed operating costs are lower in that case, and profit is less sensitive to the relative price between the two fuel sources.

The investment outlay is here determined by the costs to retool the power generation process, and is estimated at, say, 10% of average weekly profits. When, if at all, should the company switch fuel type?

An alternative is that a flexible generator is installed that can be powered by both fossil and renewable fuel. In that case, what is the optimal switching regime on a weekly basis?

In line with what has been said, it can be shown that the switching does not occur immediately when renewable energy becomes cheaper than fossil fuels: relative prices may well have to come down to, say, 85%. And reswitching to fossil fuels may only occur when relative prices are 110%. In other words: although fossil fuels may have been cheaper already for some time, the optimal decision was to stick with the previous decision — switching to renewables. Only when prices diverged for 10% was it no longer opportune to wait for a possible recovery of prices.

Of course, the exact switching point depends on the specific parameters. When relative prices are much less volatile, switching may already occur at 90% rather than at 85%. Lower uncertainty increases the probability of “investing”, narrowing the inertia zone. In the limit of zero uncertainty the inertia zone reduces to a point and the classical investment criterion becomes valid.

And if the outlay — in the example the retooling cost of the power generator — was much higher, relative price would have to be much lower, say 60%, before the fuel source is switched. If we take the limit here of an infinite switching cost from renewable to fossil fuel, we are back to the original question of whether to permanently change fuel source and relative price would have to drop to about 50% maybe. Note that reswitching to fossil fuel has now become prohibitively high, greatly extending the inertia zone.

An uncertain world requires inertia and flexibility. “Slow” management keeps its options open for as long as possible as “choosers are losers”. Flexible managers follow up on their choices once they have been made, expanding, temporarily freezing or forever abandoning them when circumstances dictate so. An investment policy that cannot quantify such a strategy, is doomed to be caught up by reality.

[from an article published in CFO Magazine]

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