A recent blog drew your attention to the power of Economic Value Added and its basic formula - that return on total capital, accurately defined, must exceed the cost of said capital. Fortune magazine has come up with an astonishing example of what happens when you forget this basic truth. Two American communications colossi, AT&T and BellSouth, are proposing to merge. That involves a staggering $280 billion of capital – a world record. Now, you wouldn’t take a step like that without being sure that the EVA was highly positive, would you?
If you’re a director of AT&T and BellSouth, yes, you would. The capital cost of both the two would-be partners is 9.1%, but the respective returns on capital are a mere 3.1% for AT&T and 5.9% for its partner in crime. The directors can only justify the deal financially if they can see net operating profit after tax (NOPAT) of $25.5 billion. The trouble is that the combined NOPAT last year was $8.5 billion. Hands up anyone who believes that the merger will create $17 billion of extra profits. No takers, I hope. As Fortune’s Geoffrey Colvin comments, ‘It’s a strategically sensible combination at a financially insane price’.
Yet this ridiculous deal, which looks certain to destroy enormous chunks of capital, is merely the worst of many, many deals undertaken by companies large and small, which ignore the costs and disregard the dangers. The private sector doesn’t have a monopoly, of course, when it comes to making commitments that cannot be justified on any sensible accounting. Governments do it all the time. The technique here is to underestimate costs so that some beloved project does indeed look reasonable – and gets the go-ahead.
Take the horrible Gulf War. Donald Rumsfeld, the US Secretary of Defence, estimated a $50 billion cost in early 2003. Appropriations for military operations in Iraq have now passed six times that sighting shot; but that incredible $301 billion doesn’t account for expenditures still to come, which might take another $266 billion. Sling in the indirect costs (like taking good care of the 17,000 wounded Americans, hardware replacement costs, etc.) and you’re well into your second trillion.
Compared to all that, Wembley Stadium and the Scottish Parliament look like well-managed operations, instead of the financial disasters they certainly are. But what about our own Iraq costs? I’ve seen no proper accounting for a politically hideous and militarily horrible engagement, which seems to have been conducted on the principle that the end (removing Saddam Hussein) justified even an absurd allocation of means.
It all makes one sympathise with the inhabitants of Anza, California, who, according to Private Eye, have a goat named Opie as their highly successful Mayor. Opie is not alone. Among others, there is Paco Bell, the donkey Mayor in Florissant, Colorado. A voter explains that, ‘We decided to have a little truth in politics by only allowing jackasses to run’. They have a point. Better to have a jackass or a goat than a lying cheat, for example…
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