HAUKE HANSEN works as a production manager for ASML in Veldhoven (NL). Prior to his current job he was an Associate Principal in McKinsey's Düsseldorf office. He served high-tech, logistics and telecom companies and supported several multi-billion dollar investment projects. He holds a PhD in physics from the University of Konstanz and was a Fulbright-scholar at the California Institute of Technology.

WOLFGANG HUHN is a Director in McKinsey's Frankfurt office. He primarily serves clients in the high tech industry as well as in energy. Wolfgang is a member of the Business Technology Office where he leads the industrial sector in Europe. He also leads the European Product Development Practice. Prior to joining McKinsey, Wolfgang studied electrical engineering and physics in Aachen and UK and obtained his PhD in Physics from the RWTH Aachen. From 1998 to 2000, Wolfgang was the CEO of a VC-backed company.

OLIVIER LEGRAND is a principal in McKinsey's Paris office. He serves clients in the transportation, steel and aluminum industries as well as in consumer goods and energy. Olivier co-leads McKinsey's global capital productivity group. He holds an MBA from Stanford Business School.

DANIEL STEINERS is an Associate Principal in McKinsey's Düsseldorf office. He serves clients in electric power and chemicals across Europe and North America and is a co-leader of McKinsey's European capital productivity group. Daniel received a diploma in business administration from Münster University and a PhD in management accounting from the European Business School in Oestrich-Winkel.

THOMAS VAHLENKAMP is a Director in McKinsey's Düsseldorf office. He serves clients in the coal, oil, gas, power, and chemicals as well as transportation industries. Thomas is the sector leader of the Energy and Materials Practice in Germany and a member of the leadership group of the European Electric Power and Natural Gas Practice. His educational background is in polymer chemistry. He holds a degree from the Technical University of Aachen (RWTH) and a doctorate from the Max Planck Institute for Polymer Research.

Acknowledgements ix

About the Authors xi

Part I Why Investments Matter 1

1 Introduction 3

1.1 Investments: the forgotten value lever 3

1.1.1 The early bird catches the worm 4

1.2 A bird's-eye view of the book content 6

1.2.1 Part I: Why investments matter 6

1.2.2 Part II: Getting investments right 7

1.2.3 Part III: Right allocation: Managing a company's investment portfolio 9

1.3 Why investments matter: the importance and structure of capital investments 10

1.3.1 The relevance of capital investments 10

1.3.2 The structure of capital investments 16

1.3.3 Time dependence of capital investments 21

1.3.4 The future of capital investments 26

1.4 Summary 27

Appendix 1.1: Wavelet analysis: Extracting frequency information from investment timelines 27

References 29

Part II Getting Investments Right 31

2 Right Positioning: Managing an Asset's Exposure to Economic Risk 33

2.1 Preface 33

2.2 Asset exposure determines the achievable return on an investment 33

2.3 Five levels of protection determine the asset exposure 35

2.4 A simple scoring metric to measure asset exposure 37

2.5 Quantitative asset exposure analysis shows high correlation with ROIC at all levels 42

2.5.1 Using exposure level analysis for benchmarking 45

2.6 Strategies to reduce asset exposure 47

2.6.1 Strategy 1: Create public-private, win-win situations in natural monopoly environments 48

2.6.2 Strategy 2: Foster regulatory conditions that enable sufficient investment levels 49

2.6.3 Strategy 3: Create the right structural conditions and ensure fair access to scarce resources 49

2.6.4 Strategy 4: Establish protection for intellectual property 50

2.6.5 Strategy 5: Achieve a strong commercial position 50

2.6.6 Strategy 6: Minimize fixed capital costs or outsource asset ownership (go "asset light") 52

2.7 Summary 53

3 Right Technology: How to Optimize Innovation Timing and Risks 55

3.1 Capital investments in technology innovation 55

3.1.1 Technology analysis 57

3.1.2 Assess risks 63

3.1.3 Mitigating technology risks 67

3.2 Summary 69

4 Right Timing: How Cyclicality Affects Return on Investments and What Companies Can Do About It 71

4.1 How cyclicality destroys value 71

4.2 Industry drivers of cyclicality 73

4.2.1 Impact of investment lead times 77

4.2.2 Slow-to-no market growth 78

4.2.3 High price sensitivity 78

4.2.4 Investment timing with respect to the cycle 79

4.3 Developing an economic model of cyclicality 81

4.3.1 A fundamental law of economic cycles 81

4.3.2 Base parameters of simple economic oscillations 83

4.3.3 Reaction of cyclical systems to external "excitation" 85

4.3.4 Economic cycles with more than one player present 87

4.4 Measures to cope with cyclicality 90

4.4.1 Reaction delay 91

4.4.2 Reaction strength 92

4.4.3 "Jokers" that can help beat the cycle 92

4.4.4 Where no joker is available 95

4.5 Summary 98

Appendix 4A: A differential equation for economic cyclicality 98

Reference 100

5 Right Size: Balancing Economies and Diseconomies of Scale 101

5.1 Introduction: The role of scale in determining profitability 101

5.2 Assessing economies of scale 103

5.2.1 Fixed cost leverage 104

5.2.2 Decreasing unit costs 105

5.2.3 Equipment utilization/chunkiness of capacity 106

5.2.4 Critical size 107

5.3 Determining diseconomies of scale 107

5.3.1 Cost elements 109

5.4 Risk elements 111

5.4.1 Utilization risks 113

5.4.2 Market reaction risks 115

5.4.3 Technology risks 116

5.4.4 Timing risks 116

5.5 An approach for finding the "sweet spot" 117

5.5.1 Scale effect model 117

5.6 Real-life examples 118

5.6.1 Automotive industry case example 118

5.6.2 Base chemicals case example 119

5.7 Summary 120

Reference 121

6 Right Location: Getting the Most from Government Incentives 123

6.1 Government incentives: An overview 124

6.1.1 Creating public-private, win-win situations 125

6.2 Common types of incentive instruments 127

6.2.1 Subsidies 131

6.2.2 Financing support 131

6.2.3 Tax relief 133

6.2.4 Other types of government incentives 134

6.3 The financial impact of incentives: A modeling approach 136

6.3.1 General impact of subsidies 137

6.3.2 General impact of financing support 138

6.3.3 General impact of tax relief 138

6.3.4 Specific impact of incentives on different industries 139

6.4 Geographical differences in incentive structures 140

6.5 Managing government incentives 141

6.6 Summary 142

References 142

7 Right Design: How to Make Investments Lean and Flexible 143

7.1 Lean design as a competitive advantage 143

7.1.1 The lean way: Moving from capital investment projects to a lean design system 143

7.2 The three dimensions of a lean capital investment system 146

7.3 Dimension 1: The technical system 147

7.3.1 Start with project objectives, design princisples, and target setting 147

7.3.2 Value engineering and lean tools 149

7.3.3 Design optimization 152

7.3.4 From the basic design to start of production 153

7.3.5 Anchoring tools and practices to formal standards 155

7.4 Dimensions 2 & 3: Management infrastructure, mindset and behavior 155

7.4.1 Project organization and performance management 155

7.4.2 Institutionalization and learning 156

7.4.3 Adapting the system to local specifics: Project design cannot be "one size fits all" 156

7.4.4 Getting started 157

7.5 Flexibility: Just what customers and the company need and no more 158

7.5.1 Macro-level flexibility: modularity in plant design to ensure flexible, cost-efficient assets 158

7.5.2 Midi-level flexibility in plant design: cater for product portfolio diversity 159

7.5.3 Micro-level flexibility in plant design: design for iso-productivity 160

7.6 How to avoid creating a front-page disaster: Anticipating what can go wrong 162

7.6.1 Performance management and decision making 163

7.6.2 Tools which every company and project team need to master 164

7.6.3 Cross-functional coordination 165

7.7 Summary 166

References 166

8 Right Financing: Shaping the Optimal Finance Portfolio 167

8.1 Why Financing Matters 167

8.2 Three-Step Financing Approach 170

8.2.1 Step 1: Evaluating the investment's cash flow parameters 170

8.2.2 Step 2: Assessing investment risks 172

8.2.3 Step 3: Composing the financing portfolio 180

8.3 Summary 183

References 183

Part III 185

9 Right Allocation: How to Allocate Money Within the Company 187

9.1 Key requirements for capital allocation 188

9.2 Four models of the corporate center role in shaping the investment portfolio 192

9.3 Capital allocation approach for operators and strategic controllers 195

9.3.1 Step 1: Treat special projects as high priority 196

9.3.2 Step 2: Allocate remaining capital to business units 197

9.3.3 Step 3: Business units distribute capital to individual investments 199

9.3.4 Step 4: Implement a capital assurance process 201

9.3.5 Improving the "capital allocation key" 203

9.3.6 Capital allocation backbone 204

9.4 Capital allocation approach for strategic architects and financial holding structures 210

9.5 Summary 213

References 213

Index 215