Carol Wright, Director of Finance & Corporate Services

Transcription

1 Chapter F2 Contact Investment Appraisal Carol Wright, Director of Finance & Corporate Services Policy Statement 1. Purpose 1.1. The purpose of this Chapter is to set out University policy for carrying out investment appraisals in the context of capital and revenue projects. 2. Scope 2.1. This policy statement sets out the methods and criteria to be used in carrying out investment appraisals within the University. 3. References 3.1. There are two reference relevant to this chapter: Appraisal and Evaluation in Central Government - Treasury Guidance ( The Green Book ) Investment Decision making: a guide to good practice (HEFCE 2003/17) 4. Policy Statement 4.1. The role of Investment Appraisal The purpose of investment appraisal is to provide a systematic approach to decisions which consider a flow of costs and benefits over time. It is therefore a tool to assist decision-making at an early stage. It is not a bureaucratic hurdle to be overcome on the way to getting approval for a decision which has already been made. Used properly, investment appraisal can help clarify objections and options and should lead to better decision making in a variety of areas. While much of what follows is aimed at investment appraisal in the context of capital schemes, the techniques and principles involved can (and should) be used to help towards making a range of business decisions How to go about an Appraisal There is no set way of going about an investment appraisal which will automatically apply in every conceivable case. The approach taken should be flexible to deal with the particular circumstances of a particular case. Nevertheless, there are basic rules and expectations which will help to produce a structured approach to an appraisal and which are expected to be followed in any University appraisal. The intention is also to ensure that appraisals are carried out on a broadly consistent basis across the University Generally, an appraisal should follow this sequence: define the objectives consider the options identify, quantify and, wherever possible, value the costs, benefits and uncertainties of each option put costs and benefits which can be valued in money terms on a comparable basis value intangible benefit, if possible carry out sensitivity analyses present the results

2 4.3. Defining the objectives Objectives should be clearly stated and, as far as possible, related to an underlying policy or strategy. Clarity is necessary not least so that it can be established after the event whether or to what extent they have been met. For all appraisals, objectives should not be regarded as unalterable. The appraisal process itself may well indicate a need to reconsider objectives, either to make them clearer or even to change them Identifying Options It is crucial that a full range of options, which would meet the objectives in full or in part, should be considered. Often one option will be to do nothing, or to invest an absolute minimum; and that should be used as a base case in the appraisal. Particularly for a major scheme, the range of available options could be very wide. All should, however, be considered, even though many may be rejected at an early stage on cost and technical grounds Basis for rejection must be carefully considered. For example, unless it is obvious that a particular approach is not technically feasible, options should not be rejected on technical grounds alone. It may be that a relatively inelegant technical solution may nevertheless come out on top in a cost appraisal because it would provide acceptable benefits at a lower cost. Similarly, an option should not be rejected untested simply because it looks more expensive or has lower benefits than some other option. Phasing over time can make a significant difference to the outcome of an appraisal so that, in discounted terms (see para 4.6.2), what appears to be a more expensive option may in fact not be; and again lower benefits may be acceptable if there is significant cost advantage as well The sort of points which should be considered when considering options (depending on course on the nature of the scheme) include: what technical options are available for meeting the scheme s objectives? are different sizes or quality of operation possible? might the project be accelerated, postponed or otherwise differently phased (this can itself produce a range of options)? are all elements within a particular option justified, or might it be possible to remove some? will staff termination costs be incurred, especially if a do nothing option is considered? could the scheme be considered with another, or make more effective use of existing or potentially refurbished building, facilities etc? are there alternative choices of location? are there alternative ways of minimising staff or other operating costs? could feasible changes of circumstance produce alternative options? Proposers should also remember when presenting cases that whoever is being asked to authorise a scheme may not know the full history of the case. Reasonable options rejected at an earlier stage should therefore be referred to in the final case, together with the reasons why they are discarded Identifying and Quantifying Costs and Benefits The appraisal should indicate the full extent of the expenditure and commitments involved and of the benefits expected. For each option being considered, all costs and benefits, both direct and indirect, should be valued in money terms as far as possible and set out in the form of a cash flow against the time when they are expected to occur.

3 For purposes of appraisal, costs and benefits should be set out in constant prices. Inflation should not be included, except where the price of a particular item is expected to vary from the general rate of inflation. Appraisals must always specify what has been done if an assumption of this sort is made. Appraisal calculations should also not include depreciation and interest, although possible effects on these elements should not be noted separately Costs which have already incurred or irrevocably committed should always be omitted from an appraisal. These represent sunk costs which will be unaffected by whatever decision is taken as a result of the appraisal, and their inclusion would therefore be misleading. Such sunk costs will include, for example, the service costs associated with running a building if these would have been incurred anyway. What matters in investment appraisals is new costs to be incurred in the future and variations in future cash streams For schemes with a mainly commercial justification, the most significant elements in the appraisal are likely to resolve around new revenue streams and the commercial benefits for the University. Consequences for other parts of the University should, however, not be lost sight of (e.g. a new facility may take work away from existing ones); and neither should the potential effects on the customer (e.g. paying for a new facility may reduce the customer s ability to afford to buy other services or pay for other facilities) Most University schemes, however, will not have a mainly commercial justification and not all will have clearly identifiable cash benefits. Appraisal techniques should nevertheless play an important role in deciding between options All appraisals should include the residual value of the facility, building or whatever is under consideration. This can often be done simply by taking the asset value and applying the appropriate depreciation to it (e.g. a new facility valued at 10m with a 20-year life would have a residual value of 5m after 10 years). In particular for buildings, however, the residual value will be better judged by using where possible the estimated commercial value (at constant price) of the building or facility at the end of the appraisal period. The appraisal should make it clear which approach has been taken and what the effect is of the residual value on the appraisal. Where commercial valuations have been used, again in particular for property investment appraisals, the range of doubt within these valuations may be an important part of a sensitive analysis For most University proposals in the UK tax considerations will not be significant and should be omitted. When they are significant, however, for example where international collaboration may be involved and/or the University is investing in facilities in another country, tax implications should be included in the appraisal. Advice on tax matters is available from the Director of Finance & Corporate Services Comparing Costs and Benefits There are a number of approaches which must be considered in appraisals in the University, namely Net Present Value (NPV), which must always be used in appraisals, and Internal rate of Return (IRR) and Payback which should be used in addition when appropriate. a. Net Present Value (NPV) The intention in using a discount rate is to reduce the value of projected future costs and benefits to their values as seen from today. Arriving at appropriate discount factors is a complex process involving judgements on opportunity costs, perceived value of money etc. University Treasury-recommended discount rates must be used.

4 For most University schemes, this rate is 6% and must be used in appraisal calculations. The exception is schemes with a mainly commercial justification, where the Treasury require a discount rate of 8% to be used An NPV is arrived at by subtracting the sum of the discounted costs of an option from the sum of the discounted benefits, all discounted to the same base date. The current year is usually chosen as the base or reference date for discounting; and the convention is to refer to this as Year 0 if the calculation of costs and benefits extend over several years. It is usually sufficiently accurate for appraisal purposes to assume that all costs and benefits appearing in a particular year will fall at mid-year. Factors to be used are then those shown in the Tables at Annex Appraisals should generally cover at least 5 years. This may need to be longer for property-related proposals, although these should still have a common end point for the options being assessed. ii Internal Rate of Return (IRR) This is the discount rate at which the net present value of a proposal is zero (ie discounted benefits equal discounted costs). Where appropriate, schemes in the University are expected normally to demonstrate an IRR of at least 12%, this is generally for schemes with a mainly commercial justification It should also be noted that IRRs will unavoidably tend to put lower weights on longer term costs and benefits and may therefore point to a different conclusion compared with a straight NPV. Attention will be drawn to this effect where it is central to the appraisal. iii Payback This is simply the number of years required completely to return the investment made. This can be done in either discounted or undiscounted terms. A payback period in undiscounted terms of over 5 years would not normally be regarded as very satisfactory Payback is clearly a broader measure than either NPV or IRR. It can provide useful supporting indications, and help in ranking options if NPV results are close. Except for very low value schemes, however, it should not be used by itself in a decision rule. iv Other Approaches There are several other methods which are not obligatory in the University but which nevertheless may occasionally be useful. These include: a. Equivalent Annual Cost or annuitised value calculations. This involves calculating the annualised value of a cash flow. For example, with a discount rate of 8%, a sum of 100 now is equivalent to 10 annual payments of 14.90, the first a year from now, since these 10 annual payments have a total present value of 100. This approach can sometimes be useful in comparing options with significantly different lifetimes. b. Probabilistic Assessment. There are various approaches to this. It can involve, for example, ascribing probabilities to various factors within options and applying the resultant overall probability to the NVP for the option concerned. This however assumes that probabilities can be assessed with a high degree of accuracy. When this is not the case (ie for factors which cannot be actuarially assessed, usually), probabilistic approaches introduce another range of uncertainty which can be difficult for those assessing a project to understand.

5 A proper sensitivity analysis is generally a better approach, particularly where commercial considerations are involved Non-Quantifiable Factors Most options will have factors which do not at first sight appear quantifiable. However, it should not be assumed too readily that this is in fact the case. For example, changes in staff efficiency and training requirements may be compared by calculating staff costs involved (although these should not normally be classed as benefits in an investment appraisal because marginal changes in staff costs are not likely to equate directly into additional revenue streams) An alternative approach to apparent non-quantifiability is to seek at least consistency of method between options by introducing a ranking system to assessment of the factors. The Treasury guidance on investment appraisal contains some useful outline guidance on how this might be done. While these approaches inevitably involve a measure of subjective judgement, they do at least make it easier to follow what those judgements are, and, at best, provide a structure to help the appraisers themselves to understand more clearly the basis for, and implications of, the judgements they are making. This approach will clearly not be appropriate in every case. However, where non-quantifiables play a significant part in choice between options, a weighting and scoring system as described In the Treasury guidance should be used Sensitivity Analysis Sensitivity analysis is a critical part of any appraisal: indeed, a recommendation based on an appraisal without such an analysis (or an inadequate one)( is of very limited value and is likely to be rejected. This aspect must therefore be seen as an integral part of the appraisal process and given adequate priority and attention An appraisal must take account of uncertainties in the estimates of costs and benefits. As a minimum for schemes above 500K, this should involve examination of best and worst case scenarios, assessing probabilities within these scenarios for all front-runner options. Derivation of these best and worst cases should be based as far as possible on a proper assessment of the risks surrounding the project. This includes not only timing and technical risks within the scheme itself, but also factors which may affect the underlying market or other assumptions made in the cases. It is not acceptable to base the analysis on an arbitrary assumption of, for example, an x% drop in income with no attempt to assess the probability that the drop will actually happen. Where practicable, this assessment should be based on past experience (e.g. track record in building similar facilities to time and cost, or experience in a particular market area) Advice and Assistance Advice on, or assistance in carrying out, investment appraisals is available from the Director of Finance & Corporate Services.