Practical Techniques for Effective Project Investment Appraisal

P

PRACTICAL TECHNIQUES FOR EFFECTIVE PROJECT INVESTMENT APPRAISAL

Ralph Tiffin

IFC

A Hawksmere Report

PRACTICAL TECHNIQUES FOR EFFECTIVE PROJECT INVESTMENT APPRAISAL

Ralph Tiffin

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The author Ralph Tiffin is a chartered accountant and has also practiced as a mechanical engineer. Ralph runs his own accountancy practice which has a wide range of successful businesses as clients. The practice has a respected reputation as management and training consultants. Ralph is an expert in the area of project and capital expenditure appraisal and consultant to a range of international businesses from power and telecom utilities, to oil companies, food and paper manufacturing companies and banks. Assignments typically focus on reviewing and developing company’s appraisal processes. He is in demand as an experienced lecturer and regularly presents technical update courses for the Institute of Chartered Accountants of Scotland, the Institution of Chemical Engineers and other professional and commercial organisations.

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Contents

INTRODUCTION ................................................................... 1

1

REVIEW OF BASICS

Non discounted methods .........................................................................4 Discounting cash flows – arithmetic of appraisal ....................................6 Discounted cash flow measures ............................................................12 Review of preparation of cash flow forecasts .......................................16

2

RATES/INFLATION/TAXATION AND OTHER ISSUES

What is meant by ‘rate’? ........................................................................26 Calculating weighted average cost of capital (WACC) ...........................28 The effect of high interest or discount rates .........................................30 How to deal with inflation ....................................................................31 Accounting for taxation .........................................................................36 Dealing with the costs of overheads ......................................................40 Inclusion of spurious costs ....................................................................40 Including or omitting sunk costs ...........................................................41 Opportunity costs ..................................................................................42 Cost of assets with infinite lives ............................................................43 Grants ....................................................................................................43

3

OTHER MEASURES

Commonly used measures .....................................................................46 Misunderstanding of NPV ......................................................................46 Other measures .....................................................................................48 Present cost ...........................................................................................48 Annual worth .........................................................................................50 Future worth ..........................................................................................52 Profitability index – benefit/cost ratio ...................................................56 Cost-benefit analysis ..............................................................................57 Appraising entire projects and businesses – discounting cash flows as measures of performance .............................58 Life cycle costing ...................................................................................60

4

RISK MANAGEMENT THROUGH SENSITIVITY ANALYSIS

Introduction – risk management ...........................................................72 The need for the most likely case .........................................................74 No need for provisions or contingencies ..............................................74 ‘One at a time’ approach .......................................................................74 What is meant by ‘sensitive’? .................................................................77 Sensitivity due to inflation or deflation .................................................81 Analysis of price and volume changes ...................................................85 Why carry out sensitivity analyses? .......................................................87 Identify the risky parameters and tie them down .................................88

5

NEED FOR CONSISTENCY IN METHODS AND MEASURES

Investment and project appraisal review process ................................94 Project appraisal – a more thorough, integrated approach ...................97 Examples from practice are the best guide .........................................100 Investment/project appraisal process audit ........................................106 Need for appraisal process guidelines (or instructions) ......................108 Example – RST plc ...............................................................................108 Definition of rates where more than one hurdle rate is considered appropriate .................................................112

6

ACCOUNTING FOR INTANGIBLE BENEFITS

Introduction – what are intangible benefits (or costs)? .......................118 Defining/measuring intangible benefits ..............................................119 Valuing benefits – valuation methods ..................................................120 Some fundamental issues .....................................................................121 The criterion of human welfare ...........................................................121 Valuation methods ...............................................................................123 Sources of data .....................................................................................129 Choosing a method of valuation ..........................................................130 Consideration of other intangible benefits or costs ............................131 Summary – the need for a process ......................................................131 Refinery cost-benefit analysis ..............................................................133

7

LENDERS’ VIEWS OF PROJECTS AND OTHER ISSUES

Understanding lenders’ criteria ...........................................................140 Project appraisal from the lender’s perspective ..................................140 Project finance .....................................................................................144 PFI accounting requirements ..............................................................145 Accounting for probabilities ................................................................155 If probabilities of cash flows are to be considered then expertise is required ....................................................................158 Appraisal process used to assist with negotiating ...............................158 Impairment reviews – valuation of intangibles ...................................161

Introduction This Report has the following aims: •

To review the techniques and measures commonly used when appraising project and capital expenditure

•

To review developments of conventional measures, discussing the pros and cons of such developments

•

To highlight the importance of all parties involved in appraisals understanding the significance of interest rates, costs of capital and the effects of inflation

•

To give examples of good practice with regard to the existence and rigorous application of sound appraisal methods

•

To demonstrate the need for straightforward, but thorough sensitivity analyses – proper sensitivity analyses lead to true risk management

•

To consider measures and models which may be used to appraise other situations which will become more and more topical especially those where there is environmental impact and cost-benefit analyses are required

•

To review how lenders perceive investment and summarise the form of PFI (Private Finance Initiative) ventures and projects.

The subject of discounted cash flows (DCF) is covered in many areas of study. Obviously by accountants, but also engineers and managers studying for MBA’s etc. Many companies carry out some form of DCF appraisals with a greater or lesser degree of competence and consistency. Many appraisal methods and the measures used will yield reasonable answers and thus the correct decisions on investment will have been made. However there is much poor practice, both as to the approach and in the execution of appraisals. It is hoped that this Report will indicate the (simple) techniques and measures which if methodically and consistently adopted will give rise to sound appraisals. Many problem areas encountered when carrying out appraisals are more apparent than real and it is also hoped that the comments made along with the summaries and conclusions on issues will form the basis for debate within organisations as to what are the most appropriate rates, approaches, methods and measures for a particular company to apply. There are many instances where the authors opinions are given or at least hinted at, particularly when considering the life cycle of infrastructure projects. Some readers will agree with the views and others disagree. The point is that many invest-

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ment decisions are, to use the over used words, highly strategic (and political!) Those appraising ought to discuss and set out their businesses views on exactly what strategies are being followed. The word ‘project’ is frequently used throughout the text. Project is possibly an over used word today but it can cover situations from simple expenditure on capital asset – a tangible fixed asset, through to expenditure on a complete business venture – a project! Such expenditure could include the purchase of tangible fixed assets as well as the funding of initial working capital required to get the project underway. The text contains many examples of appraisal process and spreadsheets. These are in different styles. Consistency in layout and format of examples in a text may be desirable, but it is felt it will be helpful for the reader to have as many approaches as possible. Hopefully some of these, though simple teaching examples, may appeal to the reader as being of practical use in their businesses. It is accepted that accountants who are involved in appraisals for businesses day-by-day will have examples which exceed some of the outlines given – for them it is hoped that there may at least be some new nuances as to content and layout which will even further improve their appraisals. To aid clarity no currency units (£’s) have been used. One reason is that it is very likely that appraisals will be carried out by readers in many different currencies. This does mean that the reader will have to distinguish between arithmetical discount factors and cash flows which are in money terms. It is felt that this is a useful discipline to develop as the very word ‘value’ with say a £ sign against the number often leads even those close to the subject to think that the number of £’s is an answer. Appraisal is about amounts (of money) on paper and decision making is about being happy or not with the relevant amount – spreadsheets with figures seldom give the answer.

2

Review of basics NON DISCOUNTED METHODS DISCOUNTING CASH FLOWS – ARITHMETIC OF APPRAISAL DISCOUNTED CASH FLOW MEASURES R E V I E W O F P R E PA R AT I O N O F C A S H F L O W F O R E C A S T S

chapter

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Chapter 1: Review of basics

Non discounted methods Accounting rate of return This is the ratio of the year by year accounting profit of a business divided by the capital employed or invested in the business and used to generate the profit. It is a measure of year by year past performance. If accounting profit is consistently calculated then the figure for accounting rate of return (also known as return on capital employed or return on investment) is useful as a measure of historic performance. It is not an acceptable appraisal measure as it only assesses one year of accounting profit and does not take account of the time value of money.

Payback The payback period for a project is the length of time (normally years) required for the initial outlay on the project to be repaid from the annual cash inflows of the project. Payback = Initial outlay Annual cash inflows

Example An energy system requires an initial outlay of 50,000. When installed, this should give savings in electricity costs of 25,000 each year. What is the payback period? Payback = 50,000

= 2 years

25,000 If cash inflows vary year to year then the payback date is more easily found using a spreadsheet.

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Thus payback is simple to calculate and easily understood. Where investments or projects clearly give high returns then payback may be an acceptable measure. Payback does however have two fundamental flaws: 1.

No account is taken of the fact that later cash flows are worth less in today’s terms compared with earlier cash flows and no account is taken of the time value of money.

2.

No account is taken of the cash flows received after the date of payback. e.g. calculate the payback for Projects A and B.


    
                             







   





If payback were the selection criterion, Project A would be chosen. This, however, takes no account of cash flows after the payback date. Project B will give a higher return over the five year life of the project.

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Conclusion Whilst payback is easy to calculate and comprehend it is too simplistic a measure. It takes no account of the time value of money (but see discounted payback – chapter 7) and more significantly does not take account of cash flows after the date of payback – it therefore discriminates against longer term projects. It may be of help where risk has to be avoided and may also be of use when ranking alternatives. If the reasons for appraising expenditure are primarily to ration cash and ensure as risk free as possible investment then using payback as the appraisal measure may be acceptable.

Discounting cash flows – arithmetic of appraisal The worth, value or cost of a project depends on two variables: •

the actual amounts of cash received or paid, and

•

the timing of the receipts or payments.

Appraisal involves estimating both the future amounts and the timing of the amounts. This is the difficult part of capital expenditure budgeting or project appraisal, the arithmetic is simple.

Time value of money The timing of receipts or payments is important because an amount of money received today is worth more than the same amount received later in time. If you were offered 1,000 now or 1,000 in one year’s time you would obviously take the money today. However, what if you were offered 1,000 today or 1,800 in one year’s time which would you chose? Firstly there is a cost of money, the so called time value of money. Money never comes free – it is a commodity (really a means of trading in other commodities) and thus in managed economies has an appropriate scarcity value. If there was no inflation in economies the ‘real’ cost of money (the real interest rate) might be 4 or 5 per cent. For practical business purposes the rate required will be the bank borrowing rate as an absolute minimum or more likely the opportunity cost of money – equal or greater than the cost of capital of the company. In simple terms the cost of capital of a business is the weighted average of the rate of return required by shareholders and lenders. For the remainder of this chapter we shall use typical UK or US required rates of 12 to 20 per cent.

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Returning to the above example, if you could invest the 1,000 today to give a rate of return of say 15% then it would be worthwhile to wait for the 1,800. The 1,000 today would only be worth 1,150 in a year’s time at the 15% rate of return. However there is also the question of risk and it might be better to accept the 1,000 today rather than hold out for the 1,800 – a bird in the hand…! The concept of early certainty of cash flows in and out underlies well known points on the importance of managing project and loan risk – get the money back quickly!

Compounding and discounting The time value of money is accounted for by the simple concept of compounding interest. There is a rate required, this can be the interest rate on a loan or the cost of capital of the company. If the calculations are concerned with discounting then strictly speaking the term discount rate should be used. The point is that there is a time value or rate for money, whatever it may be called. Compounded amounts increase in a geometric progression – at the end of a period – normally a year – 1 becomes 1 + the interest rate. With a rate of 12% 1 becomes 1.12. This is then the base sum on which interest is calculated for the second year. The sum at the end of the second year = 1.12 x 1.12 = 1.2544 and so on. Discounted future amounts are decreased by a similar progression. Discounting is the inverse of compounding.

Example The table below shows the progression in compounding or discounting over five years:

rate =

12%

for one currency unit:-



 


(future amount, worth or value)


  


(present amount, worth or value)

Year 0

1.000

1.000

1

1.120

0.893

2

1.254

0.797

3

1.405

0.712

4

1.574

0.636

5

1.762

0.567

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Tables of compound and discount factors exist, but it is easier to obtain the factors from a spreadsheet calculation as above. These factors form an integral part of an appraisal model. The formulae and notation are as follows: Required/interest/discount rate

r or i

Number of years or periods

y or n

Future amount, worth or value

F

Present amount, worth or value

P

the compound factor = (1+r) ^n ^ is the symbol for ‘to the power’, upper case on the key for 6 on the keyboard. the discount factor = 1/(1+r) ^n or (1+r) ^-n In the spreadsheet below the formulae are ‘locked’ with the $ signs to the year column and the interest rate cell. This means that when entered in one appropriate cell the formulae may simply be copied down to give all the required years’ factors.

 ! " # $ % & '    !

) rate =

*

+

,

-

0.12

compounded amount

discounted amount

Year 0

=(1+$B$1)^$A6

1

=(1+$B$1)^$A7

=(1+$B$1)^-$A6 =(1+$B$1)^-$A7

2

=(1+$B$1)^$A8

=(1+$B$1)^-$A8

3

=(1+$B$1)^$A9

=(1+$B$1)^-$A9

4

=(1+$B$1)^$A10

=(1+$B$1)^-$A10

5

=(1+$B$1)^$A11

=(1+$B$1)^-$A11

Time base The convention used when dealing with cash flows is to assume that costs will be incurred at the earliest time and income will not arise until the end of a period. This is the concept of prudence in operation and is adopted in most appraisals.

The simple truths from the tables Although made redundant by spreadsheet functions or the use of appropriate formulae (the preferred option as shown above) it is worth reviewing the six basic

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tables to appreciate the simple business truths which arise out of the effect of the ‘time value of money’. Table1 - compound factors the future amount of a single present amount at rate r in year n F = P*(1+r)^n rates - - - year 1% 5% 10% 15% 20% 30% 0 1.000 1.000 1.000 1.000 1.000 1.000 1 1.010 1.050 1.100 1.150 1.200 1.300 2 1.020 1.103 1.210 1.323 1.440 1.690 3 1.030 1.158 1.331 1.521 1.728 2.197 4 1.041 1.216 1.464 1.749 2.074 2.856 5 1.051 1.276 1.611 2.011 2.488 3.713 10 1.105 1.629 2.594 4.046 6.192 13.786 15 1.161 2.079 4.177 8.137 15.407 51.186 20 1.220 2.653 6.727 16.367 38.338 190.050 30 1.348 4.322 17.449 66.212 237.376 2,620 50 1.645 11.467 117.391 1,083.657 9,100.438 497,929

50% 1.000 1.500 2.250 3.375 5.063 7.594 57.665 437.894 3325.257 191,751 6.38E+08

Table 1 shows what an amount invested now (time zero) will be worth at a time in the future, assuming a constant annual rate. This is the basic compound interest table and the arithmetic of this underlies all the other tables and representations of the ‘time value of money’. Table 2 - discount factors the present worth of a single future amount at rate r in year n P = F*(1+r)^^ - n rates - - - year 1% 5% 10% 15% 20% 30% 0 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1 0.9901 0.9524 0.9091 0.8696 0.8333 0.7692 2 0.9803 0.9070 0.8264 0.7561 0.6944 0.5917 3 0.9706 0.8638 0.7513 0.6575 0.5787 0.4552 4 0.9610 0.8227 0.6830 0.5718 0.4823 0.3501 5 0.9515 0.7835 0.6209 0.4972 0.4019 0.2693 10 0.9053 0.6139 0.3855 0.2472 0.1615 0.0725 15 0.8613 0.4810 0.2394 0.1229 0.0649 0.0195 20 0.8195 0.3769 0.1486 0.0611 0.0261 0.0053 30 0.7419 0.2314 0.0573 0.0151 0.0042 0.0004 50 0.6080 0.0872 0.0085 0.0009 0.0001 0.0000

50% 1.0000 0.6667 0.4444 0.2963 0.1975 0.1317 0.0173 0.0023 0.0003 0.0000 0.0000

Table 2 factors are those used in typical cash flow discounting – discount factors. These factors are simply the inverse of those found in table 1 – there is only one base table! Although redundant in practice the point which the table reveals very clearly is that with high interest rates – over 10% and periods over 10 years the future value of inflows or outflows, are in today’s terms worth little – this answers the often asked question ‘over what period should we appraise’ – the answer is 10 years or in fact possibly just 5. If a project does not ‘work’ in 5 years it never will!

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The above logic does not hold true where costs or inflows rise very rapidly after 5 or ten years and the importance of appreciating this in long-term appraisals is considered further in chapter 4. The table also affirms the point that banks will not lend for general business activities (projects) over periods in excess of 7 or 10 years – the further away the repayments the lower their worth today and the higher the risk.

Table 3 is simply an additive version of table 1. That is the future amount arising from equal annual amounts. This is the life assurance salesman’s dream table – look at how the amounts factor up at say 15% over 30 years! What might not be explained is that the 15% is a nominal rate (including an inflation element) and the real ‘economic’ rate of return might be nearer 5% – not nearly so impressive. The factors in this table, if used at all today, are really concerned with the future worth of investment rather than related to project appraisal.

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Table 4 is simply an additive version of table 2. That is the present amount arising from equal annual amounts. This table was used in the past as a matter of convenience – you did not have to discount a series of equal cash flows year by year. The table clearly highlights the point raised in table 2 that for rates above 10% and periods over 10 years it really does not matter how cash flows change – the factors are converging towards a fixed number. Table 5 - annualising factors for a future amount the series of averaged annual amounts of a future amount at a rate r over n years Af = F*r/((1+r)^n-1) rates - - - year 1% 5% 10% 15% 20% 30% 1 1.000 1.000 1.000 1.000 1.000 1.000 2 0.498 0.488 0.476 0.465 0.455 0.435 3 0.330 0.317 0.302 0.288 0.275 0.251 4 0.246 0.232 0.215 0.200 0.186 0.162 5 0.196 0.181 0.164 0.148 0.134 0.111 10 0.096 0.080 0.063 0.049 0.039 0.023 15 0.062 0.046 0.031 0.021 0.014 0.006 20 0.045 0.030 0.017 0.010 0.005 0.002 30 0.029 0.015 0.006 0.002 0.001 0.000 50 0.016 0.005 0.001 0.000 0.000 0.000

50% 1.000 0.400 0.211 0.123 0.076 0.009 0.001 0.000 0.000 0.000

Table 5 shows the equal sums of money which would have to be deposited at the end of each of n years to give a final future sum. This table reveals the amounts which would need to be put aside to fund an endowment mortgage or required to accumulate a desired pension fund. The amounts will be generally lower than expected as long as the funds earn a good rate of return. A problem of course is that the future sum is in the terms of a future ‘currency’ and if there has been considerable inflation over the period of investment the actual purchasing power of each currency unit will not be what it is if expressed in today’s terms – this point may not be laboured by financial advisers trying to sell pension products!! Table 6 - annualising factors for present amounts the average annual amounts over n years equivalent to a present amount at rate r over n years Ap = P*(r*(1+r)^n)/((1+r)^n -1) rates - - - year 1% 5% 10% 15% 20% 1 1.0100 1.0500 1.1000 1.1500 1.2000 2 0.5075 0.5378 0.5762 0.6151 0.6545 3 0.3400 0.3672 0.4021 0.4380 0.4747 4 0.2563 0.2820 0.3155 0.3503 0.3863 5 0.2060 0.2310 0.2638 0.2983 0.3344 10 0.1056 0.1295 0.1627 0.1993 0.2385 15 0.0721 0.0963 0.1315 0.1710 0.2139 20 0.0554 0.0802 0.1175 0.1598 0.2054 30 0.0387 0.0651 0.1061 0.1523 0.2008 50 0.0255 0.0548 0.1009 0.1501 0.2000

30% 1.3000 0.7348 0.5506 0.4616 0.4106 0.3235 0.3060 0.3016 0.3001 0.3000

50% 1.5000 0.9000 0.7105 0.6231 0.5758 0.5088 0.5011 0.5002 0.5000 0.5000

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Table 6 shows the averaged, equal amounts required to repay a present sum over n years. It is a mortgage repayment table. A point to note that over a sufficiently long period – 20 years plus, the interest rate is the significant element – the repayment of the original capital is insignificant. This does not mean you can borrow as much as you like – you still have to pay the interest on the capital borrowed! For detailed appraisals it is possible to use periods of less than a year. In such cases the factors can be calculated using the formula: rp = (1+ra)^1/p -1 where: rp = the rate for the period, p = the number of periods in the year and ra = the given annual rate.

Discounted cash flow measures Both accounting rate of return and payback are too simplistic in approach and a fundamental weakness in both methods is the fact that they ignore the effect of the timing of investment outflows and related inflows.

Net present value (NPV) or present worth This is defined as the present value of discounted inflows less discounted outflows. If the NPV > 0 at the required interest rate then the project may be accepted. If the NPV < 0 at the required interest rate then the project should be rejected. Using the same sample figures as for the calculation of payback the NPV can be calculated as follows: rate =

12% cashflows:discount

cash

cash

factor

out

in

net

a

b

c

0

1.000

-9,000

1

0.893

1,000

1,000

893

2

0.797

3,000

3,000

2,392

3

0.712

5,000

5,000

3,559

4

0.636

5,000

5,000

3,178

5

0.567

4,000

4,000

2,270

cash flow

discounted cash flows

d

e = a x d

-9,000

-9,000

Year

net present amount or value - NPV = (the sum of column e)

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Internal Rate of Return (IRR) or DCF yield The internal rate of return is calculated as being the rate at which the NPV of a project is zero. This is found by trial and error. If the IRR > the required rate then the project may be accepted. If the IRR < the required rate then the project should be rejected. Again using the same sample data as for payback and NPV the IRR can be found by increasing the required rate to 23.38% at which rate the NPV is exactly zero. A higher required or discount rate would cause the NPV to be negative. rate =







          cashflows:-

discount

cash

cash

factor

out

in

net

a

b

c

0

1.000

-9,000

1

0.811

1,000

1,000

811

2

0.657

3,000

3,000

1,971

3

0.532

5,000

5,000

2,662

4

0.432

5,000

5,000

2,158

5

0.350

4,000

4,000

1,399

cash flow

discounted cash flows

d

e = a x d

-9,000

-9,000

Year

net present amount or value - NPV =



(the sum of column e)

NPV or IRR – which should be used? If a project is viable then it is likely that both NPV and IRR will meet a company’s appraisal hurdles. Also when choosing between two or more projects unless the profile of cash flows is quite different – in other words the projects are of quite different natures then NPV or IRR analysis will indicate the same choice. One way of summing up the message revealed by NPV is to say that at the required rate if NPV is positive then the project will satisfy the company’s criteria. NPV analysis is for ‘committed’ investors – ones who wish to be or get into a particular business and who require a certain minimum return – higher if possible! IRR could be summed up as the measure for ‘disinterested’ investors – that is investors with no particular attachment to a specific type of investment or strategy apart from maximising the company’s rate of return. Generally, worldwide, companies use IRR in preference to NPV. Are they all disinterested investors? Maybe to the extent that they do not focus on one or more restricted types of investment and business activity and settle for some desired rate. They rather look to maximise return – maximise shareholder value.

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The following example indicates that even at the level of an individual project the nature of the business should be considered when selecting the more appropriate measure between NPV and IRR

Selecting marketing strategies NPV or IRR?

Example A new pension product is to be launched in 2 years’ time and there are two distinct marketing strategies. One is to have a campaign commencing now with 30,000 spent in the two years preceding the launch. It is considered that this will establish a longer-term market for the product. The other option is to spend 55,000 on one large advertising campaign. This should give higher initial sales, although it is thought likely that this will have much less impact on longer-term sales. The cash flows for the two options are as follows: Year

Strategy P

Strategy Q

0

-30,000

0

1

-30,000

-55,000

2

25,000

40,000

3

20,000

20,000

4

20,000

15,000

5

20,000

1,000

6

20,000

1,000

The manager proposing strategy Q has calculated the IRR for both strategies and is convinced that, as his strategy has the higher IRR of 22.4% compared to that of strategy P of 18.8%, his strategy should be followed. If the company’s required rate of return is 12%, is he correct in his analysis?

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Marketing strategies

 







   

    
 


























 





























 









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!



!

 

To the extent that the IRR is higher for Q the manager proposing that product is correct. However at the company’s required rate of return of 12% then strategy P gives a higher NPV. Strategy P has more cash inflows over its life. The above assumes that the figures are reliable. The reason that Q has the higher IRR is of course that the cash flow out is later and the inflows are larger earlier, though they do tale off. Strategy P requires more investment over a longer period before results are obtained. the inflows however are apparently more stable once established.

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The question which should be asked is ‘is the product a ‘fashion’ product or a necessity?’. If short-term, fashion related in nature then strategy Q, relying on IRR should be chosen. If the product is a basic, continuing product then strategy P using NPV as the measure, should be chosen. IRR is extensively used and will satisfactorily assist in identifying those investments and projects which give the highest returns. The potential conflict between IRR and NPV identified above will only occur where two or more projects have quite different cash flow profiles. Is this likely within most businesses?

Difficulties in using IRR Another issue with IRR of which much is made in theoretical text books, is that with some cash flow profiles there is no unique IRR, you get two or more IRR’s. This will only occur where cash flows change sign more than once. For example this could occur where city centre land is purchased (an outflow), the empty site is operated as a car park (inflows), a hotel is built (outflows), the hotel operates (inflows). If there are more than two IRR’s then a simple and valid enough solution is to combine small flows with large ones of the opposite sign. In the example above the income for say a couple of years from operation as a car park could be compounded forward (at a reasonable rate) and the resultant future sum netted against the cost of constructing the hotel. With the relative size of the figures in and short time scale of the adjustment, the IRR so determined will be a reliable figure.

Review of preparation of cash flow forecasts A cash flow forecast is a budget. As for any budgeting exercise, there is a need for clear objectives. For projects, this must mean a clear specification of the project both technically and financially. The following are required to produce the cash flow forecast:

16

•

capital cost of the project, that is, the initial and any recurring outlays on tangible fixed assets – buildings, plant, equipment and vehicles

•

amount of working capital required to cover payments in advance, stockholding, debtors, etc

•

knowledge of inflows – income or sales budget, or cost savings

•

knowledge of cost of sales or manufacture

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•

knowledge of the headings and likely costs of other direct expenses, e.g. fuel costs

•

knowledge of any increase in indirect costs or overheads

•

knowledge of the TIMING of receipts and payments.

BASICS

It is often the last factor which causes problems in accurately determining cash requirements. The assembly of figures is essential but equally a cash flow forecast used as a basis of appraisal must set out the reasons for the capital expenditure or project for which the cash is required. Most importantly of all the sources of data from which the cash flow forecast is prepared and any assumptions made should be stated.

Underlying assumptions All assumptions must be known and, in preparing and presenting a cash flow forecast, all significant assumptions should be clearly stated.

Inflows Sales in total must be forecast. The source of the data should be indicated. Is the forecast based on past or similar experience of the business or is it based on market research? It is often the case with sales forecasts that at least an optimistic and a pessimistic forecast are given. This is necessary for sensitivity analysis. The basis of splitting cash and debtor sales should be determined. The type of business and competitors’ credit granting policies often determine the split. The timing of debtors paying will relate to the terms of trade and the effectiveness of credit control.

Other income If there is sundry income from, say, sub-letting a site, this should be estimated and shown in the appropriate time period. Scrap and miscellaneous sales may be relevant.

Cost savings The reasons for the savings in cost should be stated and the data which supports the calculation of the savings supplied. If at all possible, the data should be from an independent source.

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Outflows

Materials/sub contract These costs should ideally be based on firm quotes but the level of accuracy in arriving at the figure will depend on the stage of the appraisal process.

Labour This will be based on staff levels/pay rates. Not all of a month’s gross pay may have to be paid over in the month, e.g. taxes and pensions may be payable in the following month or at the end of the year.

Overheads Unless cash payments have to be made for additional overheads incurred as a result of the project, cash flows should not include a proportion of a company’s general overheads (see chapter 2 for further consideration of this issue).

Common errors which are made are as follows:

Depreciation costs are included This is quite wrong as these costs are not cash costs and in any event if depreciation was included there would be double counting. The cash flow relating to the asset is the cash expenditure on the asset at the time of purchase. Depreciation is the accounting exercise of spreading or matching the cost of the asset consumed over its useful working life.

Interest and loan repayment are included Again this is quite wrong as the exercise of discounting the cash flows over the life of the asset or project at the required rate takes account of the cost of money and will indicate whether or nor there will be cash available to cover loan interest and capital repayments.

Sunk and opportunity costs It is often the case that if a project is sanctioned then there will have been costs incurred in the past which benefit the project now being considered. These are sunk costs and have no relevance to the appraisal. Also the sanctioning of a project may give rise to a loss of income or costs to be incurred elsewhere – these costs may be relevant. The simple test to challenge anyone who wants to bring in sunk or opportunity costs is to ask the question ‘do we have to spend cash or are we denying ourselves cash as a result of proceeding with this project?’.

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Illustration of cash flow forecasting

Example Set out below is an illustration of the preparation of a cash flow forecast to be used for appraisal purposes. A food business has expanded rapidly with 9 outlets opened and a further 20 planned. It is considered more economical and reliable if a central food preparation facility is opened. The cost of the factory building and equipment can be financed by a 7 year loan from the company’s bank. A cash flow forecast is to be prepared for the first year of operation to identify whether or not any additional working capital will be required and as a basis for a full screening appraisal.

One year operating cash flow forecast CASE STUDY - PROPOSED CENTRAL PRODUCTION FACILITY

Cash flow forecast for the year to 31 December 1999 

  

  

  

  

  

 

 

 

 

214,200 91,200

    

    

    

    

 

 

 

 

total outflows









net cash flow









44,400 27,600 4,800 8,400 105,600 0 45,996 140,004 0 0 0 682,200 0 67,800




















   

   
 


total inflows

45,000

59,000



45,000



Total




Inflows

87,000

750,000

Outflows

production 
 
 
 

occupation


  
  

  !



 
  "

#

finance

   "
$  
  "
$ 

capital

%! #

&!" 

%! '
#

cumulative c/fwd

In the illustration above months February to September have been hidden.

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As can be seen there is a seasonality to the sales. Most other costs are considered fixed. Loan interest and capital repayments have been included as these must be paid. The initial capital costs have been excluded as this cash flow is for one typical year of operation.

Preparing cash flow forecasts The three groups of data which have to be collected if a cash flow forecast is to be prepared are: •

inflow data –

•

sales

outflow data –

capital costs

–

operating costs.

Note the distinction between an operating cash flow and an appraisal cash flow. The operating cash flow has also to take account of inflows and outflows related to financing, that is loans received, loan repayments and interest payments. The appraisal cash flow is only concerned with outflow and inflows from the project – not the cash flows related to the loans – this is really a separate project. In this example you would exclude the cost of finance (interest charges) and the loan receipts and repayments from the year’s operating cash flow. These will be accounted for in the DCF appraisal calculation. However, it is necessary to cashflow the expected operating cashflows including interest and loan payments as whilst a project might be viable over its life, the timing of loan repayments and interest payments demanded by the bank may not be tolerable in the early stages of a project’s life (this issue is discussed further in chapter 7).

Inflow data sales In this example the sales figures are likely to be quite reliable as 9 out of the proposed 29 outlets are operating and presumably there are records of their sales and thus their purchases which form the basis of sales for this factory project.

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Outflows – operating costs – completeness of headings We will assume that this is a completely new venture for the business concerned and they do not have experience in operating a factory. How do you ensure that all cost headings and thus all costs are included in the cashflow? It may be that new staff who have experience of the industry have to be recruited. Expertise can be purchased from consultants. Whatever experience is available good practice is to brainstorm and try and think of every conceivable cost heading which may be relevant. This will be easier if there is a team of people to be involved in the appraising of the project. It may be that a team should be brought together to do the brainstorming on cost headings as well as tackle the other aspects of cash flow preparation and appraisal review set out opposite.

Example A list of obvious factory operating costs: •

employee costs

•

depreciation of building and equipment – but this is not a cash cost!

•

maintenance costs – building and equipment

•

rates/local taxes

•

utilities – water/power

•

administration costs

•

less obvious factory costs: –

environmental compliance costs

–

health and safety costs

–

food hygiene costs.

These cost headings may be obvious to the reader and covered by one of the more general headings above. The point is that it is easy to miss cost headings and history would indicate that many projects have been undercosted not just due to poor estimating of the amount of costs, but rather due to the omission of the cost heading in the first place.

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Outflows – operating costs – estimating amounts Having identified the types of inflows and outflows the headings now have to have quantified amounts associated with them. What data is available to give reliable figures? Again brainstorming may reveal more sources of data than those already known. Estimates of both costs and income should aim to give the most likely, expected figures – there should be neither provisions nor contingencies – loading for pessimism – this can be dealt with when carrying out sensitivity analyses.

What is meant by the most likely figure? If a cost of a supply could be 5, 6, 7 8, or 9, (in the range 5 to 9) then it is unacceptable to enter 9 as the cost just because this is the (prudent) highest figure. Equally entering 5 would be careless. The estimator should look for evidence of which figure is likely to prevail during the period of the cash flow, for example if costs are considered to be stable or falling then a below average figure of 6 may be considered appropriate. If no evidence is available then a simple average figure of 7 should be used. The likelihood of the cashflow streams being higher can be reviewed by means of sensitivity analysis.

Timing/phasing and credit pattern From experience of the 9 operating units there is a distinct seasonality to the sales of the outlets and this will have a direct effect on the sales from the factory (the purchases of the outlets). However, as the cash flow is primarily being prepared for the appraisal of the project which will have an operating life of at least 10 years the monthly sales have been categorised as either high or low sales months giving rise to a higher and a lower half year sales pattern. The outlets will be expected to pay for their supplies within 30 days and with the level of detail being appraised there is no need to make further allowance for the credit given period – for the appraisal the income will be assumed to come in at the end of each six month study period to be used in the dcf appraisal.

Document the cashflow preparation The preparation of the cash flow forecast should be documented and this will form an integral part of the appraisal process as described in chapter 5.

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Checklist Cash flow forecast preparation A checklist of the matters to be considered when preparing a cash flow forecast to be use for appraisal purposes: Figures

Are figures the ‘best’ estimates?

Inflows

Can they be substantiated?

Is some research required?

Outflows

Ensure a complete list of headings

Estimate prudently – can the estimates be substantiated?

Timing

Is the phasing of the cash flows reliable?

Is there material seasonality or fluctuation which should be accommodated?

Headings

The cash flow forecast should contain only cash flows – e.g. no depreciation costs

Integrity

Does the cash flow add up?

Has it been tested?

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Checklist Basic appraisal measures A checklist of basic arithmetic, appraisal measures and their application. Payback is simple, easily understood, but too simple!

The time value of money means that cash flows after 10 years are of little consequence

NPV – too high an amount may be demanded

IRR does not consider scale of project cashflows only the return they make

More than one measure should be used

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Rates/inflation/taxation and other issues W H AT I S M E A N T B Y ‘ R AT E ’ ? C A L C U L AT I N G W E I G H T E D AV E R A G E C O S T O F C A P I TA L ( WA C C ) T H E E F F E C T O F H I G H I N T E R E S T O R D I S C O U N T R AT E S H O W T O D E A L W I T H I N F L AT I O N A C C O U N T I N G F O R TA X AT I O N DEALING WITH THE COSTS OF OVERHEADS INCLUSION OF SPURIOUS COSTS INCLUDING OR OMITTING SUNK COSTS OPPORTUNITY COSTS COST OF ASSETS WITH INFINITE LIVES GRANTS

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Chapter 2: Rates/inflation/taxation and other issues What is meant by ‘rate’? The arithmetic of appraisal requires the use of a ‘rate’, conventionally expressed as a percentage and used in discounting cash flows. The rate should be called the discount rate as the exercise is one of using the arithmetic of discounting future cash flows at the given discount rate to express the cash flows in comparable terms – today’s £’s, $’s or other currencies.

What (discount) rate should be used? Fundamental to all investment decisions is the rate used for discounting purposes. At a practical level many managers have to follow the company process and use the set company discount rate. Investment will be killed off by demanding too high a rate. There is much evidence especially in the UK that there has been a history of demanding very high rates of return with the result that there has been a lower level of investment in capital equipment and tangible assets in comparison with the rest of the world. But there is also the point that demonstrably successful companies in the US and the UK are those that live by demanding high rates of return from investment. They stick to demanding high rates (in comparison with the prevailing nominal money market rates) and deliver good returns to shareholders and also growth in the capital employed in the company. This increased capital employed also delivers the demanded high rate. Before answering the question of what rate to use or at least outlining the matters to consider when selecting an appropriate rate for a particular business or project it is important to consider other meanings and uses of the word ‘rate’.

Interest rate This is the rate normally associated with the cost of borrowing, typically a bank loan. The rate may be fixed or variable over the life or term of the borrowing.

Cost of capital (rate) In its simplest form this is the weighted average cost of capital (funding) of a business. An example is given on page 28. The average, weighted rate requires

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a knowledge of the cost of borrowing and cost of equity or shareholders’ funds. The cost of borrowing or loans will normally be quite clear – defined loan interest rates. The cost of equity may be more difficult to determine, but often markets will give an indication of what is expected.

Hurdle rate A rate chosen to ration the amount of cash expended in a specified period. The rate should obviously be higher than a businesses cost of capital or borrowing rates. The rate can be increased if too many projects meet a given hurdle rate. The rate thus has little to do with the cost of money to the business concerned or in a particular economy.

Real rate This is the hypothetical or theoretical cost of money excluding any compensation for the eroding effects of inflation.

Nominal rate This is the cost of money which includes an allowance for the effect of inflation and currency or other risks – it is the rates which would normally have to be paid to banks.

Required rate This is the preferred term when using rates for the arithmetic of appraisals. The word required implies that whilst this rate must be met there needs to be a definition of why the particular rate is required.

Examples of the need for definition are as follows: •

For a project financed from a businesses general sources of funds then the weighted average cost of capital would be appropriate.

•

For the selection of the best projects, ‘best’ meaning those projects which give the highest returns, then a hurdle rate would be appropriate.

•

For a project financed entirely by fixed rate borrowing – a fixed rate loan – then it would be (just) possible to use the loan interest rate as the required rate. There would of course be little margin for error.

In chapter 5 on the process of appraisal the examples clearly demonstrate that the word ‘rate’ must be defined.

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Calculating weighted average cost of capital (WACC) The simple example below demonstrates the principles. The business has 80,000 capital employed and is funded 70% by equity (share capital and retained profits) and 30% by borrowings (loans). In this simple example the cost of equity has been set at a rate of 18% and there is only one rate for the loan capital – 8%. There would more likely be a portfolio of loans and an average cost of loan capital would have to be calculated. The weighted averaging exercise yields a WACC of 15%. Logic dictates that if the capital employed in the business can yield a minimum of 15 % return then both the lenders and the equity investors will have their demanded returns met. Weighted Average Cost of Capital

cost of capital %

Funding Structure Share/Equity Capital

70%

56,000

18%

Loan Capital

30%

24,000

8%

100%

80,000

Total Capital Invested or Employed

annual cost of funding 10,080 1,920 total cost =

as a % of capital invested =

WACC

=

12,000 12,000 80,000 15%

There are of course many issues to consider, for example, effects of taxation, changes in interest rates and the effects of inflation or deflation. The simple arithmetic and thus logic of the WACC calculation will hold true. One obvious aspect of the model is that should borrowing increase relevant to equity (higher gearing) then there will be a lower WACC. Investments will not have to make such high returns, or more likely similar returns will be required from investments with the equity investors receiving even higher returns – their returns having been ‘geared up’. The spreadsheet on the next page shows the effect of higher percentage of borrowing. That is higher gearing, where gearing is defined as the ratio of loan capital to total capital invested (equity plus loan capital). Gearing % = loan capital equity + loan capital Gearing is now 80% as opposed to 30% in the example above. The WACC falls to 10% – as a greater proportion of the funding requires a lower return.

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Weighted Average Cost of Capital

AND

cost of capital %

Funding Structure

OTHER

annual cost of funding

Share/Equity Capital

20%

16,000

18%

2,880

Loan Capital

80%

64,000

8%

5,120

100%

80,000

Total Capital Invested or Employed

total cost = as a % of capital invested =

WACC

ISSUES

=

8,000 8,000 80,000 10%

The converse of arranging higher gearing which allows operating assets to yield a lower return, is to demand as high a possible return from assets but also have high gearing. With the figures given above if WACC is set at 15 % then the capital employed (invested in the business and projects) must deliver 15% minimum when operating. The effect on the return to equity investors is that they will gain an effective return of 43%. Weighted Average Cost of Capital

cost of capital %

Funding Structure

annual cost of funding

Share/Equity Capital

20%

16,000

43%

6,880

Loan Capital

80%

64,000

8%

5,120

100%

80,000

Total Capital Invested or Employed

total cost = as a % of capital invested =

WACC

=

12,000 12,000 80,000 15%

Having an optimum level of gearing is obviously important – the arithmetic suggests as near 100% as is possible! What is an appropriate level of gearing is a subject intrinsically tied to the cost of capital and about which there are many diverse views. In practice, lenders will often be the ones who dictate what is an acceptable (not too high) level of gearing. Due to the innate prudence of many business people it is often the case that both small through to large companies are not geared highly enough. An issue to consider is do the directors/managers have doubts about their ability to make and thereafter manage investments which will consistently yield the demanded returns? A recurring and topical issue is that it is not today’s cost of equity which is relevant (this can presumably be fairly accurately measured), but future cost of equity. What

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are shareholders’ expectations? If today’s (early 1999) markets are realistic then high returns are going to be required to satisfy the promised/expected ever increasing returns and dividends. But is this realistic? Many economists and otherwise clever business people seem to forget that laws of supply and demand still exist.

The effect of high interest or discount rates A matter of concern is the high cost of capital of companies and thus the rate used for discounting. Much has been made of the relatively high UK interest rates over the past few years and the fact that high required rates deter investment. This lack of investment in capital equipment or tangible (and intangible) fixed assets may be a fundamental reason for the UK’s relatively poor efficiency as reported in a recent (May 1998) McKinsey report. The striking difference in NPV of projects discounted at rates of 10% and 20% is revealed below. discount rate = year 0 1 2 3 4

10%

cash discount flow factor -96,000 1.0000 37,000 0.9091 37,000 0.8264 37,000 0.7513 37,000 0.6830 NPV=

discount rate = discounted cash flow -96,000 33,636 30,579 27,799 25,271 21,285

year 0 1 2 3 4

20%

cash discount flow factor -96,000 1.0000 37,000 0.8333 37,000 0.6944 37,000 0.5787 37,000 0.4823 NPV=

discounted cash flow -96,000 30,833 25,694 21,412 17,843 -217

One issue is that if a company is operating in an environment where required rates are 20% plus, then it ought to be possible to inflate future net cash inflows as there must be some inflation in the economy. Applying a constant inflation factor of 7% to the example discounted at 20% yields quite a different NPV. However the existence of inflation does not fully compensate for the effects of the much higher discount rate. discount rate = inflation rate = year 0 1 2 3 4

20% 7%

cash discount flow factor -96,000 1.0000 39,590 0.8333 42,361 0.6944 45,327 0.5787 48,499 0.4823 NPV=

30

discounted cash flow -96,000 32,992 29,418 26,231 23,389 16,029

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How to deal with inflation Is it intentional that most British appraisals are carried out with (high) nominal rates with no allowance made for the possibly beneficial effects of inflation? When there is an abundance of both money and high return projects then there is no reason to consider the probably beneficial effects of inflation. Projects with high returns will be selected using high nominal or hurdle rates. As the cost of finance is much less and any inflation increases the net inflows over the life of the project then the outcome will be much better than anticipated in the appraisal. However, there are many situations where investments are required for strategic purposes and the returns are marginal. It is in such situations – demanding too high a rate and not considering the effects of inflation (or deflation) – that either the wrong decision will be made or there will be no investment at all. When carrying out and reviewing an appraisal the effects of inflation (or deflation) are often an aspect which is misunderstood. Firstly it is important to understand the way in which words are defined by economists to define interest rates. A real rate is the hypothetical or theoretical cost of money. From research and analysis economists can tell us what the rate is and forecast what the rate might be in the future. It is the core cost of money, money never comes free! One way of understanding why there is a real cost of money, premium or interest rate to be paid on money, is to appreciate that money is a scarce resource. Money is used to trade in other scarce resources, such as oil, corn, cotton etc. There must be some premium attached to owning scarce assets including cash (where it is in a currency of a properly managed economy). Over the years one could look to Switzerland or Singapore to get an idea of what real rates are – these countries have strong, even now, currencies with low or zero inflation – the cost of money is of the order of 4%. A nominal rate is the actual rate which is charged by commercial banks and businesses – it is very real! – but that is not the sense in which ‘nominal’ is used by economists. In simple terms nominal rates can be found by taking the prevailing real rate (4% to 5%) and adding the current inflation rate for the country and currency concerned. The actual arithmetic is as follows: where:

for example:

rr = real rate

5%

ri = inflation rate

10%

the nominal rate = rn = nominal rate = (1+rr) x (1+ri) – 1 = (1.05 x 1.1) -1 = 15.5%

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A prevailing nominal rate will be based on this arithmetic, but will also be affected by other factors, for instance if the currency is perceived to be one which can fluctuate due to poor economic management of the country concerned. In this case there will be a risk premium added to the real rate as international lenders will demand some cover for the fact that they could lose out on say a sudden devaluation. Also the nominal rate can be affected by economic policy, for example the current generation of economists all seem to think that inflation is purely a monetary matter and can be controlled by managing interest rates – sending messages to the public and the markets. There is no doubt much in this, but is inflation not due to scarcity of commodities and services? There are also behavioural issues. The point is that in the UK today we have interest rates that are too high as the wise ones think they can bring inflation down solely by rationing cash. Investment or project appraisal can be carried out using real or nominal rates. The vast majority of commercial businesses worldwide carry out nominal rate analyses. The rates are those related to loans or the businesses cost of capital. Whilst an appraisal model is not a forecast of exactly how the project will ultimately be reported in a conventional financial accounting manner, the figures and amounts in the model should be realistic and give a view of how the project should turn out if approved. Traditionally government departments have carried out real rate analysis. Why? One can be cynical and say that the core reason is that treasuries, ministers and politicians do not want to have to consider or agree to any subjective assumptions, or even talk about inflation! The beauty of the real rate appraisal model is that you use a rate where cost and income streams are set in today’s terms, with no need to consider inflation. The real rates used by governments have typically been of the order of 6%-8% and for many years 8% was the UK norm. This always seemed rather high as the Government, acting as central bank could borrow at say 5% (sterling was not always perceived as an entirely stable currency and a risk premium had to be paid). Why then did the Treasury demand 8% returns for projects such as British Rail might undertake? Were these projects not in the public interest? It is interesting to note that it is only with the sale of many state businesses that commercial reality forced the Treasury to use lower rates when doing their sums! Considering the advantages and disadvantages of real and nominal rate analysis may help in understanding the issue of inflation when carrying out the more conventional and meaningful nominal rate analysis.

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Real rate analysis

Advantages Requires only a knowledge of today’s costs and inflows – inflation can be ignored and thus no opinions are required on subjective issues such as how cash flows might change due to inflation. Most importantly, if and it is a big if, the prevailing rate of inflation affects all cash flows equally and is the only constituent of the difference between real and nominal rates as discussed above, then there is no difference in the outcome of an analysis using either real discount rates or nominal discount rates with the relevant cash flows inflated at the appropriate rate. The spreadsheets below confirm that the view of those who advocate real analysis is held out. In the example below the simple cash flows for a 3 year period have been discounted at a real rate of 5%, at this (low) rate the NPV is 2,752. This has been entered in bold to remind us of the base position for the real rate analysis of this project. Interest rate Inflation rate Inflated Cash Flow Year 0 1 2 3

Cash Flow -10000 5000 5000 4000 4000

-10000 5000 5000 4000

5.00% 0.00% Discounted Cash Flow

Disc Factor 1.0000 0.9524 0.9070 0.8638 NPV =

-10000 4762 4535 3455 2752 2752

However if the same project is subjected to an analysis at a nominal rate of 15.5% then obviously the NPV will be much lower at 673.

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Interest rate Inflation rate Inflated Cash Flow Year 0 1 2 3

Cash Flow -10000 5000 5000 4000

-10000 5000 5000 4000

4000

APPRAISAL

15.50% 0.00% Discounted Cash Flow

Disc Factor 1.0000 0.8658 0.7496 0.6490 NPV =

-10000 4329 3748 2596 673 2752

If the simple links between nominal and real rates are assumed then the economy in which this project will operate has inflation running at 10% per year. where:

for example:

rr = real rate

5%

ri = inflation rate

10%

The formula above can be re-arranged from: the nominal rate rn = (1+rr) x (1+ri ) – 1 To yield the inflation rate, given the nominal and real rates: inflation rate ri = (1+rn) –1 (1+rr) inflation rate ri = 10% If inflation is expected to run at a constant 10% for the next three years then the inflows will increase by 10% year on year. This exactly compensates for the fact that the higher nominal rate of 15.5% was used. The 10% inflation was factored into the nominal rate.

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Interest rate Inflation rate Inflated Cash Flow Year 0 1 2 3

Cash Flow -10000 5000 5000 4000 4000

-10000 5500 6050 5324

AND

OTHER

ISSUES

15.50% 10.00% Discounted Cash Flow

Disc Factor 1.0000 0.8658 0.7496 0.6490 NPV =

-10000 4762 4535 3455 2752 2752

The arithmetic is sound and supports the argument that real rate analyses yield the same results as nominal analyses. This only stands if there is a direct link between real and nominal rates and more significantly all cash flows inflate at the same rate. The importance of considering differential rates of inflation is discussed further in chapter 4.

Disadvantages Not ‘real’ at all – an artificial exercise, but can be improved by taking account of differential rates of inflation. It can be argued that as these are only appraisal models, they are just numbers and quite rightly ‘value’ does not mean £’s or $’s worth. However the scale of the numbers is quite different from that which is likely to pertain in reality – why analyse ‘artificial’ numbers as these can give a quite misleading view.

Nominal rate analysis

Advantages Nominal analyses are done with a rate which is meant to be the return demanded or required by the shareholders. This nominal rate is normally considerably higher than the real rate plus the prevailing inflation rate. However the inflation rate is or at least has been the largest element of the difference between real and nominal rates. Nominal analyses are therefore carried out with realistic, meaningful rates to which people can relate. That is either rates related to costs of funding or clearly higher hurdle rates.

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Disadvantages Accountants and companies will have their own opinions and prejudices as to what rates are used and as to whether allowance should be made for inflation. The point is that the majority of companies just use a rate – having thought about it, and then just apply it as a nominal discount rate. The use of high nominal rates without taking account of the (possibly beneficial) effects of inflation is being rather tough on proposed investments – is this the intention? If the appraisal process is merely a means of rationing cash expenditure and choosing the best projects, from the point of view of return, then this may be satisfactory. Ever tighter margins, the need for lowest cost operation and production, never mind strategic issues, requires a more subtle and thought through analysis.

Conclusion Unless the appraisal process is one of selecting the best from a range of potentially sound projects using a hurdle rate then the effects of inflation or deflation should not be ignored. Further models and consideration of this topic is given in chapter 4. The nominal rates used for discounting should be realistic in today’s economy and more importantly for tomorrow’s economic environment. A related issue is that if NPV’s are considered rather than IRR’s then the amount of NPV in relation to the original investment should not be unrealistically high.

Accounting for taxation This is another topic of which much may be made. Appraisals are either carried out pre or post tax charges or credits. For the majority of appraisals on routine, continuing capital expenditure and projects carried out within an organisation the effects of taxation are ignored. The rationale being that the rate of return demanded includes an element (a percentage) to cover the cost of any tax charges and also the timing differences caused by the tax regime in force will not change the net cash flows to such an extent as to materially alter the amount of the NPV, IRR or other measure. If a project’s cash flows on eligible capital expenditure are of such a size relative to a businesses other continuing cash flows then the effects of the taxation regime on the project and company cash flows must be considered. Obviously, the tax laws applicable to the project or business need to be understood and applied to the project cash flows as separate rows or columns in the model.

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The example below is a development of the cash flow modelling example in chapter 1. It is proposed to build a factory as a central food processing unit to supply a chain of restaurants. The cash flow forecast for the first and typical year of operation is considered reliable enough and a screening appraisal is to be carried out. The required rate is 15% per year and the appraisal has been carried out over a 7 year period – the period of the loan raised to finance the project. Without any consideration of tax the project yields an NPV of nearly 76,000. For most businesses this would be far too low an NPV and the project would not be sanctioned. However, this screening appraisal leaves out the issues of volume/price increases in sales and the fact that the operating life of the project is likely to be more than 7 years. Also apart from strategic issues such as reliability of supply (from own facilities) and whether or not 15% is too high a rate. These issues are discussed further in other chapters. SCREENING APPRAISAL

CASE STUDY - PROPOSED CENTRAL PRODUCTION FACILITY required annual rate

15% year

capital costs building equipment inflows - sales

0

1

4

5

750,000

750,000

750,000

750,000

750,000

-305,400 -190,800

-305,400 -190,800

-305,400 -190,800

-305,400 -190,800

-305,400 -190,800

0

0

0

0

253,800   191,909

253,800   166,878

253,800    145,111

253,800   126,183

corporation tax

discounted cash flow

3

-850,000 -130,000

outflows production occupation

net cash flow
 

2

-980,000  -980,000

Net Present Value =

253,800   220,696

75,915

Assuming that the business is interested in this project which does have a positive, although low NPV, the effects of the prevailing tax regime should be appraised. The spreadsheet on the next page incorporates rows which calculate the tax due on profits after making allowance for capital allowances. Corporation taxes will not usually be a simple percentage of accounting profits. In this example the following assumptions have been made:

Interest payments A Row 24 is based on the interest element of the loan repayments over the 7 year term of the loan. Normally interest payments are allowed against profits and in this typical case this means that taxable profits will be lower in the earlier years of a project, when the interest element is higher.

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Capital allowances B Row 25 is calculated as a percentage of the eligible capital expenditure. In this illustration the rate is 25% (B32) which has been a typical UK rate for a number of years. This rate is expressed as a percentage of the balance of expenditure after the allowance. Thus it is 25% of the original cost (530,000 in this illustration) in year 1 and the 25% of 530,000 – 132,500 = 397,500 in year 2 and so on. This is the so called reducing balance method.

Eligible capital expenditure C B30 has been taken as all of the 130,000 expended on equipment (this would normally all be eligible) plus 400,000 of the factory cost – this could be much more subjective and if 400,000 was eligible expenditure than it would really have to be of the nature of equipment rather than just of a building which would attract zero or possibly something like a 2% rate of allowance. The point is that what is eligible expenditure is a key issue to check with the taxation accountants. The net effect of incorporating the taxation charges is that over the 7 year period the NPV becomes negative – the project should most certainly be rejected. A 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32

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B

C

D

CASE STUDY - PROPOSED CENTRAL PRODUCTION FACILITY required annual rate

E

F

G

3

4

5

SCREENING APPRAISAL

15% year

capital costs building equipment inflows - sales

0

1

2

-850,000 -130,000 750,000

750,000

750,000

750,000

750,000

-305,400 -190,800

-305,400 -190,800

-305,400 -190,800

-305,400 -190,800

-305,400 -190,800

-8,497

-17,008

-24,028

-29,986

253,800   220,696

245,303   185,484

236,792   155,695

229,772    131,373

223,814   111,275

253,800 -78,814 -132,500 42,486 -8,497

253,800 -69,386 -99,375 85,039 -17,008

253,800 -59,129 -74,531 120,140 -24,028

253,800 -47,970 -55,898 149,932 -29,986

253,800 -35,829 -41,924 176,047 -35,209

outflows production occupation corporation tax net cash flow
 

discounted cash flow Net Present Value = taxable profit before interest interest charge - A capital allowances - B taxable profit corporation tax at eligible capital expenditure - C writing down allowance rate

-980,000  -980,000

-580

20%

530,000 25%

- - - - - - - tax written down values - - - - - - - - - - - - - - - - - - 397,500 298,125 223,594 167,695 125,771

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There is no difficulty in incorporating the effects of taxation into appraisal models. The difficulties arise in being sure of the taxation regime under which the project will be built. For example if the tax writing down allowance is increased to 40% then the NPV becomes positive. This is in fact a rate change introduced and extended over the last two years by the UK Chancellor – it encourages investment. This raises the interesting argument that whilst investments may be made viable by favourable taxation regimes, are the underlying investments not truly uneconomical? There are arguments for ‘neutral’ tax regimes. A 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32

B

C

D

CASE STUDY - PROPOSED CENTRAL PRODUCTION FACILITY required annual rate

E

F

G

H

3

4

5

6

SCREENING APPRAISAL

15% year

capital costs building equipment inflows - sales

0

1

2

-850,000 -130,000 750,000

750,000

750,000

750,000

750,000

750,000

-305,400 -190,800

-305,400 -190,800

-305,400 -190,800

-305,400 -190,800

-305,400 -190,800

-305,400 -190,800

7,403

-11,443

-23,670

-32,008

-38,099

253,800   220,696

261,203   197,507

242,357   159,354

230,130    131,577

221,792   110,270

215,701   93,253

253,800 -78,814 -212,000 -37,014 7,403

253,800 -69,386 -127,200 57,214 -11,443

253,800 -59,129 -76,320 118,351 -23,670

253,800 -47,970 -45,792 160,038 -32,008

253,800 -35,829 -27,475 190,496 -38,099

253,800 -22,621 -16,485 214,694 -42,939

outflows production occupation corporation tax net cash flow
 

discounted cash flow

-980,000  -980,000

Net Present Value = taxable profit before interest interest charge - A capital allowances - B taxable profit corporation tax at eligible capital expenditure - C writing down allowance rate

11,928

20%

530,000 40%

- - - - - - - tax written down values - - - - - - - - - - - - - - - - - - - - - - - 318,000 190,800 114,480 68,688 41,213 24,728

Questions often arise as to whether or not tax savings elsewhere in an operation, arising as a result of the significant eligible capital expenditure on a particular project, should be included as a benefit of the project. This is really a question as to what are relevant costs or in this case income. If the project’s capital expenditure does give rise to clear cash flow savings of an organisation then these could clearly be associated with the project being appraised and thus should be included as ‘opportunity income’.

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Dealing with the costs of overheads As discussed in the preparation of cash flow forecasts in chapter 1 only actual cash inflows and costs should be included. Costs arising from the operation of accounting concepts such as depreciation or allocation of overheads should be excluded on the grounds that there is no additional cash cost specifically associated with the project being appraised. But if central and other necessary overheads are excluded then how in the longer term are such costs to be covered? Two options are to: •

include overhead costs, even though these do not occur as direct and clear cash outflows

•

increase the required rate to allow for the likely level of general overhead costs.

From the point of view of squaring the overhead accounts and covering costs, both of the above will deal with the problem in the short and long-term. However the inclusion of non-cash overhead costs, or more likely an increase in the required rate may well kill off some projects. The more fundamental question to ask, especially when looking at totally new projects is ‘what overheads really are necessary for the new (type) of businesses proposed and operating in the future’? Too much emphasis may be placed on levels and amounts of historical overheads. An example of this can be seen in the levels of accepted overheads in many established former state owned telecom utilities. New ventures would never be set up or structured as these are. Thus any add on projects of these businesses which have to take a ‘share’ of existing corporate overheads are at a probably impossible disadvantage to their less burdened and nimbler competitors.

Inclusion of spurious costs If the costs, particularly the initial capital cost of a project are too high then no matter what rate is used for discounting, the project is not likely to meet the required criteria. It would be quite wrong, unethical (or possibly fraudulent) to omit costs in an appraisal proposal. However there are many instances where parties with an input to a project’s appraisal will insist that costs are included even though they are not relevant. A very obvious error (which has often been made) is to include depreciation costs in a model. Their inclusion is a nonsense. The appraisal is based on cash flows and the cost of an asset is the cash flow at time of purchase. Depreciation costs are merely ‘book’ figures and do not involve the flow of cash.

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Including or omitting sunk costs A sunk cost is a cost already incurred – at an earlier stage of a developing project say, or by another party to a project. The cost is in the past, the associated cash was spent in the past therefore there is no further cash required and the cost must be irrelevant. Having stated what may appear obvious there are many instances where those involved in appraisals will argue that sunk costs should be considered as valid when carrying out the appraisal. One reason why say someone with a financial accountants frame of mind may see no problem in identifying and dismissing sunk costs from appraisals, is that they may think over a relatively short time frame and from the perspective of the business or company carrying out the current appraisal. The following illustration may clarify the differing views which can be held on the inclusion or not of sunk costs:

Example Property company A owned city centre land and proposed to build an hotel on it, some 3m was spent on a feasibility study, architects drawings and designs and on obtaining planning consents. After a year company A decided that its core activities should be focused on developing resort hotels as this market had more potential for growth. The city centre site was sold to company B which was given (for no consideration) the feasibility study for the hotel, along with the architects drawings etc. Company B believed there was scope for further city hotel development and with the ‘free’ drawings etc carried out a screening appraisal. The cash flows of such an appraisal include feasibility study, design and planning expenses (as incurred by company A), build and fitting out costs, and operating costs year by year with refurbishment at say 8 year intervals. These costs are matched with inflows from room occupancy, food and beverage sales etc. In the case of company B nearly 3m savings in up front costs are possible (the company would have to apply for planning permission in its name). For the purpose of the example let us assume that company B will invest 19m in the project and requires a rate of return of 15%. If at this rate the project has an NPV of 2m then the project could be sanctioned. It is accepted that commercially a company would probably expect a much higher NPV on the outlay of 19m – but let us further assume that this is a highly competitive industry and this hotel is necessary to complete country-wide cover – the hotel should be built. If the building and operation go to plan then the project will be a success.

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However what if you were an economist from the state planning department, whose remit is to take a broader view of economic return, surely the true NPV would be nearer – 1m. The costs of opening an hotel in the city centre would have to include the initial feasibility, design and planning costs. Thus such hotels are not economically viable (at the required rate and with the costs and inflows as above). One way of considering the opposing points of view is to say that the financial accountant is taking a ‘micro’ view of the world – from the perspective of company B, and why not. The economist is taking a ‘macro’ view. If there any doubts as to whether or not a cost should be included in an appraisal then the simple question should be asked ‘is cash physically received or expended as opposed to the figure merely being a book (accountant’s) figure?’

Opportunity costs An opportunity cost is a cost which is a measure of an opportunity (to acquire cash) which is sacrificed or lost because a particular course of action is followed. An opportunity cost is thus not so much a cost but a loss of potential income due to proceeding with one particular project. An example of an opportunity cost would be where a particular construction project requires a vacant piece of land to carry out assembly work adjacent to the main building site. If the construction company owned the adjacent land which could at any time be rented out and used as a car park then this forgone income could be an opportunity cost. By using the land for assembly purposes the company has sacrificed income. Or has it? As with sunk costs there are those who can see opportunity costs lurking everywhere. It may be that they are taking a wider view. In this example in a wider context than that of the company there has been a loss of revenue in the local economy. However the question which should be asked as the arbitrator on such an occasion is ‘by using the land for assembly are we giving up the opportunity to operate a revenue earning car park?’ The construction company probably has no wish to operate a car park and accepts that plots of land will be held vacant from time to time. For the adjacent construction project it is fortuitous that there is a free site.

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Cost of assets with infinite lives An issue which arises is what is the cost of land which in normal situations does not depreciate (and indeed is not normally depreciated in statutory accounts)? If land is purchased for cash at the outset of a new project then that is the cost for appraisal purposes. If an annual worth exercise (chapter 3) is being carried out then the annual cost is considered to be the cost found by multiplying the original cost by the annual cost factor from table 6 (chapter 1) at the required rate for an infinite life. For example at a rate of 15% the factor is very nearly 0.15 or 15% of the cost. This is logical as the cash spent at the outset is tied up or invested indefinitely and is thus ‘dead’ money. The cash could have earned the 15% if invested elsewhere – this is the opportunity cost of investing in the land. The above logic is fine, but does not take account of any appreciation in land values. That is, what is the effect of the terminal land value on the project’s cash flows? If the land is in a prime site then after say 50 years the value could have increased by factors of tens or hundreds. The anticipated terminal value can be brought into an appraisal and the figure brought back to a present value. Although an apparent inflow for a project, this may not be as significant as it appears at first sight. Table 2 which shows the present value of a single future amount has for example a factor of 0.0009 for an cash inflow in 50 years at a require rate of 15%. Apart from the heavy discounting due to the time value of money there must be questions asked about the reliability of the estimate of the terminal value.

Grants If the capital or possibly also running costs of a proposed project benefit from grants then the simple view must be that the costs to which the grants relate are lower. If this then allows the project to be sanctioned – there is sufficiently high NPV and/or IRR – then that is fine. The presumption must be that the government department (presumably it will be a government department or official body) wishes investment encouraged. This again raises the point as to how much grants and also tax breaks distort ‘free market’ decisions.

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Checklist What is the right rate? A checklist of the matters to be considered when determining the discount rates to be used in appraisals.

What is the basis of your discount rate? •

how is the project to be funded?

•

do you have the optimum level of gearing?

What is your cost of capital? •

what is the cost of equity?

•

what is the cost of loans?

Are the rates too high in light of tomorrow’s economic environment?

Is your rate pre or post taxation?

Does your rate make allowance for overhead costs

Is inflation/deflation likely to affect your cash flows?

Does your project include spurious costs?

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Other measures C O M M O N LY U S E D M E A S U R E S M I S U N D E R S TA N D I N G O F N P V OTHER MEASURES PRESENT COST ANNUAL WORTH FUTURE WORTH P R O F I TA B I L I T Y I N D E X – B E N E F I T / C O S T R AT I O C O S T- B E N E F I T A N A LY S I S APPRAISING ENTIRE PROJECTS AND BUSINESSES – DISCOUNTING CASH FLOWS AS MEASURES OF PERFORMANCE LIFE CYCLE COSTING

chapter

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Chapter 3: Other measures

Commonly used measures Traditionally the approach when measuring investment or project success or failure has been to use payback IRR or NPV. Quite often it is simply the non discounted method of calculating payback which is used. If discounting cash flows is to be carried out with the consequent recognition of the time value of money, then IRR tends to be the favoured measure. The reason is probably obvious – IRR permits the impartial selection of those investments which yield the highest returns. Impartial is used here to mean that there need be no consideration of the size of each project or the relative amount of NPV. The issue of relative amount of NPV is discussed below.

Misunderstanding of NPV Where NPV is used as the measure for selection of investment opportunities often the selection policy will demand that the amount of the NPV should at a minimum be equal to the initial capital expenditure when the cash flows are discounted at the required rate. The logic of this approach is that the excess NPV demanded gives a factor of safety or allows for a margin of error in the cash flow assumptions. The illogicality of this is however that if cash flows are estimated at their most likely outcome and if the required rate is one which satisfies the investors, then all that is required of the NPV is that it is zero or greater. This of course gives no margin for error! It may be helpful to appreciate that if it is demanded that NPV equals the initial capital investment then this is akin to demanding a return which is a multiple of the required rate. Are the investors being really honest about the rates which they demand? Demanding NPV’s equal to, or a multiple of, the original investment can be better represented as benefit cost or profitability indices which are discussed later in this chapter. The illustration below indicates the points for consideration when high NPV’s are demanded. The first spreadsheet shows a small project where the required rate is 30% and where the criteria for NPV to at least equal the initial investment is met. This should be a risk free project – it is of short duration, and both the required rate and NPV are high.

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year 0 1 2 3

cash flow -8,000 9,000 9,000 9,000

3:

required rate

30.00%

discount factor 1.0000 0.7692 0.5917 0.4552

discounted cash flow -8,000 6,923 5,325 4,096

19,000

NPV =

OTHER

MEASURES

8,345

If the project was an essential investment and the cash flows the most likely estimates then a zero NPV could just be tolerated. In this case the return the project yields is 98%! Another indicator of the fact that the project should be risk free.

year 0 1 2 3

cash flow -8,000 9,000 9,000 9,000

required rate

98.01%

discount factor 1.0000 0.5050 0.2551 0.1288

discounted cash flow -8,000 4,545 2,295 1,159

19,000

NPV =

0

A further view of what demanding high NPV’s means is to consider by how much inflows could decline before the NPV turns negative. With this example the answer is that annual inflows need only be 4,405 which is 51% less than the 9,000 expected. This is an example of one at a time sensitivity analysis which is studied further in chapter 4. The point is that investment only should be made in projects which have as certain as possible estimates of cash flows. Making allowance for possible errors by demanding high NPV’s is to say the least rather unsophisticated or crude.

year 0 1 2 3

cash flow -8,000 4,405 4,405 4,405 5,215

required rate

30.00%

discount factor 1.0000 0.7692 0.5917 0.4552

discounted cash flow -8,000 3,388 2,607 2,005 NPV =

0

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Demanding high NPV’s where projects are of strategic importance to the business may mean not selecting projects which can meet the basic demanded investment criteria.

Other measures The fact that IRR is the predominant measure for appraisal purposes, as it does ration cash and is relatively well understood, means that other measures or ways of considering projects may not be considered. There are a range of measures which can be used to understand and judge projects and most companies use more than one of the measures. Payback, NPV and IRR have been considered already and indeed ought to be calculated. This section looks at other measures. They are not so much different measures, but rather different ways of setting out and expressing models of discounted cash flows. All the measures rely on discounting cash flows and consideration of the time value of money arithmetic. Thus which ever measure is used the same arithmetical decision should be arrived at. The rationale behind using these different measures is that the layout and measure may be much more meaningful and comprehensible for the business proposition being appraised.

Present cost Where projects have no income or the service provided is comparable then NPV is an inappropriate term to use. The term present cost is more appropriate and the issue is to consider whether the present cost can be accepted at a particular required rate. If there are options as regards investment then it is the project with the lowest net present cost which should be selected. An example is where there is a need to replace a pump which is an essential piece of plant. Further examples are when considering expenditure on safety or environmental projects. With the latter examples it may be more appropriate to consider these further within a framework of a cost-benefit analysis. Even where there are only costs and there is only one option it is important to know the present cost – this might be considered as the ‘subsidy’ which has to be covered if the investment is to be made.

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Present cost analysis also underlies the concept of ‘life cycle costing’ In the example below projects A and B both have the same apparent cost over their lives, but the present cost of A is lower. The reason is that whilst maintenance costs increase over time the initial cost of project A is considerably less than that of project B. The later the spend the lower the present cost. This example indicates that the ‘cheap and cheerful ’plant is to be preferred to the high quality lower maintenance cost option – at least from an investors viewpoint! An example of the benefits of delaying expenditure or having later costs can be found in the nuclear industry. The later the decommissioning of nuclear facilities, the cheaper the cost! An example of a flaw to this arithmetically correct argument is that the effect of meeting environmental standards – the ‘inflation’ of costs on decommissioning – may be at a rate in excess of the discount rate used to calculate present cost – still that is not today’s problem!

year 0 1 2 3 4 5

compounding rate = project A cash compound flow factor 190,000 1.0000 10,000 0.8696 15,000 0.7561 20,000 0.6575 25,000 0.5718 30,000 0.4972

15% compounded cash flow 190,000 8,696 11,342 13,150 14,294 14,915

290,000 total apparent cost present cost =

252,397

year 0 1 2 3 4 5

project B cash compound flow factor 240,000 1.0000 10,000 0.8696 10,000 0.7561 10,000 0.6575 10,000 0.5718 10,000 0.4972

compounded cash flow 240,000 8,696 7,561 6,575 5,718 4,972

290,000 total apparent cost present cost =

273,522

The above is a very simple example demonstrating that the arithmetic of appraisal may be used to assist in decision making. There is much more to life cycle costing, but the arithmetic and principles of modelling are at the heart of any life cycle cost review. The concept and stages of life cycle costing are considered further at the end of this chapter.

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Annual worth As shown in the examples in chapter 1 it does not matter how the arithmetic is worked or the project modelled the ratio of inflows to outflows adjusted for the time value of money will always be the same. Why then consider measures such as annual worth? Modelling projects is not just about applying arithmetic to expected cash flows and arriving at an answer but rather modelling is a medium for seeing the project as a business proposition. The more clearly the proposition can be presented to the parties involved the better. Thus annualising the cash flows may get over to all those involved in an appraisal exactly what has to be achieved in one year and presumably then bettered annually thereafter. Certainly expressing the cost of an asset – a piece of plant or equipment as an averaged annual cost clearly shocks many as there is natural tendency to think of the cost of asset ownership as being akin to simple straight line historical cost depreciation. For example, an asset costs 24,000, has an expected useful life of 8 years with negligible disposal value or costs. The straight line depreciation charge based on the historical cost is 3,000 per year. If money costs 15% the (true economic) cost is really 24,000 x 0.2229 (the table 6 factor for 8 years at 15%) = 5,350 – a much higher time averaged annual cost of ownership and thus realistic figure. Getting over the true cost of money on an annual basis is reason enough for considering the use of annual worth. It should be appreciated that it is average annual cost or worth and this does not mean that there will be annual cash costs or surpluses of this amount. Using the figures from the life cycle costing example earlier in the chapter, for project B the annual costs are estimated as being constant at 10,000. It is only the initial outlay of 240,000 which has to be annualised using the annual worth factor from table 6 or the formula. AW factor = (r(1+r)^y) ((1+r)^y) -1 Where r is the required rate and y the number of years over which the expense is to be annualised.

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required rate = project B year 0 1 2 3 4 5

cash flow 240,000 10,000 10,000 10,000 10,000 10,000

1.0000 1.0000 1.0000 1.0000 1.0000 1.0000

3:

OTHER

MEASURES

15% annual cash flow 240,000 10,000 10,000 10,000 10,000 10,000

290,000 total apparent cost annual cost factor =

0.2983

average annual cost = (of initial investment) annual cost =

71,596

total annual cost =

81,596

10,000

For project A the average annual cost is found by finding the net present cost and annualising this figure using the annual worth factor from table 6 on page 11.

year 0 1 2 3 4 5

required rate = project A cash discount flow factor 190,000 1.0000 10,000 0.8696 15,000 0.7561 20,000 0.6575 25,000 0.5718 30,000 0.4972

15% discounted cash flow 190,000 8,696 11,342 13,150 14,294 14,915

290,000 total apparent cost net present cost = annual cost factor = average annual cost =

252,397 0.2983 75,294

Knowing the annual cost can assist in making decisions as to whether or not to purchase or lease assets. The annual cost of ownership over a period can be compared with the cost which a finance house would charge for the use of a similar leased asset over the same period. For example, using the figures from project A above, the company’s averaged cost of annual ownership/usage is 75,294. If the plant could be leased for 5 years at a cost of 74,000 p.a. then numerically the correct choice is to lease.

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Other issues to consider in lease v buy decisions 1.

Do you have the initial cash? •

in this case 190,000 v 74,000 for an ‘up front’ lease payment.

2.

Will there be disposal value or further ‘free’ use after year 5 if you buy the plant?

3.

Is there risk in owning the plant, e.g. breakdown, fire theft etc?

4.

Is there risk in leasing the plant, e.g. the lessor going bust?

This list can be extended, the point being that whilst annual worth can assist in considering whether to lease or buy, any decision should be based on consideration of all issues.

Future worth Future worth is the compounded (forward) amount or value of present amounts and/or a series of annual amounts. Appraisals, particularly where comparisons are being made, can be carried out using the future worth of the cash flows. An example is to look at the future life cycle cost of the projects described under present cost above.

year 0 1 2 3 4 5

compounding rate = project A cash compound flow factor 190,000 2.0114 10,000 1.7490 15,000 1.5209 20,000 1.3225 25,000 1.1500 30,000 1.0000

15% compounded cash flow 382,158 17,490 22,813 26,450 28,750 30,000

290,000 total apparent cost future cost =

year 0 1 2 3 4 5

project B cash compound flow factor 240,000 2.0114 10,000 1.7490 10,000 1.5209 10,000 1.3225 10,000 1.1500 10,000 1.0000

compounded cash flow 482,726 17,490 15,209 13,225 11,500 10,000

290,000 total apparent cost

507,661

future cost =

550,150

Project A will still be chosen as it has the lower total future cost – also its future cost is the same percentage of A’s as it was when present cost was considered – this is just arithmetic. future cost A present cost A = = 92.2% future cost B present cost B

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Why look at a project in future terms? Carrying out a future worth exercise is at first sight a pointless and confusing thing to do. It can be difficult enough for some to understand the concept of net present value or amount, but at least the figure is expressed in today’s currency. Expressing figures as future amounts will just confuse as the ‘currency’ used in the model is a future one. There are reasons for knowing future amounts, some more valid than others! For example if ticketing equipment was to be installed for a new metro system which is to become operational in 4 years time then the present cost of fares whilst relevant to an NPV analysis is not relevant when it comes to ordering the equipment. There will be a need to know the size of currency coins and notes which will have to be handled. The above example can be used to illustrate where future of present worths may be quoted without adequate definition. If the metro system was in a city area then the local politicians would no doubt prefer to talk of fares in present day terms rather than the presumably higher figures which would pertain at the time of opening! In this example the politician would really be quite correct to talk in today’s terms which presumably the electorate understand. An excellent example of an attempt to use the time value of money with an ill defined base as an attempt to obtain greater subsidy was quoted in a national newspaper. Funds for the UK Channel Tunnel rail link were being requested at an earlier stage of construction than originally agreed, the Chief Executive said ‘we are talking about a rephasing, a change in the timing of the cash injection. We are not talking about an extensive refinancing of the project’. These illustrations make the point that the effect of time value of money, particularly future values can certainly be used to mislead. Clear definition of the time base of any project and associated arithmetic is essential.

Future worth as a means of demonstrating the cost of delay In the example below a project has a build or start up period of three years (years -2, -1, 0) and an operating life of 5 years. The expected cash flows show a total (non time value adjusted) cost of 600 with inflows of 1,000. The idea of using future worth, or at least partial future worths for the build period is to demonstrate the probably significant cost of delay in a project becoming operational.

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 ! 



When the cash flows are compounded/discounted at a rate of 15% it can be seen that the cost of taking the 3 years to build or start up the project is 85. Also the inflows have been discounted, with the net effect being a negative net value at year zero of -14 and presumably rejection of the project.


  

       

       






   
 

 
   
                 ! !    
   !    !  !  ""    
   


 # 



If the project was considered to be of strategic importance then one way of making it viable would be to compress the build or start up period into say 2 years (assuming that this was physically possible). The net value at time zero is now 18 positive. This positive NV is the amount available to pay for the speeded up start-up. That is the contractor could be paid up to 18 more. It should be noted that if the contractor does his sums, the suggested change even with an additional 18, costs him money!

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              ! !    
   !    !  !  ""    
   


 # 



Conventional layout The original project can easily be displayed in the more conventional form with years 0 through to 7. The NPV (at time 0) is -11. This could be found by taking the net value at time zero in the above example and discounting this amount back 2 years at 15%.
  

  

   ! 

       






   
 

 
   
            !   !!     
      ""  !       
   


 

 # 


Future worth can assist in revealing the effect of delays. The exercise will give an indication of the amounts of interest cost which might be capitalised. Capitalisation of interest means including the interest cost along with materials, plant, labour etc as a constituent cost of the tangible fixed asset. The tangible fixed asset will cost more and thus depreciation will be higher – this is a realistic accounting policy as it matches the cost of assets with their revenue earning lives.

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Profitability index – benefit/cost ratio This is simply discounted inflows divided by discounted outflows. If discounted inflows equal or exceed discounted outflows then the index will be 1 or greater. Discounted inflows less than discounted outflows obviously yield a figure less than unity. The use of the profitability index is thus as follows: index > or = to 1– project may be accepted index < 1– reject project. Where there are no particular constraints the index can be used to select from a number of projects, those with the highest indices being selected first and in descending order of index until all available cash is used. The index is also used as a means of attempting to cover risk. Set the required index at say 2 or above. With an index of 2 the NPV will be equal to the discounted outflows (original capital spend). Consideration must be given as to whether this may be an excessively high NPV (see earlier in this chapter). The profitably index may be called the benefit cost ratio or cost-benefit ratio (this should strictly speaking be the inverse, with a figure of 1 or less demanded before a project is sanctioned). It is apparently the case that for some public sector projects the powers that be have rejected projects with ratios as high as 1.7:1 and even 2:1. These figures might be from the project appraisal at the (rough) screening stage or just hearsay. However, if a project’s cash flows are robust then it should not be forgotten that a figure of 1:1 (just) means viability. Setting a level of say 2:1 seems a crude way to deal with risk! The arithmetic of the profitability index again demonstrates most clearly that no matter how a project’s cash flows are considered the ratio of inflows to outflows will be constant. Profitability Index

required rate =

Project A discounted cashflows year cashflows out in 0 -10,000 -10,000 4,348 1 5,000 2 6,000 4,537 4,603 3 7,000 8,000

-10,000

Profitability index =

13,487 1.35

15%

Project B cashflows -12,000 8,000 8,000 4,000 8,000

discounted cashflows out in -12,000 6,957 6,049 2,630 -12,000

Profitability index =

15,636 1.30

If these projects were considered with annual or future worth calculations the indices would be exactly the same.

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Cost-benefit analysis Care should be taken when using terms such as cost-benefit analysis or economic analysis. It is considered important that companies and individuals carrying out appraisals are clear as to what is being appraised and in what context. Most company appraisals will be capital investment or project appraisals, carried out with clearly distinguishable and quantifiable cash flows. Some cost-benefit analysis will be carried out with clearly distinguishable and quantifiable cash flows. These might be called economic analysis as projects will only be entered into which are profitable or economically viable. Accountants and economists think of and approach business in quite different ways. This can be characterised or caricatured as thinking of accountants as seeing the world and appraising within the narrow constraints of the business or company as a legal being or entity. Thus before expenditure is sanctioned a clearly quantifiable benefit must accrue to the company. There must be an adequate IRR or NPV and thus potential future accounting profits arising from the investment. The only costs which will be considered are those which impinge directly on the business. Economists can appraise in this way if they are considering the legal entity, but often will take a much wider view of investment – the wider effects on the world as a whole. They may also be inclined to take a longer-term view of investment. Thus economists will often wish to bring past or sunk costs into an appraisal. They want to resurrect the past costs and recover the expenditure from future activities, seeing a project as one continuum. Thus the term economic appraisal may be best reserved to cover situations where the project or investment impacts on more than one entity and has independent streams of cash flows. Often the wider body of entities affected and the resultant cash flows will be more difficult to quantify and thus be labelled intangible. Again there ought to be definition of what comprises an intangible cash flow. It is interesting to note that one dictionary definition of intangible is ‘that cannot be grasped mentally’. Should we really use the word intangible? If the events and thus cash flows are intangible meaning that they are disconnected from the main cash flows then they either cannot or should not be considered. When the word intangible is used it is often meant to convey the fact that the cash flow arising from the project event is very difficult to distinguish and thus quantify. If there is a cash flow related to the proceeding with or refraining from a project then it ought to be brought into the analysis. Sensitivity analysis is the means by which the effect of a wide range in values or amounts of material intangible cash flow can be considered. Cost-benefit analysis and measurement of intangibles is considered further in chapter 6.

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Appraising entire projects and businesses – discounting cash flows as measures of performance It is interesting to note that with the development and apparent increasing sophistication of financial accounting standards performance measures based on financial accounting data are being criticised more and more as unreliable! Many analysts and other interested parties, including the managers of businesses, have realised that clear measures are required and have looked to present and future cash flows as a basis for measuring performance.

Why are more sophisticated measures required? Critics of the use of accounting rate of return or return on capital employed (ROCE – defined in chapter 1) as the prime measure of a businesses performance make the point that relying on ROCE may have the following weakness: Street wise managers realise that it is unwise to invest money in plant or projects which do not give quick pay backs. It is much better to keep and use old, fully depreciated equipment for as long as possible. Thus the capital employed will be a lower figure. Conversely the net operating profit after tax will be a higher figure as there will be a low or nil charge for depreciation of the old plant. The result of course is higher ROCE. There is something in this argument. However, a policy of revaluing and re-lifeing buildings, plant and equipment and properly considering the capital employed in the business can overcome such problems. There need be nothing wrong with using ROCE as a measure as long as capital employed and related profits are rationally and consistently calculated. An example would be for a company with considerable investment in brands. No matter what the confused UK and other accounting standards may require, the capital employed in the brands, whether purchased or internally developed, should be capitalised as an intangible fixed asset. This will then reveal the true capital employed. The presumably higher profits which flow from the brands can then be related to the investment and a realistic ROCE calculated.

Economic value added (EVA) and shareholder value added (SVA) A currently popular measure is economic value added – EVA. Like many measures EVA is not an entirely new concept. Other manifestations of the principles underlying the measure are shareholder value added (SVA) and cash flow return on investment (CFROI).

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EVA certainly has been taken up as a key measure. It was developed in the US as a tool to assist in the calculation of what a company’s share price should be. EVA is based on calculating the cost of equity and debt – calculating the cost of capital. The future free cash flows of the company can then be allocated to firstly meeting the cost of capital with the remaining free cash flow (if any) representing the wealth created by the company. The share price is then related to the ability of the company to create wealth or add shareholders value (or not). It measures the board’s and managers’ success or failure in achieving returns from the capital which is under their control.

Calculation of EVA The calculation of EVA is in essence very simple. A businesses net operating profit after tax is adjusted for any accounting distortions, for example the spreading rather than expensing in one year of research and development costs. The amount of capital invested in the business is found from the amount of fixed assets plus necessary working capital. The cost of capital or capital charge is then calculated and finally the amount of capital invested is multiplied by the capital charge (rate). This amount is subtracted from the adjusted net operating profit and a positive balance means that the business is creating value, that is, profits are in excess of the amount necessary to maintain the business. A simple judgement of EVA might be that it is really based on adjusted net operating profit after tax. The EVA calculations do not apparently require the use of discounting techniques. Some articles on shareholder value added (SVA) conclude that it is really very similar to EVA but the more sophisticated version has calculations which do require the discounting of amounts. Note the term ‘cash flows’ has been avoided as the method does not really look at simple cash flows, but rather adjusted accounting figures.

Calculation of SVA The amount of capital invested in the business is found from the amount of fixed assets plus necessary working capital. It is necessary to consider separately or exclude non performing assets or excess working capital – e.g. money on deposit. This therefore suggests that in reality the business should not have idle assets or cash! The next stage is the determination and calculation of the expected future cash flows, a terminal value of the business at the end of the study period and discount rate to be applied have to be calculated.

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The basis of future cash flows is net operating profit after tax. Various articles and texts on SVA and also EVA discuss the adding back of depreciation as this is not a cash flow. The balance of views appears to be that it is forecast future profits which should be seen as the cash flow. The soundness of this view and thus the purity of the measures really does have to be questioned. It would seem that consultants need to have many items to discuss and leave in or out based on their judgement – obviously their wisdom costs money and is a good fee earner for them! A terminal value is the selling price of the company at the end of the study period. This is the net operating profit after tax for the final year multiplied by the market indicated price to earnings ratio. The terminal value and the series of annual cash flows (adjusted net operating profits) is then discounted over the study period at a chosen rate to give a total present value. From this is deducted the non equity fund to leave the operating value available to shareholders. If this is in excess of shareholder value today then the business’s expected performance is adding shareholder value.

Conclusion This brief outline of these measures has been included to point out that there are many valid reasons for using discounted cash flows. However, whilst the arithmetic will always be sound the problems of what discount rates to use and the soundness of the cash flow data remain.

Life cycle costing Life cycle costing has as its aim the selection of the most cost-effective asset purchase by the determination of the full cost of ownership and operation of an asset over its working life. This full cost of ownership/operation is normally expressed in net present value or cost terms (although it could also be expressed as an equivalent average annual amount). When quantifying or comparing investment in tangible fixed assets decisions are thus not made simply on the basis of the (lowest) initial outlay. Recent surveys (early 1999) indicate that 75% or more of managers and investment decision makers believe the concept is a good one. This is particularly true of investment in specialist buildings (hospitals, defence establishments etc). This may well be driven by the worldwide increase in build and operate projects, in particular in the push for the (Private Finance Initiative) PFI projects in the UK.

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However, inevitable scepticism and no doubt shortage of funds means that the benefits of life cycle costing are not being pursued in practice – surveys show that only 15% of commissions for retail buildings (although this rises to 40% for healthcare buildings) actually request a life cycle costing exercise to be carried out. The reasons for little progress are obvious. Managers and sceptical accountants in particular will require a lot of convincing that higher expenditure (now) is justified. Before any life cycle costing is introduced there must be reliable data as regards the future lower operation and maintenance costs. If these costs are associated with a new product and particularly new technology then the case will be even harder to justify. This section aims to explain the rationale behind and the process of life cycle costing.

Rationale for life cycle costing A traditional view of investment appraisal – an instilled investment criteria – is the cheaper the initial cost the better. This is born out by the fact that if one looks at the sound (although criticised for being historic) measure of return on capital employed or return on investment, then the lower the capital employed the better. ROCE = net operating profit capital employed (capital employed of zero of course gives infinite returns!) ‘Cheap and cheerful’ has to be the order of the day. A related fact is that whilst a more expensive asset may be more desirable – prestige, lower maintenance and operating costs etc. The cash to purchase this may not be available or cannot be borrowed. The rationale for avoiding higher outlays of money now is pervasive as the cost is discounted by factor 1 – not at all! Later higher maintenance and other costs associated with a cheaper option are tomorrow’s problems! A more rational and logical approach would be to look at the cost of the asset and the operating costs/incremental income derived from having the better asset. Also the income received from final scrap proceeds or the costs of decommissioning should be considered (although these of course will occur at the end of the assets life and will be heavily discounted when presented in today’s terms).

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Life cycle basics The basic concept of life cycle costing is that it is not only the initial capital cost which should be considered when purchasing or investing in an asset – the total cost of ownership over the assets entire economic life should be considered. This concept fits well with the arithmetic of discounting cash flows to a common value – now. It is the principal inherent in present cost calculations used to select the lower or lowest cost options or where there is more than one way of proceeding with an action. There are many definitions of life cycle cost (LCC), the differences rather academic – a question of semantics. A straightforward definition would be ‘the life cycle cost is the net present cost of all cash spent on the acquisition, operation and final decommissioning of an asset’. LCC has been considered particularly with respect to buildings and the Royal Institute of Chartered Surveyors identified the objectives of LCC to be: a)

to enable investment options to be more effectively evaluated

b)

to consider the impact of all costs rather than only initial capital costs

c)

to assist in the effective management of completed buildings/projects

d)

to facilitate choice between competing alternatives.

These are all good arguments for considering LCC. (c) is interesting in that it suggests the process of calculating the LCC could be inverted. A present sum available for investment could be the starting point of an exercise where the design, build and lifetime operating costs have to be within the present cost budgeted amount. Terms such as ‘design to life cycle cost’ could be used. Certainly the process should encourage more imaginative use of resources and ways of operating.

Issues to consider beyond initial cost

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•

What are the minimum repair/refurbishment and decommissioning costs which can be tolerated?

•

Is repair necessary – is unnecessary preventative maintenance being carried out (if it isn’t broken then don’t fix it!)

•

Is refurbishment necessary – does the expense really ensure or enhance performance?

•

Will the plant be required for the full term of operation?

•

What would the effect be of early shut down/decommissioning of a plant or project?

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Life cycle costing process If life cycle costing is to deliver results there has to be a process in place to which the company and personnel are truly committed. The modelling and sensitivity analysis can follow the examples outlined in other chapters. The particular parameters and data which has to be considered for a LCC exercise are as follows: •

Initial capital outlay – this is not simply the purchase price: –

purchase price

–

acquisition/finance costs (although the finance costs should be accounted for by the discounted cash flow calculations)

–

installation/commissioning and training costs.

•

Economic life of the asset – is the revenue earning life of the asset known? Is research required to determine the likely economic (as opposed to say physical) life required?

•

The discount rate.

•

Operating costs – it is future, budgeted operating costs for the particular asset, operated in the way envisaged which have to be determined, not just an estimate of costs based on past experience. The question of what, if any overheads to include has to be addressed.

•

Maintenance costs – again it is data for the new assets. Past experience with existing assets is unlikely to be a reliable guide.

•

Disposal costs – consideration will have to be given to the ever increasing demands for ‘safe’ environmentally friendly disposal of assets at the end of their lives.

•

Performance measurement – consideration should be given as to how the success or otherwise, of the process of LCC will be determined. This exercise will also be helpful as an exercise in identifying problems and thus costs before they arise. For example measurements of the following will be helpful: –

downtime – failure rate measurement and forecasts

–

forecast spares/consumables requirements

–

maintenance requirements taking into account aspects such as safety

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this will require the acquisition or maintenance of data such as :


running hours




production hours




downtime/value of lost production




reasons for downtime




cause of any damage/failures




maintenance time and cost




spares usage and cost.

As with any appraisals, consideration has to be given to risk – which parameters are more likely to move in an adverse direction?

Likely areas of risk in LCC appraisals: •

Errors in estimating

•

Performance specification v actual performance

•

Changes in operation due to specification changes

•

Technological advances

•

Relative changes in prices of resources e.g. energy v labour.

As with any appraisal process if the above risks cannot be tied down then investment in the asset being appraised should be avoided. The theory of LCC is fine but unless there is commitment to the development of and the continuing use of a LCC process then the cold logic of lowest capital spend will prevail. The above are some of the main issues which need to be considered when carrying out a life cycle costing appraisal. As with any appraisals a properly documented process ought to be in place if such appraisals are to be carried out regularly. The process outlined in chapter 5 could be adapted to become a life cycle costing process. The above and other issues could be reviewed at the planning and review stages of the process.

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Checklist Summary of appraisal measures A list of the most commonly used appraisal measures, indicating what they reveal and thus where they may be used.

Measure

Outline

Use

Accounting rate of return

Annual accounting profit divided by capital employed

As a measure of past performance

Payback

Non discounted inflows compared to outflows

A simple, easily comprehended measure. Suitable for non critical, optional investments and rationing spend in a crude manner

Discounted payback (see chapter 7)

Time (year) in a series of cash flows at which the cumulative discounted cash flows reach zero

When considering time/date of break-even

Net discounted inflows less discounted outflows

Where investors are committed to investment as long as a minimum rate of return is achieved or bettered

Net Present Value

When considering the ability to repay loans

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Measure

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Use

Internal rate of return

The rate at which discounted cash inflows less discounted outflows is exactly zero

When demanding a minimum required rate of return and thus when rationing cash spend

Present cost

Discounted costs

Where there are cost only projects to be considered or compared

Future worth

Net compounded inflows less compounded outflows

Where future cost is required – e.g. the cost of an asset at date of completion. To find the amount of capitalised interest in a long-term build project

Annual worth

The net of averaged annualised inflows less annualised outflows

When looking at a typical year’s activities rather than the entire life of the project

Profitability index (benefit/cost ratio)

Discounted inflows divided by discounted outflows

When rationing expenditure or when minimum criteria can be clearly stated

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Measure

Outline

Use

Cost-benefit analysis

Essentially an NPV analysis with intangible benefits being quantified wherever possible

When trying to justify an otherwise marginal project

Due to the subjectivity in methods of benefit measurement a range of NPV’s may result

Where benefits are all apparently intangible – safety, environmental etc The benefits still have to be quantified, even though this results in a range of NPV’s

EVA analysis

A comparison of underlying free ‘cash’ flows with the cost of capital to determine whether value has been added

When valuing companies and considering share prices

SVA analysis

An NPV analysis of companies forecast results compared with cost of capital and whether or not value is being added

When valuing companies and considering share prices

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Checklist Use an appropriate measure A checklist to select the most appropriate measures for understanding and presenting appraisals.

Is simple pay back good enough?

Is IRR really the most appropriate measure?

Is too high an NPV demanded?

Would considering annual costs help?

Should the effect of delay be considered – would a future worth analysis help?

Can the logic of using your selected measures be easily explained?

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Checklist Life cycle costing analysis A checklist of the matters to be considered when carrying out a life cycle costing analysis.

Initial capital outlay is not simply the purchase price

Consider economic life of the asset

Operating and maintenance costs for the new asset are required

Disposal costs must be considered with respect to future legislation or practice

Performance measurement methods are required to control/develop the LCC process

Likely areas of risk should be identified

Changes in operation due to specification changes must be considered

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Risk management through sensitivity analysis INTRODUCTION – RISK MANAGEMENT T H E N E E D F O R T H E M O S T L I K E LY C A S E NO NEED FOR PROVISIONS OR CONTINGENCIES ‘ O N E AT A T I M E ’ A P P R O A C H W H AT I S M E A N T B Y ‘ S E N S I T I V E ’ ? S E N S I T I V I T Y D U E T O I N F L AT I O N O R D E F L AT I O N A N A LY S I S O F P R I C E A N D V O L U M E C H A N G E S W H Y C A R R Y O U T S E N S I T I V I T Y A N A LY S E S ? I D E N T I F Y T H E R I S K Y PA R A M E T E R S A N D T I E T H E M D O W N

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Chapter 4: Risk management through sensitivity analysis

Introduction – risk management ‘Risk’ and ‘management’ are over-used words. These days everything has to be risk managed. There is undoubtedly a need to formalise an approach to identifying and limiting the numerous risks which affect all businesses today. Managers or business owners cannot be expected to comprehend all the risks which might affect their businesses. Spreadsheet analysis of investment opportunities prior to commitment is an obvious way to identify and eliminate risk. The strictest interpretation could be that if the proposed investment is not risk free then do not invest. The real use of a sensitivity analysis is to identify which parameters are sensitive and thus limit risk. Where a parameter is identified as being sensitive, in that a small change in it will materially adversely affect the project outcome, then the risk should be eliminated or at least ‘tied down’. If it cannot be satisfactorily dealt with then the project should be abandoned.

Can there be too much analysis? Analysing the sensitivity of a spreadsheet model is well established and many quite detailed analyses are carried out. The aim being to identify how much decreases in inflows or increases in outflows can be tolerated or more likely what cannot be tolerated. There is no end to the number of ‘what if?’ situations which may be tested. It is obviously very sensible to carry out extensive and detailed sensitivity analyses. However there is a danger that either too much analysis is done or too pessimistic a view is taken – is it really likely that all parameters go wrong at the same time? Another potential problem with sensitivity analyses is that they may be comprehensible to the preparer of the model but may not really make clear the risks to others involved in the investment and sanctioning process.

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Need for a defined model Thus a clear base ‘most likely case’ model should be devised and the sensitivities of the parameters demonstrated in as clear and simple a manner as possible. The emphasis of the sensitivity analysis should be to identify sensitive parameters, quantify just how sensitive they are and then identify how the risk of the parameter ‘going wrong’ can be averted. Sensitivity analysis should lead to real risk management. As described in chapter 5 the process of project appraisal includes more than analysis of spreadsheets for sensitivity. The risks, commercial and otherwise, inherent in any project should be identified by structured thoughtful review of the project. The technical, commercial and ultimately cash flow risks should also be identified. The use of review checklists outlined at the end of chapter 5 may assist. Having made this very important point the use of structured sensitivity analyses of projects is of the greatest support in identifying and thus being in a position to overcome risk.

Sensitivity analysis The fact that appraisals can be so easily carried out on spreadsheets or by other computer models means that it is possible to look at outcomes based on endless arrangements of input parameter settings. This is fine, but can lead to the over abundance of output information causing the truly sensitive parameters to be missed. Although simple in concept and with the limitation that only one parameter is changed at a time the ‘one at a time’ sensitivity analysis does reveal both the sensitive parameters and indicates the materiality of changes in input parameters. The growing tendency to rely on spreadsheet and like calculations may mean that obvious business risks and sensitive parameters are overlooked. Basic arithmetical truths such as the fact that the largest figures will be most sensitive should not be forgotten. As indicated in chapter 5 on the appraisal process it is important not to rely solely on an arithmetical analysis to identify sensitive and thus potentially risky parameters. Sensitivity analysis should really only be seen as a back up to an individual’s understanding of the risks inherent in the business proposition.

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The need for the most likely case By definition since sensitivity to change in inputs is being reviewed then there must be a base position. For the analysis to reveal and quantify realistic sensitivities there should be a ‘most likely case’ – neither optimistic nor pessimistic – base model of the project. The simple but effective approach of carrying out a ‘one at a time’ sensitivity analysis may then be adopted. As the aim of the sensitivity analysis is to identify and thus quantify the parameters which are most sensitive to change (in an adverse direction) there is no point in carrying out the analysis on figures which are either pessimistic or optimistic. It is the most likely situation which is required. This demand for the most likely situation may also help in focusing on the amount of effort which goes into estimating.

No need for provisions or contingencies A follow on point is that figures in an appraisal should in no way be loaded by the existence of provisions or contingencies. In fact the inclusion of a provision or contingency is quite fatuous. No moneys have been committed – this is just the appraisal stage. It is the most likely outcome which should be appraised for sensitivity. It is also arguable that there is no need for provisions on sanctioned projects – if they exist they will only be used! However, when carrying out the sensitivity analysis, risks may become evident. The need for an amount of provisions, should the project be sanctioned, may well be capable of quantification. A business may then set up specific provisions for specific projects or may wish to hold central provisions as part of its risk management process or simply for political reasons. It should be noted that with the issue of Financial Reporting Standard (FRS) – 12 Provisions, Contingent Liabilities and Contingent Assets, the common practice of carrying provisions against future costs has been very much curtailed.

‘One at a time’ approach This method looks at changes in all or at least those considered the most critical (sensitive) parameters one at a time, e.g. if the selling price is considered the most critical parameter then what decrease from the expected sales can be tolerated before the project is not viable – that is NPV is down to zero.

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Again using a basic model with details showing sales inflows and operating cost outflows rather than just the net inflows, a ‘one at a time’ sensitivity analysis may be carried out. rate =

15% cashflows:discount

cash

cash

cash

factor

out

in

out

net

discounted

0

1.000

-9,000

-9,000

-9,000

1

0.870

3,000

-1,000

2,000

1,739

2

0.756

6,000

-3,000

3,000

2,268

3

0.658

9,000

-4,000

5,000

3,288

4

0.572

9,000

-4,000

5,000

2,859

5

0.497

10,000

-4,000

6,000

2,983

cash flow

cash flows

Year

NPV=

4,137

The question is how to determine and demonstrate in an intelligible manner the effect of changes in the parameters (estimates of cash flow) on the outcome – the amount of the NPV. A simple and thus intelligible method of doing this is to express (in terms of percentage) the adverse change in an expected cashflow which may be tolerated, or in other words, to demonstrate the maximum unfavourable change in a parameter as a percentage of the original estimate of the parameter. The maximum tolerable or unfavourable change which can be accepted is where the NPV becomes zero. In the example above a decrease of net present value of 4,137 can be tolerated. This present amount can then be related to adverse changes in the parameters one at a time. For example: •

By how much could the estimate of cost of the investment rise without the project being rejected? For NPV to be zero, investment cost would have to rise by the amount of the NPV 4,137 to 13,137 which is 45.97% more than the expected cost. 4,137 = 45.97% 9,000

The question can then be asked – is the estimate of original capital costs at all likely to be 46% out? If so (!!) and this risk cannot be managed, then this project should quite clearly be rejected.

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Sensitivity analysis is most easily carried out with the use of spreadsheets or specialist software. Either by using ‘trial and error’, using the ‘goal seek’ function or devising suitable formulae it is possible to quickly review the maximum tolerable changes of all of the parameters one at a time. rate =

15% cashflows:discount

cash

cash

cash

factor

out

in

out

net

discounted

0

1.000

-13,137

-13,137

-13,137

1

0.870

3,000

-1,000

2,000

1,739

2

0.756

6,000

-3,000

3,000

2,268

3

0.658

9,000

-4,000

5,000

3,288

4

0.572

9,000

-4,000

5,000

2,859

5

0.497

10,000

-4,000

6,000

2,983

cash flow

cash flows

Year

45.97%

0.00%

NPV=

0.00%

0

The example goes on to show how the other parameters may be tested for sensitivity one at a time. A table of the results gives a useful overall guide to the sensitivity of the project. In the example the table of the three sensitive parameters has been compiled by trial and error and shows that with a fall in sales of 17.85% the NPV is zero. An important, obvious point is that the larger the parameter the more sensitive it will be. In this example inflows from cash sales are almost twice the cash outflows, therefore any percentage change in cash inflows has almost twice the effect of an equal percentage change in cash outflows. rate =

15% cashflows:discount

cash

cash

cash

factor

out

in

out

net

discounted

0

1.000

-9,000

-9,000

-9,000

1

0.870

2,465

-1,000

1,465

1,274

2

0.756

4,929

-3,000

1,929

1,459

3

0.658

7,394

-4,000

3,394

2,231

4

0.572

7,394

-4,000

3,394

1,940

5

0.497

8,215

-4,000

4,215

2,096

cash flow

cash flows

Year

0.00% table of sensitivities

76

45.97%

-17.85% -17.85%

0.00% 41.19%

NPV=

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Linked parameters If two or more parameters are inextricably linked then a ‘one at a time’ analysis may still be carried out. The linked parameters can be reviewed together through likely ranges.

How much analysis should be carried out? Often it will be very obvious as to which are the most sensitive parameters, for example, the largest flows in particularly inflows from expected sales. The tolerable or acceptable percentage changes in these should be known. Since sensitivity analysis can be so simply and speedily carried out it is recommended that all parameters are reviewed. Parameter sensitivity can only be reviewed if data is available and separate cashflow rows or columns are entered on the spreadsheet. It is important for the appraisal and maybe more so for sanctioned projects to know in a quantified manner just how sensitive parameters are. Effort in estimating, cost control and income management can then be focused on the most important areas.

What is meant by ‘sensitive’? A common interpretation of ‘sensitive’ or ‘material’ is that if something could be 10% out from the original estimate (lower inflows or higher outflows) then that parameter would be considered sensitive. However, for appraisals what could be tolerated as not being sensitive may result in much higher percentages being reviewed. The first reason is that the ‘one at a time’ approach only considers each parameter by itself and if several were to move in an adverse way then 10% adverse variance could be quite unacceptable. The second reason is really based on commercial reality. Even where cash flows are known with great certainty would you really expect investors or providers of funds to risk their money where a 10% adverse change could start to diminish their return?

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What levels of sensitivity can be tolerated? Sensitivities may be considered in the following bandings: •

100% + change tolerable – presumably no problem.

•

50% – 100% change tolerable – parameters whose sensitivity fell within this range should be reviewed – how material is the parameter? If it is inflow then this could be serious. What can be done to ensure that a 50+% adverse change never occurs?

•

20% – 50% change tolerable – any parameter whose sensitivity falls within this range must be reviewed and demonstrable action taken to limit any change from the most likely figure.

•

20% or less change tolerable – if the investment was one of many purely speculative investments then the simple answer would be ‘walk away’. However, investment has to be made and will be part of the wider strategic plans of a business. If a parameter is 20% or less tolerable to change then it really must be tied down in amount or some compensating parameter/action sought to mitigate any adverse changes.

The limits of the ‘one at a time’ approach can be overcome by carrying out a most likely sensitivity analysis. Also, if parameters are likely to change adversely in concert then this should be tested. Note that it is sensible to have a company’s specific views or guidelines on sensitivity incorporated in the appraisal process guide – examples are given within the process outlines in chapter 5. To many, the simple truths of economics arising from arithmetical relationships are not always self-evident. Spreadsheets are a good way of demonstrating and testing simple but important relationships. The following series of spreadsheets confirm many well known business truths: A

High NPV’s (and IRR’s) – low sensitivities

B

Low NPV’s (and IRR’s) – parameters will be sensitive to change

and the larger parameters will be most sensitive to change C

Promised (later) inflows are not worth much!

In each of the spreadsheets the basic data is shown in the second column with cash flows for each of four years following. The column on the right hand side allows % change in parameters to be entered and the table of calculated one-ata-time sensitivities is shown in the adjacent column.

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If a project has a high NPV relative to the initial capital expenditure then none of the parameters will be highly sensitive to change. discount rate =

20%

0 capex inflows outfows

MANAGEMENT

capex = expected npv = year 1

2

3

4

-70,000 40,000 -5,000

-70,000 40,000 -5,000

40,000 -5,000

40,000 -5,000

40,000 -5,000

40,000 -5,000

net cash flows =

-35,000

35,000

35,000

35,000

35,000

discount factor =

1.0000

0.8333

0.6944

0.5787

0.4823

discounted cash flow =

-35,000

29,167

24,306

20,255

16,879

NPV =

55,606

70,000 55,606

% change

table of

in parameter

sensitivities

0.0000 0.0000 0.0000

79% -39% 310%

Only the inflows (the largest annual figures) are less than 50% sensitive to change. The validity of the inflow figures would have to be checked. B

If a project has a low NPV relative to the capital expenditure then all parameters are more sensitive. Another obvious truth is that the larger parameters will be the most sensitive.

discount rate =

20%

0 capex inflows outfows

-110,000 40,000 -5,000

capex = expected npv = year 1

2

3

4

-110,000 40,000 -5,000

40,000 -5,000

40,000 -5,000

40,000 -5,000

40,000 -5,000

net cash flows =

-75,000

35,000

35,000

35,000

35,000

discount factor =

1.0000

0.8333

0.6944

0.5787

0.4823

discounted cash flow =

-75,000

29,167

24,306

20,255

16,879

NPV =

15,606

110,000 15,606

% change

table of

in parameter

sensitivities

0.0000 0.0000 0.0000

14% -11% 87%

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If the project has good cash inflows but they come late on in the life of the project then they are worth less (they are discounted more heavily). Promised (later) inflows are not worth much! discount rate =

20%

0 capex inflows outfows

EFFECTIVE

-110,000 40,000 -5,000

capex = expected npv = year 1

2

3

4

-110,000 40,000 -5,000

40,000 -5,000

40,000 -5,000

40,000 -5,000

80,000 -5,000

net cash flows =

-75,000

35,000

35,000

35,000

75,000

discount factor =

1.0000

0.8333

0.6944

0.5787

0.4823

discounted cash flow =

-75,000

29,167

24,306

20,255

36,169

NPV =

34,896

110,000 34,896

% change

table of

in parameter

sensitivities

0.0000 0.0000 0.0000

107% 46% 417%

This project has a reasonable NPV but can be compared with the following example with a higher cash flow earlier in the project’s life. discount rate =

20%

0 capex inflows outfows

-110,000 40,000 -5,000

capex = expected npv = year 1

2

3

4

-110,000 80,000 -5,000

40,000 -5,000

40,000 -5,000

40,000 -5,000

40,000 -5,000

net cash flows =

-35,000

35,000

35,000

35,000

35,000

discount factor =

1.0000

0.8333

0.6944

0.5787

0.4823

discounted cash flow =

-35,000

29,167

24,306

20,255

16,879

NPV =

55,606

110,000 55,606

% change

table of

in parameter

sensitivities

0.0000 0.0000 0.0000

137% 52% 533%

It is possible to carry out many such exercises to demonstrate the effect of various cashflow profiles. The point is that whilst many of the outcomes will be obvious this is not always the case and in any event not everyone will comprehend the magnitude of sensitivities to change in cashflow profiles.

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Sensitivity due to inflation or deflation What is the effect of price or cost increases over the life of a project? Again it may be self-evident to most that the project with the high NPV will be little affected by increases (or decreases) in future inflows and outflows, whereas a project with a relatively low NPV will be much more sensitivity to input changes. Also large increases or decreases in prices or costs are likely to have a material effect. This raises the issue introduced in chapter 2 that at least for marginal projects, consideration should be given to studying the effects of even minor changes in project inflows, outflows and margins due to inflation or deflation. Because spreadsheets facilitate the speedy analysis of changes in parameters it is wise to study the effects of even low levels of inflation or deflation (price changes) for every project. As demonstrated in chapter 2 if inflation affects all the parameters of a project by exactly the same rate then the outcome will be unaffected. It is where characteristics of the parameters give rise to different rates of inflation that a study of the effects is essential. The formula for inflating cash flows is (1+rf )^n where rf = inflation rate An assumption is made that the cash flows will inflate at the same rate year on year. This may be a reasonable assumption for both a project of short duration – 3 to 4 years or even for a project with say a 25 year life on the basis that it is the averaged rate over the years which is being used. Opinions on inflation rates in the short-term may be quite reliable and whilst year by year inflation rates may differ over the life of a long-term project, there will be an average rate over the project’s life. It is of course possible to inflate year by year cash flows at different rates if there is confidence in the data available.

Example To explain the effects of differential rates of inflation consider two projects, one with high capital costs and lower operating costs, the other with lower initial capital costs but higher operating costs. An example might be the electrification of a railway line (initial high infrastructure costs) versus operation with diesel trains (higher operating costs, principally due to higher maintenance costs compared with electric units). The figures overleaf are entirely hypothetical but clearly demonstrate the need for an analysis which therefore encompasses the consideration of the effects of differential inflation.

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The first spreadsheet sets out the summary figures for the competing schemes. Only the costs are shown, as for simplicity it is assumed inflows would be equal (but see commentary below). The required rate is 12% and there is no inflation. The appraisal has been done over a ten year period, which as discussed in chapter 1 is considered a limit for most purely ‘commercial’ investments (again see commentary below for a discussion of what ‘commercial’ means). Note that only the first four years are shown. The term net present cost has been used as this is a cost only model and it is the project with the lower net present cost which should be chosen. An index of net present cost of electrification to net present cost of diesalisation has been calculated and this should be less than 1 if electrification is to be chosen. Not surprisingly electrification with the much higher initial capital would not be chosen (even with these hypothetical figures). required rate =

12% year inflation rate

Electrification Capital Costs Infrastructure Rolling stock Operating costs Service Fuel Maintenance

0

1

2

3

4

0% 0%

550 120

550 120

0% 0% 0%

23 22 12

23 22 12

23 22 12

23 22 12

23 22 12

23 22 12

discount factor

727 1.000

57 0.893

57 0.797

57 0.712

57 0.636

Discounted cash flows Net Present Cost =

727 1,049

51

45

41

36

Total costs

Diesel Capital Costs Infrastructure Rolling stock Operating costs Service Fuel Maintenance

0% 0%

80 220

80 220

0% 0% 0%

23 37 36

23 37 36

23 37 36

23 37 36

23 37 36

23 37 36

discount factor

396 1.000

96 0.893

96 0.797

96 0.712

96 0.636

Discounted cash flows Net Present Cost =

396 938

86

77

68

61

Net Present Cost Elect/Diesel =

1.12

Total costs

The second spreadsheet introduces differential rates of inflation. Electricity costs are assumed to inflate by 5% whereas diesel fuel inflates at 6%. The more significant difference is that the rate of inflation of the labour required for maintenance of the electrical units (8%) is considered to be significantly less than the rate of

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inflation affecting the cost of skilled labour required for the maintenance of the diesel units – presumably due to scarcity of the highly skilled labour. With the figures given and the study period of 10 years then electrification now becomes the option with the lower net present cost. required rate =

12% year inflation rate

Electrification Capital Costs Infrastructure Rolling stock Operating costs Service Fuel Maintenance

0

1

2

3

4

0% 0%

550 120

550 120

0% 5% 8%

23 22 12

23 22 12

23 23 13

23 24 14

23 25 15

23 27 16

discount factor

727 1.000

59 0.893

61 0.797

64 0.712

66 0.636

Discounted cash flows Net Present Cost =

727 1 , 11 3

53

49

45

42

Total costs

Diesel Capital Costs Infrastructure Rolling stock Operating costs Service Fuel Maintenance

0% 0%

80 220

80 220

0% 6% 11%

23 37 36

23 37 36

23 39 40

23 42 44

23 44 49

23 47 55

discount factor

396 1.000

102 0.893

109 0.797

11 6 0.712

124 0.636

Discounted cash flows Net Present Cost =

396 1,146

91

87

83

79

Net Present Cost Elect/Diesel =

0.97

Total costs

The above analysis has purely hypothetical figures to demonstrate the point and in reality the proposal for electrification is probably a non starter because of the very significant initial capital outlay. It is the fact that companies exposed to the demands of shareholders and the stock market are considered to have to deliver adequate risk free returns (or shareholder value!) within a short-term time horizon (will the clever new CEO be there in 20 let alone 10 years – he or she must deliver now!) that means that a ‘commercial’ view of such competing projects would be to look at the differences over a period of 10 years as a maximum. It will come as no surprise that if the above competing projects are looked at over a 30 year period, then even without the effects of differential rates of inflation electrification has the lower net present cost and should be chosen. If the net present cost is lower and the inflows are equal then electrification must give the

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higher return over the project’s life – but you have to wait for this and commercial companies and their shareholders do not want to wait. required rate =

12% year inflation rate

Electrification Capital Costs Infrastructure Rolling stock Operating costs Service Fuel Maintenance

0

29

30

0% 0%

800 120

800 120

0% 5% 8%

23 26 15

23 26 15

23 107 140

23 112 151

discount factor

984 1.000

270 0.037

286 0.033

Discounted cash flows Net Present Cost =

984 1772

10

10

Total costs

Diesel Capital Costs Infrastructure Rolling stock Operating costs Service Fuel Maintenance

0% 0%

40 220 Page 1

40 220

0% 6% 11%

23 34 36

23 34 36

23 184 742

23 195 824

discount factor

353 1.000

950 0.037

1042 0.033

Discounted cash flows Net Present Cost =

353 1966

36

35

Net Present Cost Elect/Diesel =

0.90

Total costs

A further point which this example reveals is that all the parameters should be considered fully. This is a very simple demonstration example and is but part of the process of appraising. A review of the competing proposals might reveal the following: •

Would income really be the same?

•

Might customers not prefer the faster or cleaner electrical units?

•

Have environmental compliance costs (preventing diesel pollution) been fully considered?

•

Should decommissioning costs be considered?

This is only the start of a list – a full study is certainly required.

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Analysis of price and volume changes Changes in price are not simply due to the economists’ narrow view of inflation. Competition is one example which may cause prices to fall. Further price changes are often associated with changes in volumes of business. For example, telecom prices may fall dramatically due to competition, but the loss of inflows from lower prices may well be compensated by significant increases in the volume of business – total inflows may well increase in money terms. Changes in prices and volume of business can also be considered and models can be developed further to permit analysis of such changes. Firstly the assumption is made that price changes will be compounded at the same rate each year. If more realistically there are likely to be high initial changes followed by declining changes or vice versa, then this can easily be modelled. This must be considered as an integral stage in appraising and presenting some proposals – see chapter 5.

Example The spreadsheet below sets out the base position for a project. The second and third columns allow prices and volumes to be changed. Note that the words price increase/decrease have been used rather than inflation or deflation. Monetary inflation or deflation may be the cause but price changes can occur for many reasons. discount rate =

capex inflows outfows

-110,000 85,000 -45,000

price increase decrease(-) 0% 0% 0%

volume change rate 0% 0% 0%

20%

0

year 1

2

3

4

-110,000 80,000 -45,000

85,000 -45,000

85,000 -45,000

85,000 -45,000

85,000 -45,000

net cash flows =

-75,000

40,000

40,000

40,000

40,000

discount factor =

1.0000

0.8333

0.6944

0.5787

0.4823

discounted cash flow =

-75,000

33,333

27,778

23,148

19,290

NPV =

28,549

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The spreadsheet below shows the effect of price increases, with presumably consequent volume decreases. discount rate =

capex inflows outflows

-120,000 110,000 -62,000

price increase decrease(-) 0% 1% 2%

volume change rate 0% -5% -3%

15%

0

year 1

2

3

4

-120,000 105,545 -61,343

101,270 -60,693

97,169 -60,049

93,234 -59,413

net cash flows =

-120,000

44,202

40,578

37,120

33,821

discount factor =

1.0000

0.8696

0.7561

0.6575

0.5718

discounted cash flow =

-120,000

38,437

30,683

24,407

19,337

NPV =

-7,137

It should be noted in this example that very small percentage changes in price and volumes have had a devastating effect on the project’s outcome – the NPV has gone from positive to negative. Many would argue that the NPV was too low to begin with and that volume decreases of -5% are high. However in today’s competitive global markets investments may be more marginal and price/volume decreases do occur. The formula for price changes is as for inflating cash flows: base parameter x (1+rf )^n where rf = rate of change in price or inflation rate The formula for volume changes: base parameter x (1+rv )^n where rv = rate of change in volume One advantage of the structure of a spreadsheet is that it permits the integrity of the arithmetic to be tested. The simple arithmetical relationship explained in chapter 2 should hold and with the addition of a constant rate of change in volume the relationship still holds. A combined discount rate of 20.12% arises if there is a real rate of 5% with inflation of 10% and volume increase of 4%.

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The formula is: combined or nominal rate (rn) = (1+rr ) x (1+rf ) x (1+rv) -1 where: rn = nominal or combined (discount) rate rr = real rate rf = inflation rate rv = rate due to increase volume As discussed in chapter 2 that although the combined or nominal rate (rn) = (1+rr) x (1+rf ) -1, the point is not that real rate analysis are flawed, but rather companies often carry out a nominal analysis but do not compensate for even the minimum inflation which might be expected.

Why carry out sensitivity analyses? There are many good reason for carrying out sensitivity analyses: •

to aid understanding of a project

•

to allow proper selection

•

to help run a better project

•

to remove risk.

To aid understanding of a project For a very healthy project – one with a high NPV and IRR then the sensitivity analysis is likely to yield little additional information apart from highlighting that the larger cash flows are the most sensitive. Even with what appear to be ‘bullet proof’ projects it is worthwhile to know and quantify just how sensitive parameters are to adverse changes.

To allow proper selection By ‘proper selection’ obviously risky parameters are identified and properly considered. A highly sensitive project should not be sanctioned.

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To help run a better project As discussed in chapter 5 on project appraisal methods the wealth of experience gained from carrying out and reviewing a thorough appraisal is often dissipated. The project is approved and others take over the management of initiating and running the project, ignorant of many of the issues that arose during the appraisal. Is it not wise at all times to know as much as possible about a project’s sensitivities?

To remove risk This is the most important reason. For the majority of projects and with time and tighter global conditions there is a need for thorough sensitivity analysis to ensure that as risk free as possible investment decisions are made.

Identify the risky parameters and tie them down Once the most sensitive parameters have been identified they should be ranked in an appropriate order: •

In order of magnitude – this is probably the most logical approach as the larger the cash flow parameter the greater the effect of any adverse variance.

•

In order of sensitivity – this will often be the same order as above, as normally the larger the parameter, the more sensitive the NPV will be to any adverse change in that parameter.

•

In order of difficulty of managing the risk – the most difficult to manage coming first.

Sensitivity analysis example Set out below is a demonstration example of how one at a time sensitivity analyses may be carried out. The basics of model construction as outlined in the examples in chapter 3 are followed. There is input data, an area for processing (a table of detailed cash flows which may be in a work area) and an output which contains the NPV amount. The output area is extended to give a table of how sensitive all the input parameters are to adverse changes.

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RISK

rate =




MANAGEMENT

250,000

labour

16,000

fuel

capital

8,500 22,000 -132,000

0


  


ANALYSIS

33,000

other

year discount factor

SENSITIVITY

15% capital materials




THROUGH

1.0000

1

2

3

4

5

0.8696

0.7561

0.6575

0.5718

0.4972

13,913

12,098

10,520

9,148

7,955

7,391

6,427

5,589

4,860

4,226

28,696

24,953

21,698

18,868

16,407

250,000

labour materials fuel other

  net cash flows

250,000 npv =




16,635

14,465

12,579

10,938

-99,811

-86,792

-75,471

-65,627

-45,652

-39,698

-34,520

-30,017

-26,102

74,012 sensitivities capital

250,000

29.60% percentage

labour

16,000

137.99% increase or

materials




19,130 -114,783

8,500

259.75% decrease -

fuel

33,000

66.91% which is

other

22,000

100.36% tolerable

-132,000

-16.73%

From an initial review of the figures it should be obvious that the inflows, the income of 132,000 are most sensitive. As is so often the case the income is the largest year by year figure. To this sensitivity should be added the likelihood that there is a higher risk of inflow amounts changing. Cost sensitivities relate to their size with fuel being the most sensitive. It is all very well setting out the table of sensitivities from which probably obvious conclusions can be drawn. The sensitivities expressed in percentages need also to be considered from a wider business perspective. For example, as stated above, sales are by their very nature likely to be sensitive as they are to some degree speculative. In the above example with abstract figures such facts are not available for consideration. Chapter 5 discusses in detail the need for the development of a process for appraisal and risk assessment. Consideration of the likely risks prior to using the power of a model are vital. Models can really only tell you about the relevant risks of the numbers, not the inherent risks arising from the nature of the businesses cash flows.

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Checklist Why carry out sensitivity analyses? A checklist which considers the reasons for and uses of sensitivity analysis when carrying out appraisals.

To understand the project?

To quantify risk?

To remove risk?

To assist with negotiating?

To allow proper selection of competing projects?

To assist with project management?

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Checklist Do you know your project risks? A checklist to provoke consideration of project risk.

Look for the obvious risk areas – without the spreadsheet!

What are the sensitive areas – using the spreadsheet?

What is the scale/materiality of the sensitive parameters?

Do inflation/deflation/price/volume changes have to be considered?

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Need for consistency in methods and measures INVESTMENT AND PROJECT APPRAISAL REVIEW PROCESS PROJECT APPRAISAL – A MORE THOROUGH, I N T E G R AT E D A P P R O A C H EXAMPLES FROM PRACTICE ARE THE BEST GUIDE INVESTMENT/PROJECT APPRAISAL PROCESS AUDIT NEED FOR APPRAISAL PROCESS GUIDELINES (OR INSTRUCTIONS) EXAMPLE – RST PLC D E F I N I T I O N O F R AT E S W H E R E M O R E T H A N O N E H U R D L E R AT E I S C O N S I D E R E D A P P R O P R I AT E

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Chapter 5: Need for consistency in methods and measures

Investment and project appraisal review process Traditional capital expenditure/investment/project appraisal or budgeting processes can be institutionalised, follow a set pattern as regards timing and content and be part of the company’s annual budgeting procedures. This approach whilst perfectly satisfactory highlights some of the drawbacks of the traditional methods of carrying out appraisals. One is that the appraisals are probably accounts department centred. Whilst this makes sense in that projects will be consistently appraised it may lead to insufficient scope for interaction between those requesting funds and those sanctioning the expenditure. A further drawback is that if the appraisal process is part of the annual budgeting process it means that appraisals and investments are really only considered once a year. In today’s dynamic and fast-moving world that is quite inadequate. However, an accounts or finance function centred approach has merits. The accounting function should be well aware of the cost of capital and clearly understand all the issues pertaining to the time value of money. As mentioned above there should be impartial consistency when choices are made. The decisions should be considered from the point of view of the company’s overall strategy and not subject to the whims or prejudices of individual functional or divisional managers.

An alternative approach A more flexible approach to appraisals and their review is to pass down much of the process of appraisal to those requesting funds. In a sense this leads to self selection of the projects by those demanding funds – the users of the funds. This also has the merit of allowing those that know the business and who should know intimately the risks involved to be involved in the decision-making process. Surely they are the best people to decide whether an investment is in practice likely to be a good one or not. Such a process can still be controlled by accounts or another delegated function. Updated policy statements can make clear the business areas and types of projects which do not fit in with the company’s overall strategy.

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Selecting a suitable process for your business The selection of an appraisal process which delivers risk free investments and the required returns depends very much on a company’s management culture. This in turn will be affected by the nature of the business carried out. For example, a consumer product company with hundreds of outlets would require tight central control over investment in the outlets. There would be a need for thorough consistency with probably minimal consultation with unit operators, though hopefully the operators views on the practicalities of the investment would be sought! This could be compared with a business which has operations which are quite distinct in operation both from a business and technical perspective. If ill fitting projects are to be avoided this requires the persons carrying out the appraisals and sanctioning expenditure to be aware of both the specific strategy of the company and the particular business and technical issues of any proposed investment. These two examples should illustrate the fact that there are issues of delegation to be addressed – how much does the board wish managers to become involved in decision making? Furthermore the extent of the appraisal process and in particular the appraisal reviews will depend on the size and frequency of investment. Size being relative to the annual or recurring expenditure of the business concerned. Thus small projects could be easily reviewed in say five minutes by a panel of managers. Large projects may require several stages of review, ultimately being reviewed by the board. Set out below are examples of two differing approaches to the review process. The first one is in the style of a traditional capital budgeting exercise. This approach may well deliver the required results, but a list of issues frequently not addressed follows. The second approach is a thorough process reviewing all aspects of a potential investment, passing much of the effort and decision making out to those requesting funds. This may be too detailed for many decision making situations but does aim to give as thoughtful and as risk free investment as is possible.

Traditional capital budgeting process The appraisal process may be a continuing one, where projects are forever being devised and for which financial appraisals are required or the appraisals may be part of an (annual) capital budgeting and possibly rationing process Many companies will have well established capital budgeting processes. Some distinguishing between capital expenditure on tangible fixed assets and expenditure on projects, entire business ventures or on acquisition of subsidiaries. Set out below is the description of the capital budgeting process. This highlights that

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the process is more than preparing some spreadsheets and carrying out sensitivity analysis. If benefits are to be gained from the effort involved in appraising capital expenditure then the process should be thoroughly thought through and appropriate to the business.

Typical stages of a capital budgeting process The processes are: •

State company strategy as regards business development and specifically investment.

•

Indicate amount of funds available for capital expenditure (expenditure on fixed assets) or new projects.

•

Invite outline proposals, possibly with screening appraisals (overall, ‘rough’ discounted cash flows).

•

The board, finance or other appropriate function reviews proposals and allows some to proceed while others are dropped.

•

Detailed proposals (background, estimates and cash flows) are prepared.

•

Models are constructed or more likely standard models used to produce dcf’s and the company’s chosen measures; payback, IRR or NPV applied.

•

Sensitivity analyses are carried out. The modelling and sensitivity analysis can be carried out either by the requesting department or accounts.

•

The board, accounts or other appropriate function choose the projects to be sanctioned.

•

Accounts or other appropriate function, e.g. internal audit, carry out post investment reviews (audits).

The above process has all the elements necessary to select investments which should deliver the required or best returns and also meet company objectives and strategy. However key elements which are often omitted from company processes are:

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Lack of effort in considering the investment opportunity from a ‘business’ perspective.

•

Lack of effort in focusing (keeping simple) sensitivity analysis, identifying and thus managing project risk.

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Not making full use of the appraisal exercise as an aid to contract and purchasing negotiating.

•

Not making full use of the appraisal exercise as a basis for project management.

The appraisal process described in the following pages aims to address these issues and deliver sound investment. That is investment which delivers the required return in as risk free manner as possible. The process also aims to add significantly to the understanding of the continuing operation of the investment or project and thus deliver the best possible results over the life of the investment.

Project appraisal – a more thorough, integrated approach Stages in the process

Invite proposals Obviously set criteria – maximum viable spend, expected returns etc and above all outline what the company long-term objectives are and how the projects or expenditure fits in with these. How detailed the objectives are will obviously depend on how devolved the company is from management control point of view. A general objective from group could be – ‘projects must add shareholder value’ – whatever that means! In fairness to those requesting funds it is preferable to be as clear as possible on the demands and constraints which a project must meet.

Screen proposals from a business objectives point of view If there are many proposals, before carrying out or asking for the screening appraisals it may make sense for a panel to review proposals from a business point of view – does the proposal really meet or fit in with corporate objectives? Do not dismiss ideas out of hand – maybe there is something in them for the future – or maybe the company should sponsor an independent subsidiary to develop the proposal – protect intellectual property.

Ask for screening appraisals If projects /investments are going to be accepted or rejected on the screening appraisals then there must be very clear rules as to the detail and exactness of any estimates used in the appraisal – the criteria must be clearly stated.

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If a review from a business perspective has been carried out as above then the screening stage can be carried out as more of a numbers exercise, but if no businesses review is carried out then the screening stage should be carried out intelligently. It is just not the numbers that should be the deciding factors – other issues are how the project fits with the overall business plan – its integration with the strategic plan.

Set required rate, criteria and appraisal measures The required rate (or rates where projects are categorised in some manner) should be specified – also an explanation of how the rate has been determined is helpful. The company’s preferred measures (and the reason for using these) should be clearly stated. Terms such as rates and measures to be used need to be defined – project process guidelines or sample appraisals are the best place for a set of definitions.

Ask for detailed appraisals After the screening appraisals, the aim of which is to determine if the projects are economically sound and more importantly fit in with the company’s objectives, the proposals should be subject to in-depth detailed appraisals. It may be necessary to define the level of estimating, costing and detailed analysis of inflows and outflows required for different types of projects. The best method of clearly defining project categories and thus the required level of detail is to give typical examples of projects appraised by the company

Have a clear and fair review process The review of the detailed appraisals may be a ‘paper’ or desk top exercise – suitable for relatively small, routine projects, or the review may comprise full-scale presentations with considerable deliberation as to the outcome. In either case the process(s) should be outlined. Examples of the company’s practice in action using a typical example may be the best way of describing what ‘review’ means. The consistent adherence to the process and following of timetables by the reviewers is courteous, if not more importantly, essential for business success as regards consistent, fair and timely project appraisal.

Monitor projects Project process will obviously be monitored as sanctioned projects progress – all part of live project management. Depending on the scale and duration of projects or capital expenditure being appraised there should be monitoring of the project to identify how the project is progressing. This can be done by reference to the

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final, most detailed level of appraisal estimates. The aim being to determine at as early a stage as possible if there are weaknesses in the appraisals and estimating methods, which if used on other potential investments or projects will lead to poor decision making. In the longer term ongoing operating costs and revenue streams should also be reviewed to determine how accurate the appraisal estimates were. Any material disparities should be investigated: •

are they one off – just a poor estimate or estimator?

•

are there indications of systematic weaknesses endemic in the company’s process?

Carry out a post investment review – audit Where projects are monitored or reviewed as a continuing process immediately after sanctioning this may be considered as project auditing. The exact meaning of project audit should be defined by the company. It could mean any of the following: •

Checking of project spend, simply from a cash control – proprietary point of view – items could be over specified, over priced or the wrong supplier used. As long as the paper work is correct all is fine! This sort of audit may be necessary but does not yield many benefits as regards improving project management.

•

Checking on project spend to ensure all company policies and procedures have been followed This is similar to the above audit but really means checking that the company policies, as regards obtaining competitive quotes, ensuring independence etc have been followed. Again this can turn into a merely bureaucratic process yielding few benefits in improved project management.

•

Checking on project progress and costs after completion to determine how efficiently the work has been carried out – what can be learnt.

It is really the last point which links sound project management with project appraisal. The idea is not so much to determine whether or not a particular project was appraised properly and that events turned out as expected, but to see if there are any endemic weaknesses in the project appraisal – learning from mistakes!

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Examples from practice are the best guide As a guide to uses of and approaches to appraisal there follow three examples from quite different types of business. These demonstrate the stages and headings used in different businesses. They also demonstrate the different cultural styles which may be appropriate.

Example 1 – written report style

Background to the example A financial services business – life assurance/pension provider has traditionally developed new products, for example pensions targeted at certain market sectors, with little regard for either the costs involved or the ability of the product to deliver an adequate return on the investment in set-up and running costs. With today’s competitive markets this approach can not be tolerated. Each proposal for a new product is to be treated as a project. A sum of money will be made available for the start up costs. Servicing costs over the life of the product have to be estimated. Only if it can be shown from market research on likely volumes of sales that the consequent revenues can cover the life cycle cost of investment will the project be sanctioned.

Acme Assurance plc – report on ‘Teens’ new product Restated company strategy instructions. The company wishes to grow its share of the market of specialist pension products whilst increasing margins and more importantly the return from handling such products. New niche markets are to be identified. Sufficiently robust market research is to be carried out to identify and confirm that sales will reach sufficient volumes with consequent income levels to justify the start up and life cycle costs of the product. New products are to be developed.

Funds available/investment criteria From experience launch costs of similar new products are no less than 5m and funds of up to 7.5m will be available if this expenditure can be justified. Justification means ensuring a lifetime return on the investment of no less than 12%.

Meeting the objectives – outline of the ‘Teen’ project It is proposed to create a pension scheme particularly focused at those in their late teens. It should be given a name sympathetic to the age group, with the facility to start with very low monthly contributions (as low as 15). It is believed that

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there is a large untapped market in this age group. The business, even with low premiums, should deliver the company’s required returns, but more importantly a customer base will be established which with proper care will lead to a lifelong growth of business.

Business need review The company’s strategy is to grow the business and in particular identify a range of high return niche products. This proposal meets the company’s objectives.

Risk assessment The principal risks of such projects are over estimation of the market’s worth both as a whole and as regards our share of the market. Start up costs should be certain as to amount and timing. The risk from the operating cost overspend relates to under estimation of selling and particularly regulatory compliance costs. The effect of changes in the best estimates of these figures will be studied in the sensitivity analysis.

Screening appraisal With only the lower estimate of potential sales volumes and amounts the screening appraisal of the proposal to spend 4.5m yields a return of 17.8% . It is considered that sales volumes will be at least at the median level.

Initial review by the New Product Committee (NPC) The NPC reviewed the initial proposal on 12 November. The initial risk, business and screening review of this project all indicated that it should be viable and therefore a sum of 200,000 is sanctioned to permit the carrying out of a detailed appraisal.

Detailed business review The idea of selling pensions to those in their late teens is seen as essential as a means of capturing market share. There is much more general awareness of the need to provide for retirement and the target age group does have a higher proportion of discretionary spending compared to those in their 30’s and 40’s.

Detailed appraisal A detailed appraisal using the company’s established model shows that the estimate of the most likely sales and costs yields a return of 17.7% on investment of 4.5m. At the company’s minimum required rate of return of 12% there is an NPV of 1.9m. The profitability index of 1.42 is above the minimum requirement of 1.2.

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Sensitivity analysis Income streams are the most sensitive and whilst volume is an important issue, market research indicates that the minimum volume of policies sold would be 243,000 at which level the project returns 13.4%, well above the minimum required rate of return. A more critical factor is the average value of monthly contribution. With minimum volume of sales of 243,000 the lowest tolerable average monthly contribution is 22.7.

Detailed risk assessment and risk avoidance From the above sensitivity analysis marketing will have to be focused to achieve at least the minimum sales. This can be achieved by focusing on those in the age group most likely to commit to proposals. The marketing department has indicated that such target groups have been identified. The risk of average premiums being below 22.7 per month is very real and it is recommended that the minimum monthly contribution be set at 24 even if this loses volume. A level of 24 and well above could be encouraged by the fact that contributors are allowed to reduce contributions or cease all together should their personal conditions change adversely in the future.

Negotiating uses The sensitivity analysis showing the effect of low monthly contributions should be developed as an aid to encouraging sale force to emphasise the need for reasonable levels of continuing contributions.

Performance measurements The model is to be maintained with live data showing the outcome and the continuing change in lifetime outcome through altering minimum contributions etc.

Conclusion As the project meets all the company’s criteria the project should be sanctioned.

Example 2 – form filing report style

Background to the example An established telecoms company is responding to competition from low cost competitors by being innovative and initiating a stream of new and add on services. Investment will be sanctioned if the projects yield an IRR of 30% minimum. In reality pay backs of under 3 years are desired in recognition of the very rapid

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dynamics of the sector. There are few restrictions on funds available or the nature of the project as the strategic aim is to increase if not hold market share.

Project

Home

Objectives

view

PQR

number

Project must give a risk free return > 30%

How does the project meet the objectives? The project involves the rental of mini video cameras linked to domestic customers’ personal computers. These are rented for a monthly charge which covers our costs of leasing from the manufacturer in 17 months. The revenues from additional line usage ensure a return of 55% minimum.

Risk assessment and elimination The only risk to our business is the return of cameras by customers before the contra lease payments have been completed. The minimum rental is for 12 months and the expected income from the additional usage during this period fully covers the lease costs.

Results of screening appraisal The company’s standard screening model shows a return of 55% on the investment and pay back in 14 months. Detailed

appraisal

and sensitivity

analysis

results

The company’s detailed appraisal model confirms a return of 55% with the expected level of sales. With the lowest likely take up the return falls to 43%. Early cancellation by 50% of the customers reduces return to 36%.

Risk

elimination

Risk

Eliminated

early cancellation of hire (before average of 2 years)

expected revenues in the 12 month minimum hire period cover this.

lower

if initial take up is 50% of what is expected then the same % of camera leases can be cancelled

sales

by:

Presentation venue and date The presentation will be made at the project review meeting in room 12 on Friday 12 May.

Performance measures and responses Key performance measures for this project will be:

response:

monthly sales levels compared to budget

review pricing policy increase advertising

levels of early (pre 2 year) terminations

consider 2nd and subsequent year discounts

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Example 3 – routine (small scale) capex appraisal This third example illustrates how the process may be used for a small project.

Background to the example A company in a basic food processing industry routinely budgets to spend amounts equal to current depreciation on maintaining the operating capability of the company whilst also improving returns on investment. Improvement to returns is achieved by ensuring that new plant and equipment is either or both more efficient (higher outputs) and has lower life cycle operating costs than the plant and equipment which is to be replaced. The company therefore has very clear criteria which have to be met before capital expenditure is sanctioned. These criteria recognise that much capital expenditure is on plant where there is no income as such – it is the lowest cost option which is being sought.

Project XYZ – replacing dryers

Company objectives (restated) Expenditure will only be sanctioned where replacement plant has demonstrably higher efficiency, higher processing output and/or lower operating costs.

Description The projects aim is to replace the existing dryers with more efficient (lower fuel and maintenance costs) dryers.

Alternatives The only viable alternative is to continue using the existing dryers (outsourcing of this stage of the process is impractical). Refurbishing the existing dryers with their higher continuing fuel and maintenance costs is a higher cost option -see appraisal on standard model c200.

Risks Are there any risks associated with this investment? no

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yes

if yes explain how these will be overcome.

•

Business interruption

•

Technical

•

On-going performance

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Detailed appraisal – sensitivity and risk analysis Standard appraisal model c200 should be used and a full sensitivity analysis carried out.

Risk management policy (restated) If any single parameter is sensitive to a change < 30% then the project should be rejected. Where single parameters are sensitive to a change > 30% but < 80% then the parameters should be listed below and the management of the risk due to change cleared by the relevant responsible personnel.

Risk

Clearance

If fuel costs increase > 35% then NPV becomes zero

Purchasing department have a supply contract ensuring cost increases of max 10% p.a. signed _____________________ purchasing manager

Risk If maintenance labour costs increase > 56% then NPV becomes zero

HR department forecasts indicate that skilled labour costs will not increase at a rate > than 9% p.a. signed _____________________ human resource manager

Presentation The proposal will be reviewed at the next bi-monthly small projects review meeting. This summary and backup papers will be sent to the four members of the review panel one week in advance of the meeting.

Liaison with purchasing The detailed appraisal spreadsheets are to be made available to the purchasing department with any significant time delay sensitivities highlighted.

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Audit This project may be subject to the company’s project review process. These are but outline samples of approaches to appraisal. As stated in the introduction anyone charged with devising and operating a company’s appraisal process should really focus on what is to be delivered by the process and also being aware of what will work within the culture of the company in question.

Investment/project appraisal process audit Auditing the appraisal process yields great benefits. Audit of project appraisals may be considered by many to be an exercise in finding out what went wrong (all very well) and who is to blame! Apportioning blame may well be necessary, but really is not a very positive aspect of audit. The audit exercise should deliver clear recommendations for the future development of the appraisal process and lead to improved project and risk management.

Selecting projects to audit Considering the scale of the company and the size and number of project appraisals typically carried out in any year, arrange for a team of two or three (from different disciplines – engineers, management accountant etc) to review two or three projects selected as follows: •

A model project – one which was appraised and has or appears to be working out with results as predicted in the appraisal.

•

One or two (or more!) problem projects.

Identify obvious weaknesses Are there any unique, one-off special problems which give rise to the project being off appraisal estimate? This should not be the excuse for every project being off estimate!

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Look for endemic process weaknesses If there are no one-off reasons then the projects should be reviewed to identify which aspects of the appraisal process failed to identify problems which have occurred. Ideally the review of the project from a business perspective should have picked up problems and if this was missed the basis appraisal model should have done so. Finally, the sensitivity/risk analysis should certainly have highlighted the problem areas. If it is a case of the problem parameters having been identified at each stage with risk properly identified, then is it a case of no action being taken to tie down the identified risks?

Report and make recommendations Identify and quantify the effect of weaknesses in the process.

Ensure follow up action Take the audit seriously. Ensure there is commitment to improving the process (from the top).

Audit stage summary •

Select benchmark – a ‘good’ project.

•

Select test ‘poor’ projects.

•

Identify if there are ‘special’ reasons.

•

Identify which stages did not identify the resultant problems.

•

Did lack of risk management let the project down?

•

Summarise findings.

•

Recommend practical remedial action.

•

Ensure recommendations are implemented – action from the top.

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Need for appraisal process guidelines (or instructions) The best way to engender good practice is to have practical guidelines which are comprehensible to all those involved in investment or project appraisal. A good way of disseminating good practice is to have a set of guidelines which show how an investment/project of the type typically undertaken by the company would be appraised. Set out below are headings and extracts from the appraisal guide for a company with both new project and capex appraisals. Points to consider on the use of headings or the approach follow where appropriate.

Example – RST plc Project and capital expenditure guidelines The word guidelines is preferred to manual or instructions – whilst the process might be very prescriptive and restrictive, the appraiser should be encouraged to think, not just follow instructions.

Process objectives An outline of the company’s objectives with respect to capital expenditure appraisals. The company’s capital expenditure policy is aimed at ensuring true growth in shareholder value through sound high yielding investment. This is to be achieved by all projects or capex having to make returns of 17% as an absolute minimum, with all projects thoroughly tested for sensitive parameters and risk. No project will be sanctioned where any single parameter or linked parameters causes zero NPV if its variance from expected is less than 30%. Where zero NPV would be caused by any single parameter or linked parameter varying 50% adversely from the expected then the risk of the adverse movement must be demonstrably eliminated. The objectives can be described in a lose, mission statement manner and for some companies and situations this may be sensible. However, it is recommended that clear quantified objectives are set out at the outset. In this example the detail on sensitivity requirements might be best left until the detail of the example.

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Responsible function/department/personnel The names of the functions/departments and staff who are responsible for the operation of the process and those responsible for the sanctioning and review of the process if different. The appraisal process is operated as a subset of the annual budget process by the general finance team led by Mr Smith CFO. Approval of expenditure up to 200k is made by the authorised purchase signatories on recommendation of the general finance team. Expenditure above 200k requires specific board approval on recommendation of the general finance team and after the formal review process described below.

Timetable/stages in the process/index The timetable for proposals, appraisals meetings, sanctioning and progress of the projects. For projects/capex expenditure under 200k the stages and timetable for appraisal are as follows: •

expenditure < 200k submission four weeks prior to the Jan/Mar/May/ July/Oct/Nov general finance team (GFT) meetings

•

expenditure > 200k submission four weeks prior to the Mar and Oct GFT meetings with reviewed projects to be submitted via the finance function four weeks before the June and December board meetings.

Precise timetables for submission (hopefully also for replies!) are essential.

Annual or specific objectives Specific, one off investment opportunities or constraints should be clearly stated. The particular concern this year is to ensure adequate free cash flow for both dividend payment and also strategic acquisitions. This is to be done without jeopardising the progress of the continuing businesses, but must entail a tighter rationing of cash. The required rate of return has not been increased, but total available group funds are limited to 25m instead of the expected 35m. Particular emphasis will be placed on those investments which meet the required rate of return, but more importantly can be demonstrated to be risk free and meet immediate corporate goals.

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Some companies would be silent on specific issues. However there is acceptance that managers are and probably should be more involved in a company’s direction. As a base position surely there is presumably no harm and only benefit in managers knowing what opportunities and constraints the company faces?

Screen proposals from a business objectives point of view The projects/capex proposals should be screened to see that they fit with the business objectives. Proposals are to be outlined on form CX20, stating the business case and referring to the detailed business objective (from corporate plan CP01 year xxxx) which they aim to meet. This implies that a company has very clearly defined overall and detailed business objectives, if not this stage will be virtually impossible to implement, or worse still implemented on the basis of the reviewers prejudices. If projects capex cannot be identified on the basis of business objectives it might be better to simply rely on the impartial selection found by choosing projects with the highest IRR’s.

Screening appraisals – content and style Screening appraisals will contain the following detail and the style of the spreadsheet attached (not shown). The amount of definition of style, content and measures used will depend on the company culture – devolved or autocratic. Also whether there is likely to be a consistent body of similar projects – as regards cash flow profiles, lives etc.

Detailed appraisals – content and style The content and style of a detailed appraisals. Detailed appraisals will contain the following detail and the style of the spreadsheet attached (not shown). The amount of definition of style, content and measures used will depend on the company culture – devolved or autocratic. Also whether there is likely to be a consistent body of similar projects – as regards cash flow profiles, lives etc.

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Set required rate, criteria and appraisal measures The discount rates to be used and the company’s standard measures, indicating where alternatives may, or must, be used. The appraisal criteria which have to be met and the measures used must be stated. Some would include these at the outset – directly linked to company objectives. An example of notes for a business which has more than one hurdle rate is set out below.

Review process The names of the functions/departments and staff who are responsible for the review. Reviews will be carried out by the GFT or Board as appropriate. For projects with expenditure < 200k a five minute presentation will be allowed. A LCD panel will be available to make live spreadsheet presentations. For projects with spend > 200k a minimum of 30 mins and max of 60 mins is indicated as being adequate for board review, although the duration will be set on a project by project basis. The process by which the projects will be reviewed should be clear to all involved. This may be combined with, or refer back to, the section on responsible function. In the above example some would add much more detail on the conduct of the reviews.

Process audit An outline of objectives and execution of the appraisal process audit. At least one out of ten projects will be subject to audit. This will occur during April or May each year and be carried out by internal audit. The objectives of the audit are to identify weaknesses in the appraisal process and thus recommend improvements in the operation of the process in the future. Staff are requested to make time available should their projects be subject to audit. The audit processes objectives and the manner in which an audit will be conducted should be made clear. The above example could be more detailed and explicit on both objectives and conduct of an audit.

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Definition of rates where more than one hurdle rate is considered appropriate Setting the required rate Where a company or possibly a group of companies has quite different projects in type and scale then the use of a single required or hurdle rate may be inappropriate. A method of allowing investment to proceed with different project types delivering different returns makes sense. This may be achieved by setting rate ranges with definition of the types of projects which fall within the range. For example:

10% minimum return Projects classified as essential must give a return of at least 10%.

16% return Projects classed as continuing strategic must give a return of at least 16%.

25% return New projects – developments of existing business or entirely new must meet the company’s required rate of 25%.

Definition of project types

Essential This means process continuity, health, safety, environment related expenditure. No breaches of health, safety or environmental or other statutory law and regulations can be tolerated and thus where 10% return is not achieved then expense will be sanctioned on approval of the capex board(there remains the option of ceasing an operation or process).

Strategic This means expenditure related to the operations of the business which are defined as core and of central importance. Strategic activities can be identified in the budget objectives for all existing and new operational activities.

New This means any incremental, add on or completely new projects.

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The selection of a rate by the means outlined above should ensure that the businesses running and growth is not hampered by lack of investment. However the problems with such an approach are obvious: •

the definitions of expenditure type must not be vague

•

those requesting funds may try to categorise their projects so that a lower rate of return is required.

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Checklist Does your appraisal process deliver? A checklist of the matters to be considered when devising or reviewing a project appraisal process.

Is your appraisal process appropriate?

Can your people help?

Do you want them involved?

Does your process suit your business?

Is there sufficient effort in considering the investment opportunity from a business perspective?

Is there sufficient (simple) sensitivity analysis?

Is risk identified and MANAGED?

Can the appraisal exercise aid to contract and purchasing negotiating?

Can the appraisal exercise assist with project management?

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Checklist Audit process A checklist of the matters to be considered and the stages of the audit of an appraisal process.

Select benchmark

Identify if there are ‘special’ reasons

Test ‘poor’ projects

Was an adequate business risk assessment carried out?

Identify the stage(s) which allowed the resultant problems

Summarise findings

Recommend practical remedial action

Ensure recommendations are implemented

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Accounting for intangible benefits I N T R O D U C T I O N – W H AT A R E I N TA N G I B L E B E N E F I T S ( O R C O S T S ) ? D E F I N I N G / M E A S U R I N G I N TA N G I B L E B E N E F I T S VA L U I N G B E N E F I T S – VA L U AT I O N M E T H O D S S O M E F U N D A M E N TA L I S S U E S T H E C R I T E R I O N O F H U M A N W E L FA R E VA L U AT I O N M E T H O D S S O U R C E S O F D ATA C H O O S I N G A M E T H O D O F VA L U AT I O N C O N S I D E R AT I O N O F O T H E R I N TA N G I B L E B E N E F I T S O R C O S T S SUMMARY – THE NEED FOR A PROCESS R E F I N E R Y C O S T- B E N E F I T A N A LY S I S

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Chapter 6: Accounting for intangible benefits

Introduction – what are intangible benefits (or costs)? For many large scale projects carrying out a cost-benefit (or more appropriately benefit-cost) analysis is a well established practice. Whether or not the decisions made on the basis of the analyses are correct will only become apparent with time and may then be subject to the prejudices of the reviewer. There is often a ‘political’ dimension to the benefit-cost analyses and this may go as far as causing relevant data to be omitted or overemphasised. This does not mean that such analyses are not valid – at least more informed discussion should take place.

Example: Building a by-pass road could be justified on the basis of saving intangible costs such as: •

•

cost of delays on existing roads –

the time spent sitting in cars rather than on economically useful work

–

the cost of fuel saved by engines not sitting idle in queues

–

the cost saved in not polluting the environment.

costs arising from lower accident rates –

lower fatalities and loss of income earners

–

lower costs of hospitalisation.

These are only some of the benefits which are, as is predominantly the case, really cost savings. They are termed intangible benefits, but most are really quite tangible and capable of being quantified to a high degree of accuracy. The word ‘intangible’ is often used too glibly. One dictionary meaning of the word is ‘eluding the grasp of the mind’. The fact that the justification to proceed, or not, with a particular project will partially depend on intangible and therefore often highly subjective apparent cash flows need not invalidate the conclusion.

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In the context of private sector businesses carrying out appraisals, intangible benefits (or costs) should not be ignored and the process of appraisal described in chapter 5 should include reference to consideration of intangibles for all project appraisals. Benefit-cost analysis has become an essential part of many appraisals, for example, with the heightened awareness of, and legislation relating to, environmental matters. Other decisions will become more prone to requiring a benefit-costs analysis, for example, health service provision decisions – can treatment decisions be solely left to the clinician? Would decisions not benefit from a review of the options in a quantified manner? It is evident that many benefitcost decisions will be more political and sensitive than ever! The notes that follow discuss established methods of valuing benefits and then proceed to outline a process for developing and carrying out a benefit-cost analysis.

Defining/measuring intangible benefits This is probably the most difficult issue to be faced. The fact that a benefit is intangible can mean it ‘cannot be grasped mentally’ if another dictionary definition of intangible is used. If this is what the decision makers mean then maybe the word ‘incomprehensible’ would be more appropriate! Consider how sunk or opportunity costs (chapter 2) should be dealt with. For many organisations if there is no cash flow in or out associated with the event, there will be the irrefutable argument that the event is not relevant to the appraisal. There are two points at issue. Firstly, costs can be truly intangible if the entity carrying out the appraisal only perceives (and has to perceive) projects from its own stand point. For example if an industrial company which churns out ‘acceptable’ levels of pollutants does not have to pay for the demonstrably increased levels of respiratory diseases in its area then the higher than normal costs of treatment are indeed intangible – to the company. The issue here is one of accountability. Secondly, where a cost or benefit really cannot be measured within any reasonable limits or to a satisfactory degree of accuracy then it may be more appropriate to consider it as intangible. For example, if a company decided to spend significant amounts on planting a boundary rose hedge around its factory rather than just having a wire fence then the benefits would be a nicer environment for employees and a better impression given to the public. There are benefits but they are very difficult (but not impossible) to measure. Even with this slightly

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obtuse example it would still be possible to carry out surveys of the benefits of the rose hedge. Both of these examples illustrate that for many projects intangible means that you do not have to, or cannot, easily account for a cost or benefit. This does not mean that the cost or benefit is not relevant. The first example demonstrates that with the passing of time and the general trend towards more corporate accountability it is likely that more and more presently intangible costs and benefits will become tangible. The second example demonstrates that whilst cost or benefits cannot be quantified with any degree of accuracy this does not mean they should not be considered and the best estimates of their effects quantified no matter how wide the range. Although many costs or benefits are dismissed as intangible the reality is they can be measured, often to a high degree of accuracy. The word ‘intangible’ should not be invoked to avoid a full business or economic study. Many benefits arising out of expenditure are clearly measurable income or cost savings and can with a high degree of certainty be expressed in £’s or $’s. Various valuation methods which may be used to quantify benefits to allow an arithmetical appraisal to be carried out are outlined below. The ‘science’ of measuring benefits has many established techniques but it should be noted that as interest in this area is relatively new this is a young and developing science. The notes on the following pages are particularly directed at the appraisal of environmental projects. This type of appraisal typifies the issues and range of views which have to be considered when valuing intangibles. This is also a growth area for appraisal work and an introduction is considered apposite.

Valuing benefits – valuation methods Introduction Valuation study methods are relatively recent. Many of the methods originate in the United States. In 1981 the President (Ronald Reagan) signed Executive Order 12291 which required all major federal regulation to pass a cost-benefit hurdle before they could become law. This affected many environmental agencies requiring them to look for methods of measuring benefits. Further impetus for the use of cost-benefit analysis came form Congresses ‘Comprehensive Environmental Response, Compensation and Liability Act’ which established that potentially responsible parties could be liable for cleanup and

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the damages caused by their spill or release of potentially hazardous or toxic substances. The Exxon-Valdez case with a very large tanker oil-spill in Alaska is probably the most infamous natural resource damage assessment to end up in court.

Some fundamental issues Some matters which should be considered, particularly when considering environmental appraisals: •

Rationale is required – this is certainly true if a ‘sensible’ analysis is to be carried out.

•

Consideration should be given to different views of ‘value’ depending on the culture (of the people) and country concerned – more of an issue with appraisals where comparisons are made between continents and countries.

•

Are views a majority decision – do all votes carry equal weight? Are actions only taken when benefits exceed costs at the level of a single individual?

The criterion of human welfare Environmental investments could be evaluated in terms of how they change the well-being or the welfare of the individuals being affected. Should this be the sole criterion? •

Can human welfare be defined and measured?

•

If so can well-being be measured?

•

Is this to be the only criterion?

Measuring human welfare What is human welfare? Examples are when an individual moves from a state of hunger to being adequately nourished or from living with poor sanitation to having proper sanitation, a healthy environment and thus longer life. There are conceptually distinct ways of attempting to measure well-being: 1.

Define measurable conditions such as food intake, life span, education and income. These can all be defined objectively and can be expressed in clear terms. UN social indicators are good examples of such measures. These indicators would clearly indicate the difference

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between individuals with high and low levels of well-being, but they are not direct measures of well-being as such. 2.

Measure well-being using a well-defined scale. Carry out surveys asking people to rank their well-being on the scale (say 1 to 10, 10 being high level of well-being). A flaw in this is that different people have quite distinct and differing views of what is a high or low level of well-being.

Measure willingness to pay (WTP) or willingness to accept (WTA) Another method proposed by economists is to measure the gain in an individual's well-being by measuring the maximum amount of goods or services (money/wealth) which they would forego or surrender to obtain a given level of well-being. This approach could also be used where there is a reduction in wellbeing – how much money/wealth would the individual require to compensate for the loss of well-being? Attempts can be made to determine the maximum amount of income the individual would be willing to pay (WTP) to have a certain level of environment. It would be difficult to directly measure two states of well-being and thus two combinations of income and environmental quality are considered, both have the same overall level of well-being, one with higher income and lower environmental conditions and the other lower income and a higher standard of environment. The point at which the two combinations give equal overall well-being yields a WTP figure. WTP is the monetary value of the change in quality of life and is termed the individual's compensating variation, measured in relation to the initial well-being. A rational individual is assumed to calculate a WTP figure at which the two combinations of income and environmental conditions give equal overall quality of life. An alternative approach is to ask how much additional income an individual would be willing to forego in order to have a higher standard of environment. This would be the amount an individual was willing to accept WTA. The individual is asked to consider the two combinations of income and environment at the proposed level of quality of life. WTA is an alternative measure in monetary terms of the change in an individual's quality of life resulting from an improvement in environmental conditions. Which should be used? It has generally been assumed that both methods yield a similar result. Early research and articles indicated that this was the case, but more recent empirical evidence proves that the measures can often give quite different results. WTP measures can often be substantially less than WTA for the

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same environmental change. Much of the above is due to an individuals view of what changes are worth. For example a £100.00 loss of income is often seen as much worse than a £100.00 gain.

Non-human well-being The above methods attempt to measure the benefits affecting humans. Environmentalists often object to economists only considering human well-being. A response from an economist might well be that when considering human well-being this also encompasses non-human, animal, and plant well-being etc, as humans have to co-exist with animals and plants and do consider these issues. This is often the case, but there is an argument that non-human welfare should not merely be considered as an adjunct to human well-being, but given (equal) standing in any analysis. It could be suggested that value conflicts arising out of different peoples views on non-human well-being issues should be resolved on the basis of the outcome of majority voting.

Valuation methods The above views on and measures of human welfare are particularly relevant to full scale environmental appraisals. A particular concern in any appraisal with environmental costs and benefits is to find an appropriate and reliable method of valuing the ‘intangibles’. There are many suggested methods of valuing environmental benefits and these may be grouped under the following headings: •

Market valuation of physical effects (MVPE)

•

Stated preference methods

•

Revealed preference methods

An outline of the methods and their uses is set out overleaf.

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Market valuation of physical effects (MVPE) These methods value changes in the environment by observing actual physical changes and relating the effect of this on the value of goods and services. There are three stages in calculating the market value of physical effects: 1.

Estimate the physical effect of the environmental change – e.g. 1% loss of arable per year.

2.

Estimate the difference this makes to output. Following the above example it may be more than 1% less production due to economies of scale.

3.

Estimate the loss of market value due to the net loss in output.

Methods used in the MVPE process

Dose response This is really a method which looks at the cause/effect relationship, the terms used being dose – what causes the damage and response – the damage caused. The approach may be used where dose-response relationships between causes of damage, e.g. pollution and the impact are known. The approach is applicable where environmental changes have an effect on marketable and measurable items.

Damage functions Dose-response data is used to estimate the cost to the economy of environmental change. The impact on the environment due to physical change is converted to economic values.

Production function How output is affected by inputs. That is the output will be a function of the inputs. Data which can identify the effect on output due to changes in inputs is gathered to give the production function. Effects obviously have to be measurable e.g. increased soil acidity affecting crop yields.

Replacement cost The cost of righting a wrong. Data can be obtained by observing what those affected will actually pay e.g. paying for the building of sea defences.

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Human capital The cost of the effect on humans – the cost of poor health caused by poor environmental conditions. The economic cost of poor health could be calculated by estimating the effect of lower productivity of a workforce.

Application of MVPE MVPE has widespread application as environmental changes and their associated effects are often obvious and thus easily understood. It can be used in situations such as measuring the effects of soil erosion or pollution on yields or the effects of pollutants in air or water on health. Whilst apparently straightforward one serious limitation must be that often the links between cause and effect are not as simple as first envisaged. Detailed analysis and thought is required.

Stated preference or contingent valuation method – also called direct approach This is a valuation technique aimed at determining individuals preferences. A survey is carried out asking a question or series of questions about how much they value goods or services. The word contingent is used to describe the valuation as the proposed outcome is hypothetical. This method appears to be similar to market research or opinion polling and in many respects it is. The method seeks to obtain a monetary measure of the change. This differs from most public opinion polls which seek to elicit people’s attitudes and opinions. Market research does deal with measured amounts – whether people would purchase goods at given prices. Contingent valuation deals with situations where there is no ready market in the goods or services being appraised. The pros and cons of the method are set out below.

Pros Contingent valuation method has attracted increasing attention by economists concerned with environmental issues and those involved in determining environmental policy. One reason is that contingent valuation methods are the only ones which permit the quantification of some environmental benefits – for example for those formulating environmental policy where there is a need to quantify how people value a nature reserve. Review of properly carried out contingent valuation surveys indicates that the estimates of benefits are as good as from other methods.

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Cons A problem is that the surveys have to be carefully planned and executed. It appears easy to ask a few (relevant) questions, get the answers and draw the conclusion. It is well know in opinion polling that the design of the questions(s) can very much affect the outcome – you can get the answer you want! Thus whilst they may yield useful results contingent valuation methods require a properly designed survey. The survey can be carried out in several ways and each method has advantages and disadvantages:

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By telephone:

By telephone:

•

Easy random selection of respondents

•

•

Interactive

Respondents will limit time – they don’t want to talk too long

•

Cheap

•

•

High response rate

Only words can be used no pictures etc

By mail:

By mail:

•

Good response rate

•

•

Pictures etc can be used

Does the respondent understand the survey? They may not complete it in the required, logical order

In person:

In person:

•

Interactive

•

Expensive

•

High quality results questions can be asked in the desired, structured manner

•

Surveyors may introduce their own biases

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Design of a contingent valuation questionnaire There are normally three parts to a questionnaire. 1.

Description of the hypothetical goods, services or conditions on offer e.g. what it is, when it will be available, how reliable it will be, how much the individual will have to pay, how much others will have to pay, if different.

2.

How much is the individual willing to pay or to be compensated as appropriate?

3.

Determination of socio-economic and demographic details of the individual.

There may also be questions aimed at eliciting how much the individual understands about the goods, services or conditions on offer – how intelligent is their reply.

Application of stated preference or contingent valuation (CV) CV is particularly appropriate where environmental changes have no direct effect on marketable output and it is not possible to directly observes preferences. It can, for example, be used in respect of the following issues – conservation of natural assets, air/water quality, transport improvements. A limitation to usefulness and reliability of studies is that there may not be sufficient resources (funds) available to carry out rigorous surveys.

Revealed preference methods – surrogate markets These techniques use an indirect approach to arrive at monetary values of economic benefits. They aim to measure and quantify individual's preferences for higher levels of environmental conditions by surveying market choices and behaviour. The surrogate (or proxy) market is a market for goods or services which can be in some manner quantifiably related to the economic condition to be measured. The goods or services traded in the surrogate market will have complements, attributes or components of their worth which relate to the environmental conditions being studied. Most surrogate market techniques use real, rather than hypothetical choices, and thus are often more acceptable to decision makers. They may also be called revealed preference techniques. The techniques can only be used where there is an awareness of the environmental effects. The valuations obtained may be quite ‘rough’ estimates, the accuracy obviously depending on the quality and amount of data. Also the processing techniques applied to the data used may have an effect.

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Since no market exists for environmental items (goods/services) then a revealed preference technique compares the relationship between a marketed good or service (the surrogate) and the linked environmental item. To make use of the economic data for the marketed good the relationship, if any, between the marketed good and the environmental item has to be established.

Methods use to value preferences

Hedonic pricing approach This approach aims to find a market in some item (often property) for which the environmental item under study is an attribute of or in effect contributes to the pricing of the marketed item. As an example, studies in this area could be carried out when there is a need to assess the benefits arising from noise abatement. Different locations for property will have varying levels of environmental amenity and these should be revealed in the property values. Property values can be related to a stream of future benefits – principally the use of the property as a dwelling. Also property values will be affected by the drawbacks of poorer environmental amenities. There will be many factors which affect property values and a detailed analysis is required to screen out the factor or factors relating to the environmental condition being studied. A hedonic price function is determined and this includes a component for each relevant attribute affecting the property value – components will relate to the environmental conditions being studied. A ratio or coefficient of change in property value due to change in environmental conditions can indicate what would be paid for an identical property in another area with the higher environmental conditions.

Travel cost method The average cost of reaching and the cost of time foregone visiting a natural resource e.g. a national park, may be a surrogate or proxy for the price which may be charged for entering it. The data on people’s observed and measured response to their travel costs is used to draw up a demand curve for the resources being studied and valued.

Avertive Behaviour/Defensive Expenditure What people are observed to pay to protect themselves from some real, potential or perceived deterioration in their environment. People may buy goods or services

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in an attempt to protect themselves against deteriorating conditions. This expenditure can be considered a substitute or proxy for environmental quality. Expenditure may take various forms: •

Defensive expenditure e.g. where people try to protect themselves – buying water purifiers or paying for land defences.

•

Purchasing surrogates e.g. where people purchase bottled water rather than use the public supply which they consider unreliable.

•

Relocation costs e.g. where people actually incur the cost and inconvenience of relocating to avoid poor environmental conditions,

Application of revealed preference methods The hedonic pricing method is appropriate where there are active property markets and environmental quality is an issue. The travel cost method is appropriate where sites are accessible and there is no direct charge for entry fees or for the goods/services. Also, the time and costs people spend on visiting the site or using the goods/services must be measurable. The avertive behaviour method is appropriate where people understand the threats to which they are exposed and take action which can be measured.

Sources of data Once one or more appropriate valuation measures have been selected for a benefitcost study, the data required to complete the study has to be obtained. The more reliable and robust the data the more reliable will be the study. Outlined below are sources of data.

Benefit transfer approach This approach makes use of surveys and data found in ‘similar’ situations elsewhere. If the conditions really are similar then the benefits or costs of a specific environmental policy may be assumed or at least inferred for what is considered a similar situation. The validity of the approach hinges above all on the determination that the two situations are really similar.

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Experiment/research Reliable data could be found from experimentation and research. For example if the question were asked ‘What level of sea pollution is acceptable?’ Different levels of water purity could be enforced at varying sites and local taxes varied accordingly – it could then be observed how people moved from one location to another to avoid paying higher taxes or accepting pollution. Obviously experimentation such as this would be very costly and time consuming.

Conclusion There is a great deal of data in existence and further environmental audits, feasibility studies and research can be commissioned. A company should have clearly defined criteria for various project types as to the level of detail and accuracy they require.

Choosing a method of valuation The valuation techniques described above have strengths and weaknesses and the person carrying out an analysis will have to consider which technique is appropriate for a particular case. The following points should be borne in mind when deciding which technique to use.

What are the demands or wishes of the project sponsor? Some project sponsors will have preferences as to which method is most appropriate – the sponsor should of course be clear as to the usefulness, likely accuracy and appropriateness of the various valuation methods to the particular project being appraised. It may also be appropriate to consider exactly what are the expectations and needs of the wider public which may be affected by the effects of the outcome of a cost-benefit analysis.

Use more than one technique It may be that more than one survey and/or valuation exercise may be needed or would be beneficial in understanding and quantifying benefits. Also it is possible that the work done for one survey can easily be extended by gathering additional data which would support a second valuation.

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Different techniques measure different attributes If different attributes of a project are measured using different techniques then the results may appear contradictory. The prime aim of the analysis should be kept in mind. The results from an alternative technique may still be of use, if they are considered as giving useful complimentary measures.

Consideration of other intangible benefits or costs The above pages focus on measurement of environment related costs and benefits but there are many other types of intangible. For example the valuation of the ‘knowledge’ base of employees. What is the cost of training a workforce worth? Some of the valuation methods outlined above may well be applicable. The point is that if there are any, material in amount, benefits or costs which can by some means or other be quantified then this should be done. Projects will be sanctioned or turned down on the evidence of defined cash flows, but as business becomes more and more competitive more consideration will have to be given to all the outcomes associated with an investment. The demand for demonstrably increased corporate responsibility and accountability will also increase the need for consideration of a wider range of issues than just making an adequate return.

Summary – the need for a process Cost-benefit analysis and the measuring and inclusion of intangibles in investment and project appraisals will become more and more common. Valuation techniques exist and will be developed. Valuation of intangibles, particularly those relating to environmental issues is a young science and individuals and companies have both the challenge and opportunity to develop their own methods and measures. Study of the latest techniques is advised and it is to be hoped that academics, consultants and others working in the areas of valuation of intangibles will share their experiences. Just as a sound process is required for appraising investments which have definite types and amounts of cash flows, so a clear process is required where investment is being made and there are intangible costs or benefits. The process outlined in chapter 5 can be extended to include the inclusions of intangible data collection and valuation. An outline and commentary on the headings which may be appropriate for such a process are set out overleaf.

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Outline of a cost-benefit analysis

Set company criteria: •

Environmental

•

Human resource

•

Natural resource

•

Financial

The ranking of the criteria above implies financial criteria e.g. making minimum required returns is of less importance than environmental criteria. It may be politic not to let return to be seen as the prime criterion!

Objectives or motives and business case The objectives of the investment will presumably be to give a good or adequate return, but there will be other reasons. ‘Motives’ is a good word to use to determine the true reasons for investment.

State analysis/appraisal method •

Stages

•

Measures

•

Documentation

At least an outline of the method of analysis and measures should be given. This will assist in placing in context the data used and conclusions reached.

Collect data – costs and benefits •

Tangible and intangible stating: –

specification

–

collection process for both benefits and costs

–

descriptions of sources

–

clear statement of any assumptions.

It makes sense to detail all the tangible hard data first. The more of the cash flows which are certain as to amount and timing, the more robust the appraisal will be. Intangible data sources need to be fully disclosed, particularly as regards to their bases and any underlying assumptions.

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Prepare model and carry out sensitivity analysis The model may be a specialised model or follow a company format. In any event the model should be tested and properly documented in detail. Sensitivity analyses should focus on the more intangible cash flows. Evidence to show how sensitive parameters and risks may be overcome.

Prepare presentation – ensure adequate documentation of the study The format, timing and purpose of the review process should be clear to all involved in such appraisals.

Detailed conclusion As unambiguous a conclusion as possible with full arguments on any caveats.

Carry out cost-benefit analysis process review As cost-benefit analysis including valuations of intangibles is a developing area, it is essential to set up and commit to a continuing audit or review process. Set out below is the outline of a screening appraisal which includes some intangible benefits.

Refinery cost-benefit analysis It is considered that capital investment in equipment for unloading crude oil from and to tankers can be justified for the following reasons: •

A better turn around can be offered and this will increase existing business as well as attracting new business.

•

There will be considerable labour savings.

•

There are inevitable accidents each year with all the manual work and also with new health and safety legislation the workforce has to be better protected. There will be lower risk of any spillage – these have occurred rarely and have only been minor, but local environmental groups make a fuss.

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A screening appraisal model has been set up and initial data on costs and cost savings obtained. The purpose of the screening appraisal is to:

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1.

Identify the most sensitive parameters, ranking them in order of sensitivity.

2.

Consider whether the costs/benefits associated with spillage management are material to the project and the business as a whole.

3.

Identify that if there were strong strategic reasons for making this investment (it would form part of a long-term plan to offer storage and transshipment services) which cash flow estimates should be more fully researched.

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Cash flow basis and assumptions (loading/unloading equipment investment) Costs

000’s

Cost of equipment and installation

2,050

A fixed price contract will be obtained.

155 Fixed operating costs These are assumed to be fixed but may have to increase by 3% for every 1% increase in volume, if volume of business increases by more than 10% in total.

60 Variable operating costs – maintenance-labour and parts

30

These will vary by the averaged increase/decrease in both inflows.

Variable operating costs – power and consumables These will vary by the averaged increase/decrease in inflows

340

Benefits

Labour savings These are the savings which will be made by decreasing the workforce if the automatic plant is installed – this does not include first year redundancy costs of 50K.

170 It is considered that the volume of business of the facility would increase by 2% per annum and thus the automation will give rise to a further 2% per annum of labour savings.

New business This is a prudent estimate of new business which could be handled (the equipment would only be working at 75% of capacity). Two customers have indicated that they would use the new facilities and this potential business accounts for 110k of the above 170k.

160

Health and safety/environmental Present costs of medical services for staff working in the area are 70 per year, if no new equipment is purchased then the costs could increase to 100 per year.

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The benefit to the local community of having almost zero chances of spillages, however small has been calculated, after a survey, as worth a minimum of 60 per year. A recent spillage from a similar refinery in the Far East caused clean up costs of 100 for the one incident, so the 60 value appears prudent.

General and specific economic factors It is considered that the volume of business of the facility will increase by 2% per annum and the new business will also increase by 2% per annum. Required rate

15%

study period

8 years

Costs It is assumed that the state government has inflation under control and that the costs will not increase by more than 2% per annum over the 8 year appraisal period.

Benefits

Labour savings It is assumed that the labour savings will in effect increase by 4% each year as due to changes in labour conditions greater holiday/pension/retraining costs would have to be incurred. It is also believed that a shortage of labour may increase these costs further.

New business Due to the attractiveness of the new facilities and the services they can offer it is considered that it will be possible to increase charges by at least 1% above inflation – that is by 3% per annum minimum (this is over and above the volume increase mentioned above).

Health, safety and environmental Due to ever tightening standards the worth of any benefits is expected to increase, by at very least, the general rate of inflation, and possibly by as much as three times the general rate.

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Review of case study The above is a sample of the data which would be required to carry out the appraisal. Even at the screening stage consideration is being given to price and volume changes – this seems appropriate in an industry with much volatility in both volume and prices. The sample summary spreadsheet below has at least one flaw in it – the redundancy costs appear to have been omitted! This demonstrates the need for thorough review. APPRAISAL MODEL Capital Spend

Inflation rate = Volume increase = 0 1 2 3 4 5 6 7 8

VOC's Power

Costs

2350

year or period

discount rate = Fixed Op

Capital Spend

-2350

Labour

Labour/Maint /Consumables Savings

215 60 30 2% 7% 5% 0% / / / / / / / / / / / / / / / / Fixed Op Costs

SENSITIVITY ANALYSIS Cap Spend Fixed Op Costs Var Op Costs VOC's Power

41.8% 94.3% 257.0% 555.0%

Labour Savings New Business

-45.0% -35.5%

-65 -71 -78 -85 -93 -101 -111 -121

-32 -34 -37 -39 -42 -45 -48 -52

NPV=

982

Business

340 7% 2%

Var Op CostsVar Op CostsLabour Labour ConsumablesSavings

-219 -224 -228 -233 -237 -242 -247 -252

15.0% New

371 405 442 482 527 575 627 684

470 5% 2% New Business

503 539 577 618 662 709 760 814

Net Cash Flow

-2350 558 615 676 743 816 895 981 1073 1334

Disc Factor

1.000 0.870 0.756 0.658 0.572 0.497 0.432 0.376 0.327 NPV=

Disc Csh Flow

-2350 485 465 445 425 406 387 369 351 982

Conclusion Dealing with intangibles is an area where all involved in appraisals should develop skills. The purpose of this chapter is to show that even the ‘amateur’ can carry out benefit cost analysis and valuation studies. There are many experienced practitioners who can assist.

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Checklist Appraising intangibles A checklist of the matters to be considered when appraising intangibles.

What do you mean by ‘intangible’?

Can your benefits be valued?

Is expertise required to carry out an economic analysis?

Have you a process for benefit-cost analysis?

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Lenders’ views of projects and other issues U N D E R S TA N D I N G L E N D E R S ’ C R I T E R I A PROJECT APPRAISAL FROM THE LENDER’S PERSPECTIVE PROJECT FINANCE PFI ACCOUNTING REQUIREMENTS ACCOUNTING FOR PROBABILITIES IF PROBABILITIES OF CASH FLOWS ARE TO BE CONSIDERED THEN EXPERTISE IS REQUIRED A P P R A I S A L P R O C E S S U S E D T O A S S I S T W I T H N E G O T I AT I N G I M PA I R M E N T R E V I E W S – VA L U AT I O N O F I N TA N G I B L E S

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Chapter 7: Lenders’ views of projects and other issues

Understanding lenders’ criteria It may be a good starting point when considering a lender’s view of appraisal to remember that the lender sees another project – not the physical project which the investor or manager is appraising, but rather a project which is the advancing of money now (capital expenditure), followed by the recovery of this advance as cash inflows over the life of the loan. It is this ‘project’ with which they are more concerned and which they have to control rather than any physical project which involves the purchase of assets with subsequent operation and generation of positive net present cash flows.

Project appraisal from the lender’s perspective If an appraisal is being carried out within a company or group then the criteria which have to be met in order to ‘win’ the cash for a particular project will normally be clearly stated (as illustrated in chapter 5). If the project is to be financed by banks or other lenders then once again the criteria to be met should be clearly stated at the outset. This is not always what pertains. Those sponsoring the project and thus carrying out the screening appraisal may not be exactly clear as to the extent or scope of the project. Also the screening estimating may be subject to a wide range of values. If, as often is the case, there are outside interests – environmental or health and safety – then further uncertainty as to the final amounts and timing of cash flows will arise. Even with a demand for a specific amount of finance at specific dates, with defined amounts and timings or repayments, lenders will deliberate before sanctioning the funding. The project will obviously have to meet their criteria with respect to the return it makes and the sensitivity of the parameters etc. The rules which hold good for internal company or group reviews of projects will hold good for lenders.

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Typical criteria which lenders require to be met are as follows: •

Repayment of loans should be completed within a ‘safe’ time period, that is ‘safe’ as defined by the lender. Lending convention is that the term of a loan will be for as short a period as is possible – lenders know the risks of repayments promised away in the future! An illustration of the need for a project to be able to repay loans over a relatively short period is given below. Consideration of what is an acceptable project from its ability to repay borrowing is revealed by finding the discounted payback.

•

Cash inflows should be ‘guaranteed’ and the project should be demonstrable and certain, as to amount and timing of cash inflows. Typical situations where such criteria should be met are cash inflows from power utilities and rental income from property development. In the latter case there is frequently the cyclical problem that there may be oversupply of accommodation and rents fall or property remains unlet. Lenders will often demand that a tenant be signed with a binding lease of duration at least as long as the term of the loan.

•

There should be adequate security at all times to cover the loans advanced. There should be tangible fixed assets which will hold value and are tradable if not saleable. By tradable we mean ownership may be easily transferred to another lender. What determines whether or not an asset holds value? The principal support for an asset’s value is the fact that ownership and operation ensures the continuance of a stream of cash inflows. It could thus be argued that lending is based not on security so much as future cash generation.

Even where the above criteria can apparently be met the vital need for loans to be repaid within a ‘safe’ time period remains. This point for the lender is the mirror position of the issue that investments really must deliver – make an adequate return within 5 or at the most 10 years (the discount factors are too low after 5 to 10 years).

Ability to repay loans The spreadsheet below shows a project with a 10 year life and with an NPV of 6,370 at a discount rate of 15%. If the project is to be funded to the extent of 14,000 out of the 18,700 (25% gearing*) investment by a 7 year loan at an interest rate of 8% then the project is quite able to repay the loan leaving a return of 29.36% to the providers of the 4,700 equity. (The return of 29.36% was calculated by discounting the free cash flows attributable to the shareholders [i.e. after loan repayments] and relating this to the 4,700 equity investment at time zero).

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required rate

year 0 1 2 3 4 5 6 7 8 9 10

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15.00%

discount cumulative cash flow factor d.c.f. d.c.f. -18,700 1.0000 -18,700 -18,700 500 0.8696 435 -18,265 1,800 0.7561 1,361 -16,904 3,500 0.6575 2,301 -14,603 4,600 0.5718 2,630 -11,973 5,700 0.4972 2,834 -9,139 6,700 0.4323 2,897 -6,242 7,600 0.3759 2,857 -3,385 8,900 0.3269 2,909 -476 11,300 0.2843 3,212 2,736 14,700 0.2472 3,634 6,370 46,600

6,370

Gearing * the ratio of loan to equity could be expressed as: total investment = equity = loan =

gearing =

debt to equity =

18,700 4,700 14,000

loan = total investment (or capital employed)

14,000 18,700

=

75%

loan equity

14,000 4,700

=

3:1

=

Opposite is a spreadsheet which shows the annual payments of 2,689 required for seven years to cover the repayment of the 14,000 loan and interest at 8%. The spreadsheet really proves that a series of 2,689 annual cash flows over seven years, discounted at a rate of 8% (the loan interest rate) gives a present value of exactly 14,000 – the amount borrowed at time 0.

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1 4 0 0 0 loan 8% interest rate 2 6 8 9 annual repayments over 7 years

year

cash flow

discount factor

0 1 2,689 0.9259 2 2,689 0.8573 3 2,689 0.7938 4 2,689 0.7350 5 2,689 0.6806 6 2,689 0.6302 7 2,689 0.5835 8 9 10 Net Present Value of repayments at 8% interest rate

present value of repayments 2,490 2,305 2,135 1,976 1,830 1,695 1,569

14,000

The point is that whilst the project generates more than the 8% required by the lender (the IRR is 20.52% shown in the spreadsheet below) the timing of the project cash inflows is such that there are insufficient cash inflows to make the loan repayments in the first four years. required rate

year 0 1 2 3 4 5 6 7 8 9 10

20.52%

discount cumulative cash flow factor d.c.f. d.c.f. -18,700 1.0000 -18,700 -18,700 500 0.8297 415 -18,285 1,800 0.6885 1,239 -17,046 3,500 0.5713 1,999 -15,046 4,600 0.4740 2,180 -12,866 5,700 0.3933 2,242 -10,624 6,700 0.3263 2,186 -8,438 7,600 0.2708 2,058 -6,380 8,900 0.2247 2,000 -4,380 11,300 0.1864 2,107 -2,274 14,700 0.1547 2,274 0 46,600

0

The structure of loan repayment would have to be different, or the project would have to borrow elsewhere to reach the required repayments of 2,689. A lender would be very nervous of such a project and the reason is of course obvious – the project may ultimately be considered a success, but it only comes right at the end – when the reliability of the cash flow estimates is most questionable. This is far too high a risk project and thus would not normally be considered by lenders.

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The art of lending successfully is to make as high a risk free return as possible. Lenders have their own views on structures of loan packages. An example of lending structure is ‘project finance’.

Project finance Lenders can look at lending on a project by project basis rather than to a company as a whole. Funds can be lent for specific clearly defined projects. Lenders prefer this concept as a means of their being able to fund to a much higher extent compared with funding a company as a whole. A cynic might say that it is not the customer that the lenders are satisfying with the project finance package, but rather themselves! An illustration to explain the concept of project finance is as follows: A power plant is to be built for an new entrant into the electricity supply industry. The equity partners in the new venture are an existing utility, an equipment manufacturer and a construction company. All equity partners are substantial concerns and will own 33.33% of the venture. Each equity partner could no doubt borrow from lenders to finance the project, but the lenders whilst potentially having the security of all the assets of all partners and a lien on the cash flows of the main businesses might quite rightly be concerned that any loans sanctioned would not be used as intended. Also the ability to repay may deteriorate as this would depend on their existing business prospects rather on the prospects of the new (and safer) venture. The lenders are lending to fund a project – it is not just general business lending. If the new power plant was to be set up as a joint venture, in limited company form, then the lender or lenders could lend to the ring-fenced project. It will be clearer to them whether or not their lending criteria are being met. For example: •

Repayment period – the plant will operate for up to say 20 years – there should be ample funds for them to be repaid within say 10 years.

•

Adequacy of inflows for loan repayment purposes – there will be ‘guaranteed’ cash flows from the sale of the essential commodity – electricity.

•

Security – there will be security in the substantial tangible fixed assets.

In the illustration above, the lenders may be able to lend up to 80% of the funding required.

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Whilst following the general principles described above, lenders will have their own detailed criteria for lending. It makes sense for the business person to know as much as possible of the criteria in operation when negotiating the finance for asset or project investment.

PFI accounting requirements Introduction No matter what ones views on the politics of Private Finance Initiative (PFI) contracts they have achieved UK and international acceptance as a means of satisfying demand for public services. DCF calculations are a key part of the process and thus the majority of this text concerned with investment appraisal will apply to the appraisal of PFI projects. The greatest problem with PFI projects is the determination of whether or not they do pass risk from the Treasury (tax payer) to third parties. It would be simple enough to define events and related cash flows in such a way that the contract was definitely ‘off balance sheet’, that is neither an asset of nor a corresponding liability of the Treasury (the taxpayer). However a major thrust of accounting and financial reporting in the last few years has been to prevent entities (commercial companies) from hiding assets and more significantly the related liabilities – taking them off balance sheet. Financial Reporting Standard (FRS) no 5 – Substance of Transactions aims to prevent assets and liabilities being taken off balance sheet. This standard applies to all accounting and reporting, not just that of commercial companies. Thus anyone involved with PFI contracts must be aware of the issues involved. The sections below set out the standard views on the topic and this is followed by Treasury views. FRS 5 Application note F – Private Finance Initiative (PFI) and similar contracts.

Features of a PFI contract A contract to provide services is awarded by a public sector entity (the purchase) to a private sector entity (the operator). The contract will specify the service required and the terms of payment. Normally a property (hospital, prison, railway facility etc) will be necessary to perform the service. The operator will normally design, build, finance and operate the property. The property might have potential for third party use during the term of the contract.

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Arrangements for ownership and use of the property at the end of the contract will be specified at the outset. The purchaser (a public sector body) will be required to demonstrate that the PFI contract offers value for money when compared with alternatives ways of providing the services.

Basic principles Present (accepted accounting) practice is not to capitalise contracts for services. Payments by the purchaser for services extended over a number of years will be considered as period by period payments – they are not considered an asset in today’s terms with the recognition of a corresponding liability to make the contracted future payments. However, where a property is an essential requirement for the fulfilment of a contract to provide services, then present practice may require the property to be recognised as the purchaser’s asset. The question is then to determine: •

for the purchaser – whether the purchaser in a PFI contract has an asset of the property with a corresponding liability to pay the operator for it, or simply a contract only for services

•

for the operator – whether the operator has a tangible asset, of a property or a financial asset being debt due from the purchaser.

The general principles of the FRS conclude that a party has an asset of property where the party has access to the benefits of the property and exposure to the risks inherent in those benefits.

The concept of a separable contract – SSAP 21 applies Some PFI contracts will have separable elements. That is the contract is in commercial reality a series of contracts and the services provided and the related PFI payment operate independently of each other. It might be argued that an aim of bundling together a series of contracts into apparently one single contract is to hide the fact that the major part of the payments to the operator was for the supply or lease of property. Where separable elements can be identified, for example, payments for a service agreement for cleaning, then these should be removed and only the core contract considered.

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If then the core contract consists substantially of payments for a property then these payments are likened to lease payments and the UK Statement of Standard Accounting Practice 21 (SSAP 21) accounting for leases and hire purchase payments should be followed. The standard requires the disclosure of property purchased under a finance lease as an asset of the purchaser, with the corresponding finance shown as current and long-term liabilities. The Standard defines a finance lease as one which transfers substantially all the risks and rewards of ownership of an asset to the lessee – the purchaser. An analytical method of identifying whether the above definition holds or not is to compare the fair value of the asset – the property with the present value of all the agreed minimum future lease payments. If the present value is in excess of the fair value then the assumption must be that the purchaser is buying the property – they are paying more than its worth. The application note to FRS 5 recognises that the use of a high discount rate would lower the present value and thus possibly give a false answer. It is suggested that if applying SSAP 21 follows as the PFI contract is of a separable nature then a lower discount rate appropriate to that used for investment in similar property should be used. If the contract includes the provision of services as an integral part then FRS 5 applies. An important issue is then that any PFI contract is in commercial reality an integrated contract to supply both property and services where substantial risk is passed to and remains with the operator.

A non separable PFI contract – FRS 5 applies The principle aim of FRS 5 is to require disclosure of assets and corresponding liabilities in the balance sheets, of those entities which in commercial reality ‘own’ the asset and have the obligation to make a series of future payments in respect of the asset. Thus even though a PFI contract is not separable the FRS ‘tests’ are aimed at identifying those contracts which are in effect contracts for purchase of property and for which disclosure as a finance lease is required.

Questions to be considered in the determination of treatment Demand risk – will the demand for the property be greater or less than expected and if so who carries the risk? Third party revenues – if material in amount, then do these flow to the operator or the purchaser? Nature of the property – who specifies the nature of the property?

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Penalties related to under performance or non-availability – do these exist and how material are they? Potential changes in relevant costs – who carries any changes in property costs? Obsolescence – effects of changes in technology – if obsolescence is at all likely who will carry the associated costs? Residual value – at the end of the contract who will carry costs or benefit from the current property value?

Concluding whether or not a property is an asset of the operator or the purchaser FRS 5 application note F discusses the above questions in more detail and then requires the following to be considered in light of available answers to the above questions: •

only variations in property profits/losses are relevant

•

the overall effect of all factors taken together must be considered

•

greater weight should be given to those factors that are more likely to have a commercial effect in practice.

Treasury View PFI contracts are considered as an efficient method of financing and supplying cost effective public services. Services are provided efficiently with the risk of changes carried by the operators. Thus any property assets, and the significant financing of them, will remain the property of the operator. At the time of writing (June 1999) the guidance from the Treasury on the accounting for PFI contracts was being reviewed and extracts of the guidance notes are shown on page 152. Earlier Treasury view on applying FRS 5 to PFI projects:

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•

Characteristics of a PFI transaction.

•

A contract awarded by a public entity to a private sector entity for the provision of services.

•

The contract specifies the services required over the period of the contract and the form of the payment for these services.

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The private sector is responsible for the design, build, financing and operation of the underlying assets which are essential to the delivery of the services.

•

The contract is long-term and transfers risk form the public sector to the private sector.

ISSUES

Analysing the key risks in the transaction ‘Evidence that an entity has rights or other access to benefits (and hence an asset) is given if the entity is exposed to the risks inherent in the benefits, taking account the likelihood of those risks having a commercial effect in practice’ – FRS 5 In the context of PFI the risks need to be evaluated to determine the extent to which those risks are expected to have a commercial effect in practice. The procuring entity should not recognise the underlying asset if the combined effect of the key risks exposes the operator’s equity holders to real commercial risk over the operating phase of the contract. Real commercial risk manifests itself as potential for significant variability in the expected return to the operator’s equity holders and some risk of that return falling below the lender’s return.

Risk analysis approach A.

Identify what, if any, commercial risk the operator is exposed to.

B.

Evaluate the financial effect of the key risks.

C.

Conclude on the risk analysis.

The key risks are similar to those described in FRS 5.

Separation of underlying assets A service under a PFI transaction may be used and paid for to a significant degree by both the procuring entity and third party users. The underlying assets (new and/or existing) may be separable into assets which provide services exclusively to the procuring entity and assets which provide services exclusively for third party users.

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Separation of the contract into components A PFI transaction may be seen as a single contract between the procuring entity and the operator, or a series of components subdividing the overall provision of services. The PFI transaction should be considered as a whole, not broken down into separate components, unless both the following factors apply: •

the service payment is separable

•

the contract is separable.

For each component – what is the relative cost of the underlying asset? If the initial capital cost of the underlying asset is not significant (less than 10% of the NPV of the expected service payments) in the context of the transaction as a whole, then the procuring entity should not recognise the underlying asset. If the initial capital cost of the underlying asset represents the vast majority (more than 90% in NPV terms) of the total cost of the transaction it is effectively a lease of the underlying asset and the accounting treatment of the lease should be determined under SSAP 21.

Volume risk Some or all of the service payment may be linked to the volume of the service consumed by the procuring entity over the whole life of the transaction. For services where the volume is not volatile, such as property or hospitals, the underlying asset is likely to have a largely fixed capacity. However, the operator may assume volume risk through designing the facility in a way which enables capacity to be increased or decreased over the medium to long-term in response to changing demand (e.g. through sub-letting sections).

Third party revenue If the service is being used, and paid for, directly by third party users to a significant extent then the operator is likely to receive variable revenue streams relating to the underlying asset.

Availability and performance risk Some or all of the service payment may be linked to the availability or performance of the service for a particular period.

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Pricing risk Changes in price are another reason for variability in revenue to the operator.

Residual value risk This represents the potential variability between the actual residual value of the underlying asset at the end of the contract period and the expected residual value ascribed by the operator at the outset.

Operating cost risk The greater the scope for variability in the operating cost base, for example, from efficiency savings due to technological changes, the more significant the potential impact on the operator’s expected return.

Design risk The ability to implement certain critical or innovative features of the design or development, which significantly affect the fitness for purpose of the underlying asset is a risk affecting the operator’s ability to continue to deliver the service. It is a key feature of a PFI transaction that the operator can make investment decisions concerning design and development to improve the operating efficiency of the underlying asset.

Construction risk Construction risks derive from the financial implications for cost and time overruns. Such risks may be similar to those borne by a constructor under a traditional fixed price construction contract.

What is the equity (genuine risk capital) in the transaction? It will be necessary to consider the commercial risk to the holders of all capital instruments where those instruments possess the economic characteristics normally associated with equity.

What is the proportion of equity in the funding structure? Where the proportion of equity is below the level considered normal for a particular type of transaction (typically between 10% and 20%) the approach set out above may give misleading results.

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How to account for PFI Transactions – HM Treasury taskforce guidance Set out below are extracts with comments on sections of the guidance notes on PFI released by the Treasury in July 1999. The objective of the Note is to provide additional practical guidance for certain public sector bodies on the following areas of FRS5 Application Note (AN) to ensure the over-arching (the Treasury's words!) principles of the AN are consistently applied. The guidance has been approved by the Financial Reporting Advisory Board (FRAB) to the Treasury and is mandatory for all bodies preparing their financial statements in accordance with the Resource Accounting Manual. The Note is also mandatory for Non-Departmental Public Bodies, Trading Funds, NHS Trusts and those Public Corporations that prepare their accounts in accordance with an Accounts Direction issued with the approval or consent of the Treasury.

Focus on value for money Achieving value for money when taxpayers money is spent is a much spoken of doctrine. The Note makes the point that the prime reason for choosing PFI funding of projects is to obtain the best value for money. ‘Purchasers should focus on how procurement can achieve risk transfer in a way that optimises value for money and must not transfer risks to the operator at the expense of value for money’. What exactly is this meant to convey? ‘Optimise’ presumably means that the cheapest is not necessarily best. Risk must not be transferred to the operator (the private supplier) at the expense of value for money – presumably because transfer of risk to the operator will cost more. But is it not an aim of PFI to transfer the risk from the taxpayer? The bases for determining value for money are not defined, presumably life cycle costing should be used. Following from the requirements of FRS5 and earlier Treasury notes the question of whether or not PFI contracts are separable remains a key issue.

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Separation of the contract The first stage when identifying the status of a project is to identify whether or not elements of the PFI payments can be related to independently operating contracts. Any separable elements which relate solely to the provision of services should be excluded when determining which party has the asset of property. Paragraph F10 of the AN indicates that a contract may be separable in a variety of circumstances including but not limited to the following three situations: 1.

The contract identifies an element of a payment stream that varies according to the availability of the property itself and another element that varies according to usage or performance of certain services (AN F10{a}).

2.

Different parts of the contract run for different periods or can be terminated separately. (AN F10{b}).

3.

Different parts of the contract can be re negotiated separately (AN F10{c}).

The underlying intention of PFI transactions is that the individual elements of the payment stream should not relate to the delivery of any specific event. There are three common payment mechanisms used to date.

Model A – non separable The unitary payment is based on the number of places available (for example, prisoner places). For a ‘place’ to be available, not only the physical space but the associated core services such as food, heat and light to defined standards, should be supplied. There may be mechanisms for reduction of payments due to substandard provision of services.

Model B – non separable The unitary payment is based on the full provision of an overall accommodation requirement which is divided into different units. Availability is defined in terms of being useable and accessible and will include some associated core services such as heating within specified temperature ranges. As for model A there may be deductions for substandard performance. The key differences between A and B is that A is based on available places whilst B divides the total accommodation requirement into different units.

Model C – separable The unitary payment is a combination of an availability payment stream and a separate performance related facilities management payment stream. This is different from models A and B which do not have separate payments streams.

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Once any separable service elements have been excluded paragraph F7 of the AN states that PFI contracts can be classed into: a.

Those where the only remaining elements are payments for property. These will be treated as a lease and SSAP 21 should be applied.

b.

Other contracts – that is where the remaining elements include the provision of some services. These fall within the scope of FRS5 and should be further assessed in accordance with Section 4 of the Technical Note.

Note 4 – how to apply FRS 5 This is the key section as it contains the basic arguments as to how a contract should be accounted for. The purpose of section 4 is to: •

elaborate on some key principles

•

summarise the qualitative indicators to be considered

•

provide a methodology for undertaking the quantitative risk analysis

•

give further guidance on the principal factors.

The key is to be found in AN 4.3 Determining the substance of transactions is a matter of professional judgement, which involves weighing up all the relevant indicators (both qualitative and quantitative) as to which party has an asset of the property. AN4 goes on at considerable length in reasoned tones. ‘An important point to consider when undertaking a quantitative risk analysis in a PFI context is the danger of spurious accuracy… …those risks which, depending on the circumstances of a particular case, may not be capable of meaningful quantification for inclusion in the qualitative risk analysis due to the level of uncertainty surrounding them. The potential impact of these risks on the overall judgement will therefore need to be carefully considered and properly justified. For example, whilst it may be foreseeable at the start of some PFI contracts that future changes in technology or public policy would adversely affect various factors in the risk analysis, it may not be possible to foresee what those changes might be, when they might occur and what their commercial effect might be in absolute terms. In such circumstances, the commercial effect of these changes cannot be modelled in the quantitative risk analysis due to uncertainty. Conversely, on other PFI contracts the impact of such changes in technology or public policy may be quantifiable.’

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Conclusion The above extract should give a flavour of the subjectivity involved in assessing whether or not a contract passes risk to the operator or not. Anyone involved with PFI contracts would have to study in detail both FRS5 and the Treasury Notes. Whether or not property in a PFI contract is to be accounted for as owned by the operator or the purchaser (the State) depends on a thorough assessment of where the real commercial risk lies. Interpretation of contract clauses will no doubt remain a subjective area.

Accounting for probabilities (Of higher costs and/or lower inflows) Another issue for sensitivity analysis is to consider the possibility of cash flows being more or less than the expected values. This could simply be a sensitivity analysis based on parameters being set to their most pessimistic. Note this does not mean that all parameters should be set at their possibly most pessimistic amounts – there is no end to pessimism! Rather it is a realistic ‘what if’ view of a poor outcome of a venture. At this stage it is worth reiterating that an appraisal should be carried out with the most likely expected cash flows – with neither optimism or pessimism factored in. Assuming the project meets the required criteria (sufficient NPV or high enough IRR) then a one at a time sensitivity analysis can identify the parameters which have to be controlled to ensure the predicted outcome. There will be cash flows within some projects where the possibility of more or less cash flow will be dependent on some parameter whose probability of occurrence is known. An example is the probability of delays with resulting increased costs due to changes in weather patterns. It would be foolish not to make use of such data, in some instances the probabilities may be more reliable than the amounts of the related cash flows.

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In its simplest form an expected NPV is the outcome of the exercise. A simple illustration is as follows.

Example A manager of an ice cream factory is requesting funds for the installation of a production line for new products. The measurable cash flows are expected sales and the associated variable and fixed operating costs. There will also be benefits of more flexibility in operation (quicker response to change in product runs) although this has not been quantified at this stage. Sales of ice cream are obviously very weather dependent and rather than appraise using average figures it is considered that the statistical evidence of weather patterns over the years is reliable enough to be incorporated into the model. Sales values for good and poor summers along with the probabilities of these occurring in each year are shown in the spreadsheet below, along with the revised variable and fixed operating costs which would be incurred if the capital expenditure of 2,700 is incurred. Ice cream equipment

enhancement

year sales - good summer sales - poor summer probability of good summer probability of poor summer variable costs - % of sales fixed operating costs capital expenditure

2000

expected NPV =

required rate = 2002 2003 8,000 8,000 4,200 4,200 0.4 0.6 0.6 0.4

15% 2004 9,000 5,000 0.4 0.6

2004 9,000 5,000 0.5 0.5

2005 9,000 5,000 0.5 0.5

20% 3,000 -2,700

expected sales expected variable costs fixed operating costs net cash flows discount factors discounted cash flows

2001 7,000 3,500 0.4 0.6

-2,700 1.0000 -2,700

4900 -980 -3,000

5720 -1144 -3,000

6480 -1296 -3,000

6600 -1320 -3,000

7,000 -1400 -3000

7000 -1400 -3000

920 0.8696 800

1,576 0.7561 1,192

2,184 0.6575 1,436

2,280 0.5718 1,304

2,600 0.4972 1,293

2,600 0.4972 1,293

3,324

The outcome is an expected Net Present Value of 3,324 at the required rate of 15%. This would appear to be a worthwhile investment, but of course a full sensitivity analysis and risk management exercise should be carried out. A strong argument in favour of considering the need for incorporation of probabilities into models, can be demonstrated by showing the outcome for the above proposition with only worse case scenarios considered.

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Ice cream equipment enhancement

variable costs - % of sales fixed operating costs capital expenditure

2000

 

AND

OTHER

ISSUES

15%

2001 3,500

2002 4,200

2003 4,200

2004 5,000

2004 5,000

2005 5,000

3,500 -700 -3,000

4,200 -840 -3,000

4,200 -840 -3,000

5,000 -1000 -3,000

5,000 -1000 -3000

5,000 -1000 -3000

-200 0.8696 -174

360 0.7561 272

360 0.6575 237

1,000 0.5718 572

1,000 0.4972 497

1,000 0.4972 497

20% 3,000 -2,700

expected sales expected variable costs fixed operating costs net cash flows discount factors discounted cash flows

PROJECTS

required rate =


  


 

  

year sales - poor summer

OF

-2,700 1.0000 -2,700



The NPV is negative and thus the project should certainly not be sanctioned – but will all summers really be poor?

Points to note •

Is the statistical data from a reliable source?

•

Is the data detailed enough? In this case a month by month analysis would seem more appropriate and presumably such data exists.

•

Has the spreadsheet been checked? There are more cells and figures to miscalculate!

•

A worse case view, with poor summers assumed every year kills off this project. Using a worse case view is not really realistic – we do get some good weather!

•

The benefits of quicker response to product change should be quantified – in this competitive industry product innovation and responding to demand will be vital.

This model is useful when making the point that NPV’s are not ever £’s that will be received at time zero or spread over the life of a project, but rather an amount, expressed in today’s terms of the surplus cash flows over the life of the project. Adding probabilities in no way detracts from the usefulness of knowing the NPV or expected NPV. It is true that if cash flows are estimates (however reliable) and the probability distributions are estimates (by their very nature) then the expected NPV must be more subjective than a simple NPV – the quality and reliability of the NPV amount obviously depends on the quality of the data.

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If probabilities of cash flows are to be considered then expertise is required If probabilities are to be incorporated then sufficient expertise should be available – it is dangerous to ‘dabble’ in such areas. A real life example was where an appraisal was carried out to justify the purchasing and holding in store of a strategic piece of plant. If the plant was not available then the whole operation would have had to close for several months with a resultant loss of income. From experience with similar plant it was identified that all similar pieces of plant items tended to fail at least once in an eight year period. From this evidence it was concluded that there was a 12.5% chance of plant failure each year in a sixteen year study period. Was this a realistic probability distribution? Of course not. Further research might have revealed a probability of 5% failure in years 1 and 2 followed by 10% in years 3 to 6 with 25% probability of failure in the final two years. In summary the concept of bringing in probabilities is a sound one where the data is understood and reliable. As highlighted earlier proper consideration of all business issues and risks will be just as important as the incorporation of a range of probabilities. If probabilities are to be incorporated then there may be the need for expertise in understanding and handling the data.

Appraisal process used to assist with negotiating The work carried out in forecasting cash flows followed by discounted cash flow modelling and sensitivity analysis is very often wasted, in that valuable work done on estimating and considering all the inflows, outflows and particularly the phasing of the cash flows is ignored when it comes to the negotiating and management of sanctioned projects. As an example of the use of appraisal spreadsheets in negotiating consider the project for building the central food processing factory introduced in chapter 1. The time period of building may appear too short for an appraisal by the contractor, but a cash flow would be required, even if it was not discounted over the year or so of build. It is worth making the point that it is not the cost of money borrowed which should be applied when a contractor finances work in progress, but rather the opportunity cost of money – what rate of return might the contractor make elsewhere in his or some other business. The spreadsheet below reflects the inflow from the contract all coming in at time zero – all up front payment by the customer – this was the unlikely(!) initial proposal

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for the initial appraisal for factory building. Costs for labour, materials, sub contract are assumed to be based on realistic estimates. Overheads have been set at a rate of 12% of the labour cost and this will be assumed as reasonable for this example, however the question of what rates of overhead to apply (if any at all) is discussed further in chapter 2. With the cash flow amounts and timings given it appears that this twelve month project will yield a profit of nearly 21,000. Not a very impressive profit on a project with sales of 850,000.

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21

A B
  

       required annual rate 0% month inflows building

0

C

D monthly rate =

1

2

E

N

O

0.00% 3

1 2 totals

-850,000

outflows materials labour sub contract overheads net cash flow

 


   

-850,000

180,000 10,000 120,000 1,200

90,000 30,000

0 35,000

0 15,000

3,600

4,200

1,800

305,000 291,000 240,000 34,920

-850,000

311,200

123,600

39,200

16,800

20,920











-850,000

311,200

123,600

39,200

16,800

  

 

 

overhead rate =

12%

If a required rate of 15% per year is applied – the effective monthly rate is 1.17% and can be found by using the formula: monthly (or other period) rate = (1+ar)^(1/n)-1 where

ar = the annual required rate

and

n = the number of periods in the year, in this case 12, being months

When the cash flows are discounted month by month with the annual rate of 15% then not surprisingly the project makes a much lower profit of 14,904.

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A B
  

       required annual rate 15% month inflows building

0

C

PROJECT

D monthly rate =

1

2

E

INVESTMENT

N

O

12

totals

1.17% 3

850,000

outflows materials labour sub contract overheads net cash flows


   

850,000

-180,000

-90,000

0

0

-10,000

-30,000

-35,000

-15,000

-305,000 -291,000

-120,000

850,000

 

  

 

-240,000

-1,200

-3,600

-4,200

-1,800

-34,920

-311,200

-123,600

-39,200

-16,800

-20,920

!!

"#!

""

-120,754

-37,854

-14,609

 850,000

APPRAISAL

 -307,597

 $

Although this is still a profit, it is not at all impressive. In reality it is very unlikely that all the inflows would be received ‘up-front’. The following spreadsheet is more realistic in that the cash inflows are spread over the project’s life, with a final 10% of project value being retained by the customer for a 12 month period after completion. The impact of this on the cash flows gives a far more realistic view of the project – it will make a loss of 48,000 unless either the inflow amounts and timings, and outflow costs and timings, can be negotiated in favour of the contractor.

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21

A B
  

       required annual rate 15% month inflows building

0

net cash flow


      

 

D monthly rate =

1

2

180,000

outflows materials labour sub contract overheads

 

C

E

N

O

P

Q

24

totals

1.17% 3

12

180,000

45,000

85,000

-180,000

-90,000

0

0

-305,000

-10,000

-30,000

-35,000

-15,000

-291,000

-1,200

-3,600

-4,200

-1,800

-311,200

-123,600

140,800

28,200

85,000

!!

"#!

""

!#"

-120,754

135,965

24,522

64,272

-120,000

180,000

 180,000

850,000

 -307,597

-240,000 -34,920 -20,920

$ !%&" 12%

In conclusion, incorporating the effect of the time value of money is not difficult and is an essential exercise when considering the negotiating of even a short-term project.

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Impairment reviews – valuation of intangibles Intangible assets, commonly goodwill, appear on the balance sheets of many companies and questions have to be asked as to the worth or value of such assets. At the date of purchase of an entire business or an intangible such as a brand name, the price paid gives a certain figure of the value – at that date! An acquirer of an intangible, such as a brand name, can enhance the value by increasing advertising, or destroy the brand through lack of support. The value of intangibles after the date of acquisition is thus highly subjective. One method of valuation is to identify the ‘super profits’ that the brand delivers. Research can be carried out to identify the increased volumes and margins which branded products achieve when compared with unbranded ones. The present value of these ‘super profits’ could then be considered the brand or intangible’s value. There will of course be many assumptions made when such an exercise is carried out. UK and international accounting standards rightly require that intangibles shown on balance sheets are subject to review of their values. The applicable standards give detailed guidance on how this may be carried out. Not surprisingly one of the most significant issues is the discount rate which is used. It does seem that a valuer of intangibles could come up with a legitimately wide range of values! The UK and international accounting standards on intangible assets including goodwill could be considered by many to be somewhat confused. Principally on the issue of whether internally generated intangibles (brands) should or should not be considered an asset in the balance sheet. The weight of opinion of the experts is that internally generated brands should be excluded on the basis that they are too ‘intangible’, subjective and difficult to value. This does seem at odds with the fact that impairment reviews are required to support or write down an intangibles value. If the impairment review is considered reliable enough for this exercise can it not be used to support intangibles’ valuations? The point is that the arithmetic of appraisals is used in the area of intangible and brand valuation and no doubt will be used to a greater extent in the future. The accounting standards give guidance on the application of the arithmetic and process for impairment reviews. Internally companies do carry out brand valuations and again this will no doubt become a more and more important exercise.

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Checklist What does the lender want? A checklist of the matters to be considered when financing an investment with loan capital.

Is the project viable?

Is the project sufficiently risk free from the lender’s prospective?

Is there adequate security?

Will there be adequate free cash flow to cover interest payments and repay capital when due?

Can the cash inflows be guaranteed in some way?

Is the level of borrowing envisaged acceptable to you the borrower?

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