Time is another important variable, which needs to be considered because capital projects are time consuming. This essentially means resources are tied up and again the importance of making the correct investment decision is highlighted. All investments have an opportunity cost; this is best defined as an “investment may entail an early opportunity cost which is incurred in order to increase benefits later” (Price 1993).
An important decision of any capital investment programme is that it must be financially viable, that is the value of expected future income should be greater than the initial required investment and it must reflect future needs, opportunities and technologies, this is also known as the strategic assessment. Any capital investment programme combines three levels of planning which are vital to any future investment decision. The first is strategic and financial considerations, which I have already mentioned above. The second level of planning involves operational assessments of investments. This considers the different scale and size of facilities available. This also involves the rate and direction of technological innovation and change in characteristics of service supply. A rapid change of pace of technological change militates against large-scale investments. The third level of planning involves the size of the investment, the location, the cost and the time. This is known as the technical definition of project specification.
Areas of finance for capital projects include, current revenue, money raised through taxation, capital grants, money received from the sale of assets including privatisation and also borrowing. Public agencies have a long list of projects of what is viable to them to take on. Due to insufficient resources for all projects, they are ranked according to which is most profitable. The most profitable ones are chosen and the rest are put on a reserve bid, (Coombes & Jenkins 1994).
Managers need to look at their own roles in relation to long-term benefits and discourage short-termism trading thus exempting funds from tax and too much trading. This may lead to under-investment in immediate needs. Decisions need to be prudent and wise. Managers also need to be more versatile and aware of their surroundings.
The relationship between strategic planning, investment decision making and budgeting is vital to ensure the investment is appraised correctly. The need to review the activity is very important. Due to capital projects being large in their nature it is important for the strategic plan to be well defined therefore making it easier to fit all the parts of the decision making process together. It is important that not too much time is taken in these decisions as it may lead to “knock-on” effects in other budgets.
There are therefore two sets of controls on capital investment, the first being project authorisation, where the investment is justified, and the second being expenditure authorisation, whereby the availability of funds is realised. By linking the strategic plan to cash management this can help overcome any potential cash restraints.
When deciding which investment to choose, it is important to know what the value of the outcome will be. This is known as intertemporal choice which looks at the difference between two different times. For example, “Happiness today is worth more to me than happiness next year” (Price 1993). In the context of capital investment this means that money held now can be safely invested and earn interest and be worth more in the future. These differences make future benefits less certain due to a number of factors including changing fashions and preferences. Inflation is also another important factor which investors take into account. In turn this makes decision all the more important.
The statement made in the above paragraph is known as a technique called discounting (Price 1993) and is based on presumptions. Discounting uses increased choices and allows to be seen clearly at present and in the future. Discounting helps investment appraisal between present and future worthwhile projects. Early costs can be compared with that of later benefits.
There are two types of appraisal techniques, (1) discounting methods and (2) non-discounting methods. Non-discounting methods include appraisal techniques such as payback and return on capital employed (ROCE). Discounting methods look at appraisal techniques such as net present value and the Internal Rate of Return (IRR).
The simplest method of appraisal is the payback method. It looks at how long it takes a project to repay the original investment outlay, known as the “payback period”. This refers to the amount of time it takes for an investment to repay its initial outlay. For example if a £6000 investment yielded net cash flow of £100 per month, the payback period would be six months. See Appendix A. In the example given in the appendix, a £100000 investment brings in £30000 in year 1 and £40000 in year 2. By the end of year 2, therefore, the company is still £30000 down. In year 3 +£60000 is expected, so the anticipated payback is half way through the year. Overall payback is 2.5 years. It is generally used for certain public projects such as those that are experiencing cash flow problems. The benefits are gathered year by year until they match the original investment. The advantages of the pay back method are that it is simple to calculate and managerial mistakes are limited. It is generally a good first tool for approximation to evaluate an investment. If there is no payback there is no further enquiry.
The disadvantages are that if the pay back period is over a long period of time then the interest rate is critical because if the interest rate is high it would be difficult to go ahead with the project. The appraisal does not allow for variations in timing, and also it does not take account of the time value of money. It also ignores what happens after the payback period therefore it is very short-termist.
55% of London boroughs use payback calculations for investment decisions. However 62% of district councils did not use and had no plans to use payback methods in judging relative efficiencies of investment decisions. (Audit Commission, 1997). So it does have its opponents with a number of factors against its use as it is considered superficial.
When considering predicted cash flows in the future, it is worth remembering that money has a “time value”. This means that having money in the hand now is worth more to the government than the same quantity of money in the future. In the same way, asking a student if they would prefer to receive £100 now or £100 in five years time will almost always be answered by taking the money now. £100 put into a savings account today could earn a lot of interest over five years. When considering potential capital investments on the basis of predicted cash flows, it makes sense to ask: “what will the money we receive in the future really be worth in today’s terms?” these present values are calculated using method called discounting. To discount a future cash flow, it is necessary to know:
- How many years into the future we are looking.
- What the prevailing rate of interest will be.
There are two ways the government use this technique of discounting future cash flows to find their present value. These are the Net Present Value (NPV) and the IRR method.
NPV calculates the present values of all the money coming in from the project in the future, and then sets these against the money being spent on the project today. The result is known as the net present value of the project. It can be compared with other projects to find which has the highest return in real terms, and should therefore be chosen.
For example, there are two alternative proposals for investment. Both cost £250,000, but have different patterns of future cash flows over their projected lives. The rate of interest over the period is anticipated to average around 10%. See Appendix B.
Despite the fact that both these projects have the same initial cost, and they bring in the same quantity of money over their lives, there is a large difference in their present values. Project Y, with most of its income coming in the early years, gives a much greater present value than Project Z, whose best days come later in life.
This method of appraising has an inbuilt advantage over the previous techniques. It pays close attention to the timing of cash flows and their values in relation to the value of money today. It is also relatively simple to use the technique as a form of “what if?” scenario planning. The other advantage of using NPV includes the fact that it takes the opportunity cost of money into account. The disadvantages of using NPV is that like all quantitative techniques it has the inability to include qualitative factors; the meaning of the result is often misunderstood, only comparable between projects if the initial investment is the same and it is complex to calculate and communicate
The IRR method is another investment appraisal technique. Many investors like this technique because they find it easier to understand. However it is important to take care when explaining project investment which is greater than one phase. Unlike Net Present Value, IRR makes it possible to compare projects with different initial values. But instead of attempting to predict what the prevailing interest rate will be, it allows the interest rate to vary until a rate is found at which the NPV equals zero. This rate is then compared with either a pre-set criterion internal to the public service organisation to decide if the project passes that criterion, or with the prevailing rate of interest to see if the project is financially viable.
Discounted cash flows do not look at past or sunk costs, future benefits and costs and therefore there is increased risk and uncertainty. It also attempts to link successive single periods with the use of interest rates and assumes a perfect capital market in which the Public Service Organisation will borrow so long as they can show excess return.
Problems with Net Present Value include capital markets not being perfect; due to capital rationing it is more likely that organisations will use high interest rates to legitimise investments. It is also unlikely that those organisations have perfect information of all market activities; this can increase risk and again lead to uncertainty.
The concept of irreversibility of decisions is also important, as most public sector investments are irreversible. There are no real alternatives to large-scale investment programmes and these projects once built cannot be disposed of.
Cost benefit analysis is another method, which can be used as appraisal technique. This method looks at both private and public costs, and benefits, and it also includes positive and negative externalities. It is an in-depth look at all parts of a possible investment. This includes a clear definition of the project, evaluation of needs, a calculation of all benefits and comparisons between projects.
Appendix C shows all the various stages of investigation before an investment is given the go ahead. This is a very long and arduous process and hence an expensive method as it takes a long time to investigate all the options that maybe available.
A simplified example can be seen in Appendix D of the tangible and intangible costs and benefits for a planned motorway construction programme. As illustrated in the example it shows a number of problems that may occur when an investment appraisal is undertaken, such as unavailable data. This may included not being able to estimate the number of users for the service. It is also an expensive process, which is major issue. Also the opportunity cost may mean while one project is being considered others may be overlooked.
This may be a realistic option for large scale investment, as it is a detailed analysis of the possibility of a project proceeding or not. It also gives a much more defined idea on how viable a project is. It may also be used in conjunction with discounting methods to help give a clearer reflection of investment potential.
The whole concept of appraising capital investment projects needs to look at a wide range of issues. Including improved management techniques and continual assessment of projects so if it does not look likely a project will succeed, it should be replaced with one that is more feasible. However it can be said that the cost benefit analysis maybe of more worth for evaluating capital projects because these have such a long life hence it is imperative that the correct decisions be made. The other appraisal techniques should not be discounted but also used to help in the analysis of potential investment projects.
