Transcript Slide 1

Making a Financial Case
Asset Management
ILM Level 5
Mark Freeman
Professor of Finance
School of Business and Economics
Objectives
 This course is divided into four parts
 Until 2.30 today. Capital budgeting in the University sector
 After 2.30 today. The Loughborough context
 Tomorrow morning. Writing a case
 Tomorrow lunchtime. Case review with the DVC
The agenda until 2.30
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9.00 – 10.30
10.30 – 11.00
11.00 – 11.15
11.15 – 12.15
12.15 – 1.00
1.00 – 1.45
1.45 – 2.30
“Dragons’ Den”
The capital budgeting process
Coffee
Analysing monetary costs and benefits
Analysing non-monetary costs and benefits
Lunch
Combining the monetary and non-monetary
Core sources
 The UK Treasury “Green Book”
 “Appraisal and Evaluation in Central Government”
 http://www.hm-treasury.gov.uk/data_greenbook_index.htm
 HEFCE
 “Investment Decision Making”
 http://webarchive.nationalarchives.gov.uk/20120118171947/http:/w
ww.hefce.ac.uk/pubs/hefce/2003/03_17.htm
Another University
 University of Leeds
‘The University must follow both Treasury and HEFCE
guidelines and is ultimately accountable to the Committee of
Public Accounts on the use of public monies’
Guidelines on Investment Decision Making: Capital Equipment over
£100k (excluding Research Equipment)
Academic and corporate best practice
 It is important to realise that the Green Book / HEFCE
guidelines conform closely to what is considered by
academics to be ‘best practice’
 The techniques are also very similar to those most widely
used in the private sector
The Capital Budgeting Process
Quotations liberally taken from the HEFCE guidance
Project stages
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Organisational Need
Strategic Context
Objectives
Appraisal
Monitoring
Evaluation
Feedback
Primary focus today
Choosing
between two or
more options
when something
must be done
Deciding whether to
take on a project
that is optional
Organisational needs
‘At the outset, the institution will have determined that there is a
problem to be solved or a need to be satisfied. This must be
clearly defined, since it will form the basis of the whole analysis.
As the analysis develops, it may call into question whether the
problem or need does in fact exist.’
Strategic context
‘The appraisal must be placed in its strategic context. This
should refer to the aims and objectives of the institution, the
strategic plan, the capital and infrastructure plans, and other
relevant policies.’
Rationale
‘The statement of objectives sets out what is to be achieved and
defines a firm boundary to the appraisal. It provides the criteria
against which options will be judged, and against which the
success of the project will be evaluated. Experience has shown
that it is a crucial factor in the subsequent steps of the
appraisal.’
Project appraisal
 This is where we will spend most of the rest of today:
 Identify all the possible options
 Identify all the possible risks
 Identify all the appropriate costs and benefits
 Analyse the data
 For others within the University
 Is the project affordable?
 How will the project be financed?
Monitoring, evaluation and feedback
‘At the time of the appraisal it is important to plan for monitoring
during implementation and post-project evaluation of the
decision. This provides feedback into future decisions.
Evaluation should cover the extent to which the objectives were
met, any cost and time overruns, the relationship between
estimated and actual costs and benefits, and any implications
for future decisions.’
 Detailed guidance on project evaluation in the public sector is
given in HM Treasury’s Magenta Book
http://www.hm-treasury.gov.uk/data_magentabook_index.htm
Project Appraisal
Choosing options
‘It is important, particularly for major investment decisions, to
consider a wide range of options, even though many may be
rejected at an early stage. Rarely will there be no realistic
choice of options. Institutions must keep an open mind, and be
prepared to ‘think the unthinkable’. Experience indicates that
institutions gain considerable value from using a wide-ranging
multi-disciplinary team, and involving the end-users in the
development of the project from an early stage.’
Choosing options
‘Institutions must include a ‘do nothing’ option as a baseline,
even if it falls short of the operational requirement.’
I think this is wrong for reasons I’ll explain on the next slide.
The sentence below, though, is in my opinion correct
‘Where a ‘do nothing’ option is clearly unacceptable, then a ‘do
minimum’ option should be considered.’
Identifying costs and benefits
 The identification of costs and benefits are reasonably
straightforward in principle:
Incremental cost/benefit = cost/benefit with project – cost/benefit
without project
 The incremental cost/benefit approach automatically
compares to the ‘do nothing’ option
 This is why I disagree with the first point on the previous slide
 This definition is surprisingly difficult to implement accurately
Over-optimism bias
 Managers have a systematic tendency to be too optimistic
about proposed projects
 Green Book: “To redress this tendency, appraisers should
make explicit adjustments for this bias. These will take the
form of increasing estimates of the costs and decreasing, and
delaying the receipt of, estimated benefits.”
Project Appraisal
Analysing Financial Costs and Benefits
Cash today vs. tomorrow
 In financial cost / benefit analysis, capital budgeting involves
comparing an investment cost today against (hopefully)
greater cash flows in future
 So we are comparing a money cost today with a money gain
in the future
 How do we do this?
The four things that matter
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When looking at the monetary gains that a project will
deliver, four things primarily matter
 The expected MAGNITUDE of the gains
 WHEN the gains occur
 The RISK that those gains will not occur
 The gains offered by OTHER projects
Net Present Values
 The way in which we evaluate a project is to use “Net
Present Value” criteria
Expected financial
gain in year 1
E[C1 ] E[C2 ]
NPV   I 

 ...
2
1  r (1  r )
Initial
investment
Discount rate / Cost of Capital
NPV decision rules
 If the NPV is positive (negative) then the project is good (bad)
 When choosing between two projects, select the one with the
higher NPV
Why use the NPV criteria
 There are alternatives to NPV for assessing financial costs
and benefits (Payback Periods, Return on Capital Employed,
Internal Rates of Return, etc.) but:
 Green Book: “The NPV is the primary criterion for deciding whether
government action can be justified.”
 HEFCE Technical Guidance: “To compare options, costs and
benefits must be discounted so that a single figure – the net
present value (NPV) – can be calculated for each option.’
 The NPV is also the criterion most heavily used in the private
sector for capital budgeting purposes
Simple example
 A proposed project requires an investment today of £1m. We
expect financial benefits of £0.25m in one year, £0.6m in two
years, £0.3m in three years and nothing thereafter. The
discount rate is 10%
0.25 0.6 0.3
NPV  1 
 2  3  0.0514
1.1 1.1 1.1
 The NPV here is negative, so this is a bad project
The time of gains
 In project appraisal, the sooner the benefits arrive the better
 Inflation erodes monetary value
 Investors and managers are, by nature, impatient. Even
after adjusting for inflation, investors need about 1% - 2%
a year to encourage them to invest in a risk-free project
Real vs. nominal discounting
 Real analysis
 Nominal analysis
Analysis undertaken in
current £ terms
Analysis undertaken in
actual £ terms at the time
 The difference between real and nominal analysis is inflation
 Of course, it is necessary for the discount rate & the cash
flows to be consistent
Real discounting
 The Green Book has an explicit preference for real analysis,
“The valuation of costs or benefits should be expressed in
‘real terms’ or ‘constant prices’ (i.e. at ‘today’s’ general price
level), as opposed to ‘nominal terms’ or ‘current prices’.”
 “The discount rate is used to convert all costs and benefits to
‘present values’, so that they can be compared. The
recommended discount rate is 3.5% (real).”
Dealing with project riskiness in the private sector
 As a general rule (but not invariably) the riskier the project,
the less attractive it is, all else being equal
 To account for this, companies usually use higher discount
rates for riskier project than less risky ones
 Expected future benefits then have to be higher for risky
projects to give the same NPV as safer ones
 This, though, is not true in the public sector
 The Green Book uses 3.5% irrespective of project risk
Dealing with project riskiness in the University sector
‘It is particularly important that decision makers take account of
risk and uncertainty. In many cases, their impact can be valued
and factored into the decision-making process. Even when the
impact cannot be defined precisely, institutions must recognise
the potential for risk and uncertainty to influence their decision.
The process will be clarified if the risks and uncertainties are set
out in a formal risk register.’
Project Appraisal
Analysing Non-Financial Costs and Benefits
Example
 Consider a situation where a project will not only have
financial implications, but will also impact on:
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Academic quality
Flexibility of provision
Student experience
Equal opportunities
Internationalisation
 How do we include these features in project analysis?
Apples and pears
 The problem, of course, is that you are now comparing
apples and pears
 For this reason, the standard recommendation is to
combine everything into a single non-monetary unit
QALYs
 The best known example of combining different
elements to one common unit of measurement is the
“Quality Adjusted Life Year” (QALY) measure used by
the National Institute for Health and Clinical Excellence
 Effectively they consider all drugs, irrespective of their
medical benefits, on the single QALY criterion
 This measures a combination of life expectancy and life
quality as a consequence of taking a certain medical
remedy
Scorecards
 The basic principle involves determining each type of
potential benefit that you are looking to achieve and then
ranking these with a weighting depending on their importance
 Then, for each project, a score between 0 and 100 is
allocated for each type of benefit
 A weighted score can then be determined for each project
 The supplementary guidance to the Green Book gives further
information about these scoring techniques
(http://www.communities.gov.uk/documents/corporate/pdf/1132618.pdf)
An example
Option A
Option B
Weight
Score
Total
Score
Total
Quality
10
75
750
50
500
Flexibility
5
30
150
90
450
Experience
7
80
560
50
350
Equality
9
50
450
90
810
International 4
10
40
50
200
Total
1950
2220
Two tasks
 There are two elements here that should not be confused:
1. The key non-financial criteria and their relative
importance. This is a University-wide issue, based on the
University strategic objectives, and should be largely
independent of the particular options under consideration
2. The weighting of each project against the scorecard.
This should be done as independently from the project
stakeholder as possible
Group exercise
 What are the seven most important non-financial objectives
for the University?
 Weight their relative importance in your own opinion
 What weighting structure do you think the University Senior
Management Team would give to each of these non-financial
objectives?
Project Appraisal
Combining the Financial and Non-Financial
(The Controversial Bit)
An example
NPV
Scorecard
Project A
+£150,000
1950
Project B
+£100,000
2220
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Both projects are financially viable
Project A is better than Project B on financial criteria
Project B is better than Project A on non-financial criteria
Which one do we choose?
Implicit monetisation
 Project A beats Project B by £50,000 financially
 Project B beats Project A by 270 points on the scorecard
 So, the two projects are equivalent if each scorecard point is
worth 50,000/270 = £185.19
 Therefore, by choosing A or B we are implicitly valuing each
scorecard point at either less or more than £185.19
 So our choice implicitly reveals the way in which we monetise
non-financial benefits
Implicit monetisation
 As the Green Book observes
“… weighting and scoring can be used to bring data
expressed in different units into the appraisal process ... It
often involves an implicit monetisation of different impacts
once the performance against the various criteria is
compared to the costs considered worth spending to secure
or to avoid them.”
Explicit monetisation
 The Green Book’s recommendations dislike this implicit
monetisation
 It instead recommends explicitly valuing each scorecard point
“The valuation of non-market impacts is a challenging but
important element of appraisal, and should be attempted
wherever feasible…It is difficult to determine whether a health
programme should be funded, or how large it should be, without
first allocating a monetary value to the projected health gains.”
The value of a QALY
“In the early days of NICE the cost/QALY ‘threshold’ was not
particularly explicit, although frequently people applied a ‘rule
of thumb’ of £30,000 … The figure quoted now tends to be
£20,000 … My personal view would be that it is helpful to
consider three ranges rather than one point:
£0-£20,000
£20,000-£30,000
>£30,000
intervention is cost-effective
a ‘grey area’ …
intervention is not likely to be costeffective”
Professor Brian Ferguson, Director of YHPHO and Chair of DPHIG, 2006
A Cost-benefit analysis framework
 Assign a monetary value to the scorecard points. Again, this
should be a University-wide / project-independent process
 The monetised scorecard values for each option can be
added on to the simple financial costs / benefits of the
proposed project. You are no longer adding apples and
pears
 From this, an NPV value can be calculated and simple NPV
decision rules can be implemented (positive good, negative
bad, choose the project the with the most positive NPV)
 This is consistent with Green Book best practice