Investment appraisal

Definition

Investment appraisal is a collection of techniques used to identify the attractiveness of an investment.

General

The purpose of investment appraisal is to assess the viability of project, programme or portfolio decisions and the value they generate. In the context of a business case, the primary objective of investment appraisal is to place a value on benefits so that the costs are justified.

There are many factors that can form part of an appraisal. These include:

  • financial – this is the most commonly assessed factor;
  • legal – the value of an investment may be in it enabling an organisation to meet current or future legislation;
  • environmental – the impact of the work on the environment is increasingly a factor when considering an investment;
  • social – for charitable organisations, return on investment could be measured in terms of ‘quality of life’ or even ‘lives saved’;
  • operational – benefits may be expressed in terms of ‘increased customer satisfaction’, ‘higher staff morale’ or ‘competitive advantage’;
  • risk – all organisations are subject to business and operational risk. An investment decision may be justified because it reduces risk.

A financial appraisal is the most easily quantifiable approach but it can only be applied to benefits that produce financial returns.

The simplest financial appraisal technique is the payback method. The payback period is the time it takes for net cash inflow to equal the cash investment. This is a relatively crude assessment and is often used simply as an initial screening process.

A better way of comparing alternative investments is the accounting rate of return (ARR) which expresses the ‘profit’ as a percentage of the costs. However, this has the disadvantage of not taking into account the timing of income and expenditure. This makes a significant difference on all but the shortest and most capital-intensive of projects.

In most cases, discounted cash flow techniques such as net present value (NPV) or internal rate of return (IRR) are appropriate to evaluate the value of benefits and alternative ways of delivering them. NPV calculates the present value of cash flows associated with an investment; the higher the NPV the better. This calculation uses a discount rate to show how the value of money decreases with time. The discount rate that gives an investment a NPV value of zero is called the IRR. NPV and IRR can be compared for a number of options.

Appraisal of capital-intensive projects and programmes should take into account the whole-life costs across the complete product life cycle as there may be significant termination costs. In the case of the public sector, where income is usually zero, it is common practice to identify the option with the lowest whole-life cost as the option that offers the best value for money.

The appraisal on less tangible and non-financial factors is more subjective. In some cases, a financial value may be calculated by applying a series of assumptions. For example, work that improved staff morale may lead to lower staff turnover and reduce recruitment costs. A financial appraisal of this benefit would have to include assumptions about the numerical impact of increased morale on staff turnover and the estimated costs of recruitment.

Where benefits cannot be quantified then scoring methods may be used to compare the subjective value of benefits.

Project

Stand-alone projects will use investment appraisal to compare alternative approaches to achieving the required benefits. Wherever possible, the project should use techniques that are the organisational, programme or portfolio standard approach.

Where a project is part of a programme, the initial investment appraisal may be performed by the programme management team. That does not exempt the project management team from being familiar with the content of the appraisal or the techniques used to perform it. It will still be responsible for keeping the business case up to date and this will involve repeating the investment calculations to account for changing circumstances.

Where a project is undertaken by a contracting organisation, the financial appraisal is relatively straightforward as it will simply be a comparison of costs with the fee paid by the client, probably using a discounted cash flow technique.

Programme

Programmes are usually defined to bring about organisational change. This inevitably gives rise to a higher proportion of intangible and non-financial benefits being included in the business case. Commercial programmes must be careful not to be overly dependent on non-financial benefits, as anything can be justified through subjective views of value.

The programme management team must set out standards for the appraisal of the component projects and their associated benefits. Consistent and compatible techniques must be used across the programme so that individual project business cases can be aggregated and summarised in the overall programme business case.

Portfolio

In the definition phase of a portfolio there may be many ideas and suggestions for projects and programmes to meet the strategic objectives. The portfolio management team must establish a system for capturing and screening these ideas.

This is where broad-brush techniques such as payback may be used. A criterion may be set that requires payback within the financial planning cycle. Any projects or programmes that do not provide payback in that period are discarded. As the higher-potential ideas are captured, they will be subject to more detailed, analytical techniques.

The prioritisation and balancing phases of the portfolio will rely heavily on how investment appraisal has built the business cases of the component projects and programmes. It is essential that the portfolio management team establishes standard methods and consistent approaches across the portfolio to ensure reliable decision-making. The team should also provide specialist advice and guidance on the use of appraisal techniques to all project and programme teams.

The portfolio management team must also ensure that investment appraisals consider potential investments in the context of the existing and planned projects and programmes. For example, to identify opportunities for reuse of components and avoid double counting of benefits.

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