Consultation 98/55

Appraising investment decisions: Consultation

Draft for consultation

Outcomes of consultation (March 1999)

Executive summary

1. Purpose

2. This document invites comments on a draft guide to Appraising Investment Decisions.

3. Action required

4. Comments on the draft guide to Appraising Investment Decisions should be sent in writing to Tim Russell, Private Finance Adviser at the HEFCE, by 30 November 1998. We intend to issue the guide by January 1999.

The electronic version of this document contains the main text only, it does not include the annexes. The complete printed document is available from HEFCE publications.

Contents

Foreword
Introduction
Using this guide
When is appraisal required?
How detailed should the appraisal be?
Basic principles
Establishing the outline business case
Developing the full business case
Valuing the costs, benefits, timing, risks and uncertainties of each option
Analysing the results
Assessing affordability
Presenting the results
Monitoring and evaluation
Annex A - Example case study
Annex B - Appraisal checklist

Foreword

The Council has a responsibility to ensure that public money is spent effectively. Conducting effective option appraisals is one of the ways of ensuring good value for money. We have expertise in our own finance, audit and estates functions, and we have experience of good practice in the higher education sector and in the private sector from our involvement with public/private partnership projects. This guide aims to share this experience, and assist institutions and their advisers in structuring their analysis of investment decisions.

Taking informed investment decisions is a key facet of the governance and management of higher education institutions. The outcome may have significant impact strategically and financially, both in the short term and far into the future. The decision process must be well-structured, and the information presented in a clear and logical manner.

The principles of option and investment appraisal are not new. However, much of the published advice is directed at decisions that are purely commercial. Guidance for the public sector is useful, but not all of it can be applied directly to the higher education sector.

This guide is designed to provide advice specific to the higher education sector, to help institutions structure their investment decisions. It sets out a framework for the appraisal process which institutions can use for all kinds of decision making. The details may vary but the same principles apply across a whole range of decisions. They are as valid for a decision about setting up a new course as for one about property options, and institutions can tailor the process to suit their individual circumstances.

HEFCE guides are designed to cover a wide range of institutions. We are of course aware that a number of universities and colleges will have arrangements which fully match these guidelines, but we hope that institutions will find value in the systematic approach presented here.

1. Introduction

2. Appraisal is a technique for obtaining value for money by systematic comparison of alternative investment options. All major investment decisions should be supported by a thorough option appraisal. This (draft) guide sets out the basis of the HEFCE's policy on appraisals. It also reflects the recommendations of the National Audit OfficeÆs study of the management of building projects at English higher education institutions.
3. Decisions must be justified: the reasons for them must be analysed and supported by evidence. To obtain maximum value from the appraisal process it is necessary to understand the assumptions on which the decisions are based, and also the circumstances which might lead to a different outcome. Consequently the assessment of risk and uncertainty will be as important as the base estimates for each option, and this should be reflected in the appraisal.

4. Using this guide

5. The process of option appraisal can involve people at all levels in an institution. It is not confined to those in the finance and estates functions, since option appraisal can and should be applied to many decisions besides those involving property. Some will already be familiar with the appraisal process, and look for specific guidance on only a few points. Others will be new to the techniques and will seek more detailed guidance.
6. We have not attempted to provide a basic textbook on investment appraisal. In setting out this guide we have used existing Treasury advice as our starting point. æThe Green Book - Appraisal and Evaluation in Central Government - Treasury GuidanceÆ (H M Treasury, 1997) sets out the principles to be followed. The Green Book is the main authority and this guidance should be read in conjunction with it.
7. We have included a detailed case study in this guide, which is designed to illustrate the key points. However, while institutions may find this useful as a model of the process, they should beware of following it slavishly, or believing that it only applies to property issues. They must decide for themselves what level of detail is needed for their particular case, judged on the significance of the decision they are taking. It would not be appropriate to provide a pro forma, or even to specify a threshold value at which any particular procedure becomes necessary.

8. When is appraisal required?

9. Our Financial Memorandum with institutions requires them to demonstrate the value for money to be generated by a project when this is financed from borrowing and where the level of borrowing requires prior written Council consent. An appraisal is also required when we invite applications for grant support for specific projects.
10. However, we would also expect appraisal techniques to be applied to:
11. 1. Any investment involving HEFCE funds, or Exchequer-funded assets, even if the proposal does not require consultation or consent.
    2. Options in an estate strategy.
    3. Any other investment proposal, even if it is funded entirely from an institutionÆs private sources.
12. There is a tendency to think of option appraisal just as a means of deciding between different ways of acquiring a physical asset. Property is a costly and often inflexible resource, and a properly conducted appraisal for property is an essential element in a business case. Examples of property decisions which require appraisal include:
13. 1. Relocation, or consolidation of an institutionÆs activities onto a single site.
    2. Moving from one building to another, new construction, acquiring additional accommodation, or retaining accommodation that would otherwise be released.
    3. Reducing the amount of accommodation required, leading to options of complete or partial disposal.
    4. Whether to improve or refurbish existing buildings, perhaps as an alternative to building or acquiring new property.
    5. Whether to buy or lease.
    6. Replacement of existing equipment, or the supply of new equipment.
14. However, institutions can and should follow the same principles in making any investment decision, such as setting up a new course, or acquiring a service or an item of intellectual property. Options need not involve purchase of assets or services outside the institution: the techniques are just as valid for choosing between options that place demands on internal resources such as staff time. Examples include:
15. 1. Providing services, which may involve contracting out.
    2. Providing contracted-out services, which may also involve providing the associated assets.
    3. Possible changes to teaching methods, such as increased use of information technology.
    4. Investing in a joint venture or a subsidiary business venture.
    5. Developing the academic portfolio.
    6. Developing quality of service.
    7. Improving the competence of staff.
    8. Early retirement schemes.

    How detailed should the appraisal be?

16. All appraisals should follow the same principles, but institutions will have to make their own decisions about how much detail is appropriate. The effort that goes into the appraisal should be judged against the significance of the investment decision. Obviously the size of the institution will be a factor - what is a key decision for a small institution might be seen as relatively insignificant by a large one - so it is not possible to lay down any hard and fast rules. It would not be sensible to suggest there is any threshold where institutions should start to use a particular appraisal technique, or to set out a pro forma to be completed for projects above a certain size. The structure of each appraisal will be very similar, but ultimately it is for the governing body of each institution to decide how much detail it requires to inform its decisions.

17. Basic principles

18. The Green Book is written for Government departments, and institutions will need to modify its approach; particularly in the scope of their appraisals, the way they treat taxation, and the discount rates used in their appraisals. This guide is intended to supplement the Green Book by explaining those differences, and expanding on some other points that are known to give difficulty. It includes at Annex A a case study illustrating the points set out below, and at Annex B a checklist of the main questions to be asked in formulating a good appraisal.
19. Appraisal and evaluation are often taken to be synonymous. However, the Green Book makes the distinction between appraisal carried out to inform a decision before it is made, and evaluation carried out subsequently to review the decision. This guide follows the same convention.

20. Basic steps of appraisal

21. The Green Book describes the following steps in the appraisal process:
22. 1. Define the objectives.
    2. Consider the options.
    3. Identify, quantify and where possible value the costs, benefits, risks and uncertainties associated with each option.
    4. Analyse the information.
    5. Present the results.
23. However, to be useful to higher education institutions, these steps alone will not be sufficient. The Green BookÆs approach is one of deciding between competing options, when affordability is often a matter of deciding spending priorities between a number of different projects. By contrast, an institution will need to decide what it can afford within a limited budget, where the project may be a significant factor in terms of overall spending, as well as deciding between competing priorities.
24. For institutions, appraisal needs to be seen in the context of developing a business case. This is an iterative process. It should be carried out at an early stage when broad strategic options are being considered, and refined when a detailed solution is being chosen. Institutions may have to re-appraise their options as new information comes to light, or if major developments affect the assumptions underlying the appraisal. At each stage they may have to go back to the start and revise the initial assumptions.
25. For the purpose of developing this guide, we have assumed that institutions will go through at least two stages: first to produce an outline business case, and then again to refine it into a full one. They might build an outline business case using their own resources, before engaging outside advisers to develop it in more detail. Many of the steps are common to both processes, varying only in the level of detail. This guide therefore describes the steps in developing the outline and full business cases, before providing more detailed advice on some of the requirements of the appraisal process. However, institutions need not follow the process dogmatically. A simple decision could well be taken with both stages combined into a single process. By contrast, a significant project might require further iterations before the institution felt it had completed a sufficiently detailed appraisal to proceed with confidence.
26. A case study of the process is at Annex A. It is designed to show the key features, but should not be taken as a representative full worked example. In particular, in the interests of clarity, it analyses fewer options than would normally be acceptable in a satisfactory appraisal.

27. Establishing the outline business case

28. The development of an outline business case is illustrated in Figure 1.

29.  

    Identify the need or problem

30. 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. This will be obvious if the problem is clearly stated in the first place.

31. Consider the strategic context

32. The starting point for the appraisal should be a statement of its strategic context. This should refer to the aims and objectives of the institution, the strategic plan, the estates strategy, and other relevant policy documents.

33. Decide objectives

34. The statement of objectives sets 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. Objectives should not be so narrowly defined as to prevent consideration of a range of options, nor so loosely defined as to generate unnecessary work.
35. The objectives should include the scope - a statement of the range of activities which the project will be expected to provide, and the context - the facilities or services needed to carry out these activities. Technical constraints should not be unduly binding. In all cases institutions must guard against over-specification of requirements. Matters such as the standard of the services or facilities provided, their location, whether it is new-build or refurbishment, and procurement methods such as lease or purchase, should all be treated as options rather than objectives.

36. Identify the options

37. It is important, particularly for major expenditure 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 æthink the unthinkableÆ. They will construct a much more convincing case if they can show that they were prepared to be innovative in their search for a solution. 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.
38. Institutions must include a ædo nothingÆ option as a baseline, even if it falls short of the operational requirement. It will be the basis for comparing the costs and benefits of all the other options, and for determining the priority to be attached to the proposal.
39. Where a ædo nothingÆ option is clearly unacceptable, then a ædo minimumÆ option should be considered. This situation is very rare, but might occur, for instance, if there was a statutory obligation to make safe a derelict building.
40. The appraisal should consider timing changes - such as postponement for various periods, or phased delivery of the project - since the timing of payments will affect the value of the project. It may also be possible to structure the project in different ways, for instance by contracting out some aspects of service delivery.
41. Before proceeding to a first assessment of costs and benefits, some options can be discarded if they are clearly unrealistic. There must be good grounds for rejecting them: the process must not be used to rule out options just because they do not fit with preconceived ideas.

42. Assess outline costs and benefits

43. Appraisal is concerned with obtaining the best use of resources. Where the costs and benefits of a project will accrue exclusively to the institution, then that is all that needs to be included in the appraisal. However, there may be occasions where a project is financed jointly by the institution and another body. For example, an institution might receive support from a lottery board, for a project intended to bring benefits to the public at large, as well as meeting the needs of the institution. Alternatively, it might consider a joint venture with a commercial organisation. In cases such as these the costs and benefits to the wider community, or to other interested parties, will need to be included in the appraisal. Other external costs and benefits, such as environmental advantages and penalties, should be included where they are relevant to the objectives of the proposal.
44. An appraisal should contain a list of the factors to be considered in each option, even when it is not possible to quantify them, or value them in monetary terms. Appraisals are often primarily concerned to identify the best value option for a particular standard provision, such as teaching accommodation, but even then the benefits may vary. For instance, the quality of accommodation may affect performance - measured by attendance, actual output or staff turnover. Other relevant benefits may include a convenient location, and reducing work on split sites. The appraisal should assess, and where possible quantify and value, all such benefits.

45. Select a preferred solution

46. At this stage, many of the costs and benefits will be difficult to define and quantify precisely. More detailed advice on how to handle these aspects is given in paragraphs 46-54. The main object is to select a preferred solution that can be tested for affordability, so that the institution can decide whether it has an option to take forward for more detailed analysis. Of course, this more detailed analysis will have to consider competing options as well, since the relative costs and benefits may change when examined more closely. However, those that are clearly non-competitive can be discarded at this stage.
47. The preferred solution must be viable. For instance, there would be no point in continuing to analyse what purported to be the preferred solution if it assumed a building could be provided in an unrealistic and therefore unacceptable timescale.

48. Initial assessment of affordability

49. At this stage, it is unlikely that the institution will have explored all the procurement options available, or how they might be financed. For a first assessment of affordability, the institution will need to estimate the financing costs to see how they might fit its overall financial strategy. This may indicate that the preferred solution is unaffordable, even though it may appear to give the best value for money. In these circumstances, the institution may have to consider the next best option, or look again at how the option might be financed.

50. Seek commitment of the governing body

51. Before proceeding to a full business case, institutions should seek the approval of their governing body or the appropriate delegated authority. The decision makers must have an exposition of the business case at an appropriate level of detail to match the scale of the project. It is not sufficient for them to be presented with a ætake it or leave itÆ decision: they must understand the range of choices open to the institution, and the logic behind the selection of the preferred option. Further advice on the responsibilities of governors is available in the HEFCE publication æEffective financial management in higher educationÆ (HEFCE 98/29), and in the æGuide for Members of Governing Bodies of Universities and Colleges in England, Wales and Northern IrelandÆ published by the Committee of University ChairmenÆ (HEFCE 98/12).

52. Developing the full business case

53. The steps involved in developing a full business case are shown in Figure 2.

54.  

    Consider procurement routes

55. With the commitment of its governing body, the institution can devote more resources to exploring the appraisal options in detail. In particular it will want to explore the practicality of different procurement routes. For instance, for a building procurement these might include a PFI solution based on service delivery, and a traditional design and build contract. There may be a number of further stages to consider, since each option may have a number of different procurement routes with different costs and benefits.

56. Assess financing options

57. At this point the institution will need to explore in more detail the financing options and their associated costs. In some cases, such as PFI, the financing method is closely linked to the procurement route. For more traditional procurement, a number of options will still be available, from the use of reserves to a wide choice of short-term and long-term borrowing arrangements.

58. Reassess and select preferred solution

59. In analysing the various combinations of options, procurement routes and financing options, institutions will need to consider in detail the risks and uncertainties associated with each. More detailed advice on how these should be treated is given in paragraphs 80-89. At this level of analysis, it is likely that the prospective solutions will have different levels of risk, and so comparisons will have to be made on a risk-adjusted basis. This is particularly true if PFI solutions are being considered, when transfer of risk is one of the benefits being sought.

60. Financial impact

61. The institution will need to re-assess the impact of its preferred solution on its overall financial situation, in the light of the increased level of detail available in the full business case. This will be the basis for the analysis of affordability that it will present to the governing body for final approval.

62. Approval and review

63. In considering the full business case, the governing body needs enough detail to be able to appreciate the implications of proceeding. Governors will need to understand the logic behind the choice of the preferred solution, but also the risks and sensitivities that go with it. Even when approval has been given, the management of the institution should advise the governing body if any of the assumptions are invalidated and this has a material effect on the decision.

64. Valuing the costs, benefits, risks and uncertainties of each option

65. All the implications of each option must be accounted for. This will involve considering all the costs and benefits, including the non-financial benefits and penalties. It will also involve analysing the effect of variations in timing, and any risks and uncertainties involved.
66. For a typical project relevant costs might include:
67. 1. Capital costs - such as land, demolition, construction or refurbishment costs, fees and expenses, equipment, commissioning and handover costs.
    2. Running costs - such as rates, water and sewerage charges, maintenance, power, heating, lighting, staff costs, and payments for contracted-out services.
    3. Costs of other features that are affected. These may be associated with ease and availability of access, operational convenience, ease of communication, flexibility, environmental factors, and costs of retaining and disposing of vacated accommodation.
68. Relevant benefits would typically include:
69. 1. Fee income from further student enrolment.
    2. Research income.
    3. Rental or conference income.
    4. Income from third party use of facilities.
    5. Capital receipts - such as proceeds from disposal of the building being replaced.
    6. Residual value at the end of the appraisal period.
70. All relevant costs and benefits should be included, even where the costs do not involve cash expenditure. For example, the value of an asset should be included even when it is already in the institution's ownership. Such an asset could be used for other purposes or sold if it were not employed in the project being appraised, and therefore there is a cost involved in using it, the size of which depends on the alternative uses. This is known as the opportunity cost. For property, the opportunity cost is normally taken as the market value or the value in alternative use, whichever is higher. Similarly benefits, in the form of cost savings or an improved quality of output, should be included even where they do not produce a cash flow.
71. Some assets will have a value at the end of the appraisal period - the residual, exit, or disposal value - which should be counted as a benefit. These assets may not be just land or buildings: ongoing businesses and intellectual property rights (IPR) can also have a residual value. Such values should be assessed in prices current at the date of the appraisal.
72. When calculating residual value, land and buildings should be considered separately. Buildings will depreciate over their lifetime, while the site value may remain constant, or even appreciate. Accordingly the usual assumption is that the value of the site remains unaltered in real terms. Actual increases in land prices should not normally be counted as benefits if they would have occurred even if the project had not taken place, since they would be realised equally by the ædo nothingÆ option. The buildingÆs residual value will be that which gives the highest figure from the range of options, including refurbishment, alternative use and site value.
73. There are complex issues associated with property valuation. The Royal Institution of Chartered Surveyors Appraisal and Valuation Manual gives a detailed framework and guidance. This is an area where institutions may need professional advice.
74. Many types of cost or benefit can be included under a number of heads, but their value must only be counted once. Examples of a double counting error are the inclusion of both rents and capital values for the same building in the same cash flow; or including what is a cost in one option as a benefit in another. The ædo nothingÆ option provides a common baseline to avoid this sort of mistake, since each option in the appraisal should represent a change from the base case.
75. Costs and benefits which can be valued in monetary terms should be allocated to the time period in which they are expected to occur. It is generally sufficiently accurate to treat all costs incurred in a particular year as falling at mid-year. However, longer-term variability in timing can have a significant effect on the appraisal, and the range of options should include possible scheduling variants for the same idea. Even if monetary values cannot be assigned, it is important to indicate how the timing of impacts will be spread over the appraisal period.
76. Estimates of costs and benefits should be accompanied by assessments of any risks or uncertainties. It is helpful to list them all in a risk register, to ensure that none are over-looked. This can then be used as a checklist to ensure the analysis makes proper allowance for the significant ones. Risk and uncertainty are dealt with in paragraphs 80-89 below.

77. Appraising non-financial aspects

78. In an environment such as higher education, many of the benefits of an investment decision will not be realised as a cash flow. Even more difficult to analyse will be those benefits which cannot be expressed in financial terms at all. In many cases, institutions will have to make a judgement as to the desirability of an investmentÆs outcomes, and what is a fair price to pay for them. However, such decisions are easier if the relative merits of different decisions can be presented in a rational way.
79. Appraisals will have to handle non-financial aspects differently, depending on how easily they can be measured. They can be categorised as:
80. 1. Benefits which can be valued.
    2. Benefits which can be measured in some other way.
    3. Benefits which cannot be measured at all in conventional terms.
81. In practice it may be possible to put values on the benefits and costs of a decision, even though there is no market value for them that can be realised in cash terms. For instance, investments that save staff time can be compared by putting a value on the time saved: locations for a student residence might be compared by including the costs to the students of using public transport.
82. If institutions use this method of comparing alternatives, they must be careful to distinguish between the notional values, which will influence their decision on which option offers best value for money, and the actual costs which will have to be met from their budget. There is no sense in selecting an apparently attractive option if it proves to be unaffordable in cash terms. Further advice on assessing affordability is given in paragraphs 92-94.
83. There may be costs and benefits which can only be assessed in non-financial terms, but which can nevertheless be quantified. For example, options may deliver more or less of an outcome, whether it is units of student accommodation, seats in a lecture theatre, or shelf space for books. Institutions can use such data to inform their decisions. It is often helpful to understand what is the incremental cost of a particular feature. In such cases, institutions will have to decide what is a reasonable price to pay for the additional benefit.
84. A different problem is posed by attributes which cannot be measured in conventional terms. For instance, alternatives may offer different levels of satisfaction under headings such as:
85. • the contribution to an institutionÆs long-term strategy
    • flexibility for the future
    • political acceptability
    • enhancement of the institutionÆs academic image
    • compliance with planning constraints
    • protecting an institutionÆs market position.
86. Institutions will often have to make qualitative judgements of this kind. Their appraisal will carry greater conviction if the basis for the decision is made clear. They should therefore be quite explicit about the criteria used, and how they assess each option. The simplest analysis defines the criteria that are significant in the appraisal, and ranks the options in order of preference. The institution will have to reconcile the perceived benefits with the cost of each option.
87. A scoring system, even a subjective one, can help to clarify the decision process and give it more rigour. The institution must first decide what criteria are significant and how to score them; scores can be weighted to reflect their relative importance. The results are only an aid to decision making, and can never relate to any absolute measure. However, even if the scores and weightings are fundamentally subjective, the institution will be in a better position to explain the rationale for its decision.
88. A sample of such a scoring system is included in the example in Annex A. The Green Book, Annex C, gives further advice.

89. Taxation

90. The Green Book is written from the point of view of Government departments. When appraising investment decisions for bodies which are totally dependent on public funds, taxation can normally be ignored since any charges will be reflected in a direct benefit to the public purse. Therefore to assess the value for money from public expenditure, generally market prices should be used in appraisals, without adjustments for the effects of VAT or other indirect taxation. No adjustments should be made to market prices for direct taxes such as income and corporation tax.
91. Higher education institutions will rarely be in this position. In their appraisal, institutions must include all the cash flows they will actually incur, even if they might be dismissed as transfer payments in a Government appraisal. Taxes fall under this heading, as do charges arising from the occupation of property which vary according to location, such as business rates and water and sewerage charges. In formulating cash flow statements and in determining its own preferred solution, the institution should consider the impact of VAT on both capital and recurrent items. Even when they are totally dependent on public funds, institutions must still be aware of the effect of taxation on their cash flows. They may have to conduct their appraisal twice, once without taxation to establish best value for money from public funds, and a second time to check affordability.

92. Appraisal period

93. The appraisal period should normally be the period for which the service is required, or the remaining economic life of the main asset.
94. For buildings it is essential to distinguish between the physical life of a building and the period during which it has occupational value, which may be much shorter. A new building may typically have a physical life of over 60 years providing it is properly maintained. Its occupational value will fall during that period. However, at several points during its physical life, reduction in the occupational value can be restored by refurbishment. At these points an appraisal will be required to confirm continuing need and to determine the relative merits of refurbishment, redevelopment or disposal.
95. In the absence of any other determining factor, it is sensible to use an appraisal period of 25 years for buildings, unless there are compelling reasons for choosing another figure. Since 25 years is traditionally the length of a property lease, this assumption will facilitate comparisons between freehold and leasehold.
96. In exceptional circumstances, where buildings are constructed for a specific purpose, and no market exists for the property, it may be appropriate to appraise a building over its physical life. If a property option is appraised over more than 25 years, it should be scrutinised carefully, and the cost of refurbishment or the replacement of major elements needed to retain its physical life should be included.
97. If, exceptionally, the project exceeds the remaining economic life of its building, then the appraisal must still consider all the costs for the whole life of the project. These may include the costs of decanting from the building, and of refurbishment or redevelopment.

98. Procurement Options

99. Each option being appraised may be associated with a range of procurement methods. These may also include a range of financing options, as well as different forms of public/private partnership, such as:
100. • financing capital expenditure from internal funds
     • loans
     • finance leases
     • operational leases
     • private finance initiatives (PFI)
     • joint ventures
     • contracting out.
101. Where any form of external finance is involved, the source should only be selected after a competitive procurement exercise. Similar considerations will apply to nearly all forms of procurement, and in many cases the institution will be subject to the European Community Procurement Rules. There are a few exceptions. For instance, if the institution receives an approach from the private sector for a joint venture, then the deal can only be negotiated with the proposer of the scheme. If in doubt, institutions should take legal advice on whether EC Procurement Rules apply.
102. If a PFI solution is to be considered, then there may not be enough cost data in the early stages to make an appraisal. Under these circumstances, institutions should cost a æreference projectÆ based on supplying the same outputs procured conventionally, to provide the comparator for assessing the viability and affordability of the project.
103. The full range of procurement options may not apply in every case, but the appraisal should consider all realistic combinations. For example, the decision on whether property is to be purchased or leased should be determined on value for money grounds. Projects involving leasing property should also be appraised on the basis of buying the freehold interest in the property if it is available. If not, buying an alternative property should be included among the options, even if the institution believes there are compelling reasons for preferring a leasehold option. Similar principles apply to equipment and other types of investment decision.
104. Buying equipment or a building may offer better value for money than leasing; capital finance costs may be lower than rentals and freehold ownership has a residual value. But in some cases there may be no property available for purchase immediately. In others, differences in quality, the earlier availability of leasehold or its greater flexibility, including the option of short-term use, may offset the benefits of purchase. When comparing freehold and leasehold options institutions should allow for the effects of tenure on running costs. For instance the leasehold option may assign some costs or risks to the owner. Options such as PFI can offer even greater opportunity for risk sharing.
105. Some appraisal exercises will involve looking at solutions that may not be recognised as procurement options in the conventional sense. For instance, an institution could be faced with a choice between developing different teaching methods, which require the investment of staff time; or having to decide between a number of different research projects. In both cases, staff time represents a resource which has an opportunity cost, and the institution is effectively appraising options for procuring teaching or research.

106. Analysing the results

107. The principles to be applied in calculating the results of an investment appraisal are generally well understood. They are covered in other literature, and in the Green Book. Examples of discounting are in Annex A of this document. The following notes provide additional advice on specific points that sometimes give difficulty.

108. Calculating the present value of costs and benefits

109. Even when all the costs and benefits, including cost savings, are expressed in real terms it will generally not be possible to compare options directly because the costs and benefits are spread over time. Almost all expenditure proposals produce benefits later than the costs. With proposals for achieving the same objective, the choice is often between extra investment expenditure now and extra operating costs in later years. To compare options, costs and benefits must be discounted so that a single figure - the net present value - can be calculated for each option. Examples of these calculations are given in Annex A.
110. To give more weight to earlier, rather than later, costs and benefits, a discount rate is applied. The discount rate determines how rapidly the value today (the æpresent valueÆ) of a future pound falls away through time, just as a real rate of interest determines how fast the value of a pound invested now will increase. It is related to the ætime preferenceÆ of money - the fact that normally people would rather have cash now than later, and would prefer to pay bills later rather than sooner - and must not be confused with inflation. A fuller explanation of the rationale behind discounting is presented in an Appendix to Annex G of the Green Book.
111. Where an investment uses public money, the Government specifies a standard rate of discount. This rate is currently 6 per cent and should be used in appraisals involving HEFCE funds or Exchequer-funded assets. For further discussion, and for some exceptions, see the Green Book, Annex G.
112. It is more likely that an institution will be funding an investment without public funds. In this case, the discount rate used should be one which reflects the institutionÆs normal real long-term cost of borrowing. Borrowing rates are normally quoted in nominal terms, which reflect inflation, but the rate to use in the discount calculations is the real rate of interest after inflation adjustments have been removed. Institutions without a track record of borrowing may need to investigate the market to establish a realistic rate to apply.

113. Comparing financial options

114. All other things being equal, the most beneficial option will be the one with the highest net present value (NPV) or lowest net present cost. This is the appropriate basis for comparison. In the simplest cases, the costs and benefits of each option can be expressed as differences from the ædo nothingÆ values. However, this can lead to confusion in more complicated cases, particularly where the structure of the costs and benefits varies significantly from option to option, and from the structure of the ædo nothingÆ case. It can be difficult to keep track of all the variables, and there is a significant risk of double counting, with the same change being listed as a cost in one option and credited as a benefit to another. As a general rule, it is better to list the costs and benefits of each option separately, including those of the ædo nothingÆ option.
115. Besides comparing NPV or net present cost, the private sector uses two other decision-making methods. However, they both have limitations, particularly for projects which will never deliver a financial benefit that outweighs the costs.
116. 1. The internal rate of return (IRR) is the discount rate at which the net present value is zero. This can be compared with the cost of capital to see whether the project proposal represents a worthwhile investment. An institution would set a threshold IRR level against which it could carry out the same sort of comparison. In theory, this measure should provide the same answer as comparing net present values. It can be helpful in comparing the relative merits of project options when capital is rationed. However, if the costs of the project do not yield a net financial benefit it will not produce a meaningful measure.
     2. The payback method measures the number of years required to produce a return on the original investment. It provides a crude measure of project risk. An institution could set a target payback period as a criterion to appraise investments. Like the IRR, this method will only produce a result when the discounted financial benefits of the project outweigh the discounted costs. It has a further disadvantage, in that it takes no account of costs which occur after the payback point has been reached.
117. Use of the NPV or net present cost measure has the additional advantage of focusing attention on the actual costs and benefits derived from the project year by year. This is particularly helpful for institutions in appraising project options where affordability will also be a key factor in decision making.

118. Handling inflation

119. Normally, net present values are calculated by expressing all costs and benefits in present value terms, and applying a real discount rate. This approach is valid so long as all the factors included in the calculation are affected equally by inflation. Costs and benefits should be expressed at prices applying when the appraisal is carried out. The figures will usually need to be reviewed and revised as part of the iterative process of investment appraisal, so it is important that the cost base used is clearly stated. This information is also required later for evaluation.
120. However, if there are grounds for expecting some prices to increase at a significantly faster or slower rate than general inflation, this should be taken into account in the calculation. For example, any variation in the fuel prices relative to the general price level will influence the real cost of heating a building. Another factor is pay, which in many sectors has risen in real terms in the longer run. Construction costs may rise or fall during the course of a project if the contract contains price variation clauses. Any such anticipated price changes which differ from those of the general price level will have to be justified.
121. Some leases provide for rent reviews, typically at five yearly intervals and upwards only. Where the resulting rents represent a real rise or fall in costs, this must be allowed for in the appraisal.
122. There are two ways of handling inflation:
123. 1. Use present values and a real discount rate, but adjust those costs and benefits which do not follow the general inflationary trend. This is normally the preferred method.
     2. Use nominal values throughout, showing the effect of inflation on all costs and benefits. Under these circumstances, the discount rate used must also be a nominal rate which reflects anticipated inflation.

     Valuing risk and handling uncertainty

124. Estimates of costs and benefits always involve assumptions about the future. Changes in assumptions can seriously affect the balance of advantage between options, so it is important to take account of them in the appraisal. The risk register, compiled to show all the areas of risk and uncertainty, is a good starting point. In considering how they can be handled, it is helpful to distinguish between risk and uncertainty.

125. Risk

126. Risk is the product of probability and consequence. If these two factors can be quantified, then the overall effect can be measured, and a risk assessment made. Depending on the procurement method, risks will have different effects. For instance, a design and build contract will transfer the construction risks to the contractor. If PFI procurement is used, many more risks can be shared with the private sector. In deciding what risks to allow for, it is helpful to construct a risk matrix showing the different options under consideration and, for each one, where the effect of each risk will fall.
127. A number of techniques exist to incorporate risk in an investment appraisal, but in most cases a simple risk adjustment will be most appropriate. For each variable, a cost or value can be calculated by assessing the financial impact multiplied by the probability of the event occurring. For instance, if late completion of a new building will result in a consequential cost, then the effect can be expressed in financial terms. Analysis of this sort depends on having sufficient data to estimate the probability and consequences of the event. This might be from the institutionÆs own experience of similar projects, or perhaps from published sources.
128. Institutions are likely to find this technique the most useful. It is particularly relevant when appraising a number of options representing different levels of risk to the institution, such as options which include procurement using PFI. It makes the effects of sharing risk readily apparent, and allows comparison between options that transfer different amounts of risk.
129. Institutions may encounter two other techniques for assessing risk:
130. 1. Where more data are available, risk can be evaluated by æMonte CarloÆ techniques, using a probability distribution to calculate the range of possible outcomes and their effects. However, such methods require specialised computer software, and the data are unlikely to be available to most institutions without support from professional advisers.
     2. A simple assessment of the impact of risk can be achieved by applying a higher, risk-adjusted discount rate to the project cash flows. However, this technique is a blunt instrument. It relies on experience of how the finance market might view the risk of the investment option, and is unlikely to be helpful unless there are examples of similar projects to draw on.
131. If a PFI option appears to be the most favourable, institutions will need some sort of comparator to check that the successful bid still represents better value for money than a conventionally procured alternative. In public sector procurement this is called the public sector comparator (PSC), though in the higher education sector a more appropriate title is conventionally procured comparator (CPC). The CPC is a costing of the equivalent level of service delivery procured by conventional means or, if the same level cannot be achieved, the next best option. Because the PFI supplier is likely to take a different level of risk, the comparison must be made on a risk-adjusted basis. The CPC must also include the cost of financing conventional procurement.

132. Uncertainty

133. Where the probability element of risk cannot be quantified, uncertainty remains, and there is still scope for testing the effects of altering key assumptions by sensitivity analysis. An appraisal should indicate the accuracy of all cost and benefit estimates. Unless the figures are certain, the effects of variability should be assessed. One way is to ensure that all possible abnormal effects have been identified, and a view taken on their significance. Another is to scrutinise critically the cost and benefit estimates, using expert advice as necessary, and taking into account experiences of cost and time over-runs for similar completed projects.
134. Sensitivity analysis involves repeating the appraisal calculation with the value of the cost or benefit set at the upper or lower end of the range of likely estimates, and possibly at some intermediate values. In addition, some account should be given of the effect of different combinations of individual elements.
135. For instance, in an appraisal of a leasehold option with a five-yearly rent review, it might be appropriate to consider cases in which the rental growth in real terms varied about the central estimate. The range used must represent a realistic assessment of the range of possibilities. It may be prudent to assume that initial estimates will be subject to the same degree of error as occurred on average in the past, unless there are special reasons for thinking that they are more accurate. Such reasons should be explained and justified.
136. Income expectation is also subject to uncertainty. For example, if an option depends on additional student numbers, then sensitivity analysis should be used to assess what might happen if student numbers fell. Similarly, where the project assumes income from disposing of a property, then sensitivity analysis should address the effect if it realises more or less then its valuation.
137. It is important to minimise, and where possible remove, the likelihood that costs turn out higher than expected, or benefits and cost savings lower than expected. It may be necessary to draw a distinction between different project options, and different methods of procurement and financing, which can bring additional sensitivities to be considered. For example, some financing options are sensitive to inflation, such as loan repayments that are indexed to a specific percentage or the rate of inflation, whichever is greater. Institutions also need to assess what might happen if inflation falls, leaving them with repayments which increase in real and in cash terms.

138. Choice of options

139. In some appraisals, analysis of the options will result in a clear-cut recommendation. Often this will not be possible: for example when there are significant uncertainties attached to costs, benefits or both; or when there are significant elements which cannot easily be valued in monetary terms, or even quantified at all, such as environmental factors.
140. Where no clear-cut optimal solution is available, or the choice between two or more options is finely balanced, the appraiser should present the balance fairly, so that the decision-takers can make an informed judgement.

141. Assessing affordability

142. So far, this guide has concentrated on assessing the competing merits of investment alternatives taken in isolation. However, there would be little point in adopting a solution that the institution could not afford. Therefore the institution must assess the impact of the preferred option on its overall financial position. This will involve looking ahead over the life of the proposal.
143. In particular, the institution will need to look at:
144. 1. The income and expenditure generated by the project, and its impact on the income and expenditure account of the institution.
     2. The effect of depreciation on the income and expenditure account.
     3. The effect on the institutionÆs cash flow, broken down into sufficient detail to show the amount and timing of any shortfalls.
     4. The funding of the project, the timing of receipts and their relationship with the cash flow.
     5. The project and its funding in the context of the overall capital expenditure programme, to keep track of the total level of proposed investment.
     6. The effect on the balance sheet.
     7. The desirability of the project when compared with others, particularly if available capital is limited and capital rationing decisions are required.
145. The institution will also need to consider how the project can be reconciled with its financial strategy, and how its current policies on borrowing levels and contributions from the revenue budget might be affected.
146. The institution will have to draw on the appraisalÆs earlier work on risk and uncertainty, since it needs to know the possible financial impact of the best and worst case, as well as the planned outcome. It will also need to know whether there are any implications for its Financial Memorandum with the HEFCE, and whether any additional approvals will be required. The strength of the institutionÆs covenant - how its credit-worthiness is perceived by the financial sector - may influence its ability to make use of the full range of finance options, as well as their cost.

147. Presenting the results

148. The results of an appraisal should be set out in a report covering:
149. • the strategic context
     • the objectives
     • the options considered
     • the results obtained, in both financial and non-financial terms
     • the preferred option(s)
     • how the preferred option(s) compare with the alternatives
     • how the risks have been evaluated
     • the sensitivities of the preferred option(s) to variations in key assumptions
     • the impact on the institutionÆs financial position
     • how and when the project will be monitored and evaluated.
150. The important features of the appraisal must be set out clearly, in a logical order, and all the relevant assumptions should be made clear. The appraisal should indicate how the costs are to be borne. It should also include discussion of the major unquantifiable costs and benefits, and contain sensitivity analyses of the effects of changing key assumptions. Tables setting out in detail the costs and benefits of each option should be available. In addition, it is important to record such details as the price basis and the base date for discounting.
151. Even after they have taken a decision, institutions will need to keep their appraisal under review. The initial appraisal will of necessity be based on coarse data which can be refined as the project progresses. Institutions will need to confirm their initial estimates as they reach key decision points, and check that their assumptions are still valid. This is an iterative process. In the early stages, not much will be lost if re-appraisal leads to changes in key decisions; however, scope for manoeuvre will become more limited as a project progresses.
152. The report should set out clearly the effect of the preferred option on the overall financial position, by presenting forecasts of its effect on the income and expenditure and cash flow. The impact of changes in key assumptions should be modelled, showing the effect of best and worst case scenarios. The effect on key financial indicators and budgets should be made explicit.

153. Monitoring and evaluation

154. At the time of the appraisal it is important to plan for monitoring and post-project evaluation of the decision. This will be a good management discipline, and provide feedback into future decisions. Evaluation might cover the extent to which the project met the objectives set, any cost and time overruns, the relationship between estimated and actual costs and benefits, and any implications for future decisions.
155. The appraisal report should specify the monitoring data which will be collected in the course of implementation. This will serve as a management tool while the project is underway, and provide the main information input into the evaluation. The appraisal report should also outline how a full evaluation might be carried out. The decision whether to proceed with a full or partial evaluation can be taken at a later stage.
156. The evaluation should usually be carried out when the investment stage is complete and when enough experience has been accumulated of operation and maintenance.