Asset Management

Making a Financial CaseILM Level 5 Asset Management 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 • 9.00 – 10.30 “Dragons’ Den” • 10.30 – 11.00 The capital budgeting process • 11.00 – 11.15 Coffee • 11.15 – 12.15 Analysing monetary costs and benefits • 12.15 – 1.00 Analysing non-monetary costs and benefits • 1.00 – 1.45 Lunch • 1.45 – 2.30 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:/www.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 • 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 • 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 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% • 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 Analysis undertaken in current £ terms • Nominal analysis 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: • 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

Two tasks • There are two elements here that should not be confused: • 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 • 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 • 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 intervention is cost-effective £20,000-£30,000 a ‘grey area’ … >£30,000 intervention is not likely to be cost-effective” 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

Asset Management