Meeting documents

OPTION APPRAISAL - APPENDIX 4

A guide to appraising investment and disposal decisions

TABLE OF CONTENTS

1. Introduction

2. Assessing need

3. Identifying options

4. Methodology

5. Evaluating options

6. Decision making

1. INTRODUCTION

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.

Taking informed investment decisions is a key facet of property management in the Local Authority environment. Option Appraisal is a technique for obtaining value for money by systematic comparison of alternative investment options. All major investment decisions should be supported through option appraisal.

Examples of property decisions which require an appraisal include:

• Relocation proposals.
  
• Reducing accommodation.
  
• Whether to improve or refurbish existing buildings as an alternative to building or acquiring new property.
  
• Whether to buy or lease.
  
• Replacement of existing equipment or the supply of new equipment.
  
• Sale/Disposals.
  
• Acquisitions.

2. ASSESSING BUSINESS NEED

In order to progress an option appraisal assessment it is necessary clearly to define the business need that has to be addressed. This should be done within the service context by setting out gaps in current service provision and what level of service is required to meet the user needs and Council objectives and targets. This could come from processes identified under the Asset Management Plan, as a result of statutory inspections or could be as a result of an unforeseen event, for example, a loss through fire.

3. IDENTIFY THE OPTIONS

Having established the objectives it is then necessary to set out the options available to achieve this.

The main options, or alternative ways of meeting the objectives, should be listed. Normally, at one end of the range of options will be "do nothing" or "do minimum" and this should be included as a base case. Comparing the options with the base case will assist with the justification of need and identification of the consequences of not proceeding with the project.

The range of options to be considered will depend on the nature and scale of the project being appraised. For small-scale projects there will not be a wide range of options. However, for major capital investment, a wide range of alternatives may be identified. Each listed alternative will require detailed consideration before some are rejected and the remainder are short-listed for full-scale analysis. Factors for early consideration may involve:

• timing.
  
• physical scale
  
• location
  
• stakeholder involvement
  
• planning issues
  
• environmental factors
  
• alternative uses for assets released
  
• financial implications
  
• opportunities for innovative design and technology
  
• sustainability
  
• funding

At this stage of the process it is important that the right people are involved in identifying the options and this could include Asset Management and Planning as well as service area Officers and stakeholders.

4. METHODOLOGY

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.

Whole Life Costing

Whole Life Costing (WLC) is not a new concept but is assuming increasing importance as prospective building clients evaluate the long-term future costs of ownership. This is an important feature of option appraisal.

In comparing investment options there is a tendency to concentrate on the initial capital costs of the development and not consider the costs of operating a building or facility for its lifetime. A rule of thumb ratio of whole life costs is:

Initial capital costs = 1

Operational / maintenance costs = 5

Client occupancy costs (including staffing) = 200

WLC is particularly used to:

• Determine whether higher initial costs are justified by reduced 'future' costs or
  
• Identify whether a proposed change is cost effective against the 'do nothing' alternative which, typically has no initial costs, but involves higher 'future' costs.

There are two important elements to consider as part of the WLC calculation:

1. Discount Rates and Inflation

The discount rate is used to calculate the present value of a future income stream or expenditure and more information on this is contained in section 8.

2. Facility/component life

The facility or component life chosen makes a significant difference because certain major elements, such as roof coverings or heating installations, require replacement at varying intervals. A building life increase of, say five years, may mean major unplanned expenditure or conversely, a reduction in building life may mean that decisions regarding high initial cost, low maintenance components prove not to be cost effective. Wherever possible, guidance should be sought from manufacturers, professional bodies or commercial performance data organisations regarding anticipated component life cycle, maintenance and replacement costs.

WLC factors

For a typical project the following costs might need to be included in WLC calculations:

• Capital Costs - such as land, land restoration, demolition, asbestos removal, construction or refurbishment costs, fees and expenses (including planning fees), furniture and fittings, plant and equipment, decanting and removal, commissioning and handover costs.
  
• Annual Running Costs -such as rates, water and sewerage charges, annual maintenance, power, heating and lighting, cleaning, insurance, security, staffing costs, supplies and services and payments for services bought in.
  
• Periodic Refurbishment / Replacement Costs - such as external and internal decoration, heating system replacement or upgrade, communications installations, plumbing and sanitary appliances
  
• Costs of other features that are affected -these may be associated with ease and availability of access, operational convenience, environmental factors and costs of retaining and disposing of vacated accommodation.

Typical Benefits

• For a typical project the tangible benefits might include:
  
• Fee income from new services / facilities available / new opportunities
  
• Income from third party use of facilities
  
• Capital receipts from disposal of land / property that is being replaced or freed
  
• Residual value at the end of the appraisal period
  
• A reduction in rental payments where a leased building is no longer required and can be surrendered.

Clearly a project may generate non-tangible benefits and these are referred to below.

All the 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 owned by the Council. Such an asset could be used for other purposes or sold, if it were not used 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 and for property is usually taken as the market value or the value in alternative use, whichever is the higher.

Similarly benefits in the form of cost savings or an improved quality of service should be included even where they do not produce a cash flow.

Some assets will have a value at the end of the appraisal period -the residual value, which should be counted as a benefit and these will largely be land and buildings.

When calculating residual values, land and buildings should be considered separately. This is because buildings usually depreciate in real terms over their lifetime at a rate depending on standards of maintenance. On the other hand the site value behaves differently and may depreciate, remain constant or even appreciate. Depreciation may be attributable to, for example, contamination, mineral workings or heavy foundations.

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 `do nothing' 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.

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 might include possible scheduling variants for the same idea. For example, timing in generation of income at a new sports facility could have a significant impact on the option chosen.

Some benefits of an investment decision will not be realised as a cash flow, and there could be benefits which cannot be expressed in financial terms at all. In some cases judgements will have to be made as to the desirability of an investment's outcome, however, such decisions are easier if the relative merits of different decisions can be presented in a rational way.

Appraisals will have to handle non-financial aspects differently, depending on how easily they can be measured. They can be categorised as:

• Benefits which can be valued
  
• Benefits which can be measured in some way
  
• Benefits which cannot be measured at all in conventional terms

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:

• contribution to the Council's long term strategy /objectives
  
• flexibility for the future
  
• political acceptability
  
• enhancement of image
  
• compliance with planning constraints
  
• staff wellbeing

A scoring system, even a subjective one, can help to clarify the decision process and give it more rigour. First it must be established 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 process does provide a better basis to explain the rationale for a decision.

The appraisal period should normally be the period for which the service is required or the remaining economic life of the asset.

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 shorter. 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 a different period.

A risk can be defined as anything that may impact upon an organisation's ability to achieve its objectives: this may be a hazard or the failure to recognise an opportunity.

Risk management is a process through which potential opportunities and adverse effects are identified, evaluated and controlled, leading to improved planning, decision making and processes. It consists of the following steps:

(ii) Identify the risks and analyse them in relation to existing controls

(v) Report all risk documentation to relevant personnel.

5. EVALUATING THE OPTIONS

Initial Option Appraisal

This stage looks at both the financial and non-financial costs and benefits of each option and seeks to eliminate some options which are clearly not viable or deliverable. This stage acts as a `sifting' mechanism which will hopefully prevent abortive work on costings etc. Options that are considered worthy of further consideration will then go forward to the full appraisal stage as outlined below.

Detailed Option Appraisal

Calculating the present value of costs and benefits

For options remaining after the initial appraisal stage, a detailed appraisal is carried out.

Even when all the costs and benefits, including costs 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. To compare options, costs and benefits must be discounted so that a single figure -the net present value - can be calculated for each option.

Comparing financial options

All other things being equal, the most beneficial option will be the one with the highest net present value (NPV) or the lowest net present cost. This is the basis for comparison and each option should be compared to the `do nothing' option.

Besides comparing NPV or net present cost, in some cases it may be appropriate to use the Payback method in some circumstances.

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. For certain types of project, for example, capital for revenue type schemes, a target payback period could be set 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.

Handling inflation

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 where all the factors included in the calculation are affected equally by inflation. However, here it is expected that some prices are likely to increase at a significantly faster or slower rate than general inflation, this should be taken into account in the calculation. This is done by showing the effect of inflation on all costs and benefits at the appropriate rates and then by using a nominal discount rate which reflects anticipated general inflation

Non-financial costs and benefits

Sometimes it is difficult to estimate absolute costs and benefits but easier to estimate the differences between options. The differences are the key factors in making comparisons.

To be able to compare costs and benefits which are not easily valued and are essentially qualitative it is necessary to score or rate each option on its contribution to the project objectives. In other words, rate each option against the extent to which it delivers what is being sought to achieve. This can be done by the use of a 0 - 10 scale where a zero rating is a measure of complete failure to deliver an objective and a 10 rating indicates that the option fully delivers the objective.

Objectives are unlikely to be of equal importance. To differentiate between essential and desirable objectives it is necessary to apply weighting factors to reflect the relative importance of each objective.

This ensures that the most important factors have the greatest influence on the outcome of the option appraisal. Using a weighting scale of 1 - 5 will usually be sufficient to ensure that the appropriate result is achieved.

Combining Financial and Non-Financial Factors

To assist identification of the preferred option, the following alternative approaches may be employed:

(a) application of weighting factors to the results of financial assessments to produce a weighted score solution, or

(b) combining the weighted scores for non-financial factors with the Net Present Value of each option to arrive at a value for money rating. In order to provide a weighted score solution as in (a), it is necessary to decide the relative importance of financial and non-financial factors. Should non-financial factors (the project objectives) be deemed more important than the cost-ranked factors, then those non-financial factors should be weighted greater in proportion to the relative degrees of importance. The factors are then scored against their weighted total and the preferred option is the one achieving the highest combined score.

Assessing affordability

In identifying costs and benefits and evaluating the options, projects have been assessed in terms of the competing merits of the investment options. However, there would be little point in adopting a solution that the Council could not afford and therefore the impact of the preferred option on the overall financial position of the Council must be assessed. This will involve distinguishing between those costs and benefits which have a direct impact in cash terms and those such as opportunity costs which impact on value for money but have no effect on affordability.

In particular the following factors will need to be looked at:

6. DECISION MAKING

The presentation of the results of an Option Appraisal is an aspect which deserves particular care. The important features of the appraisal must be set out clearly, in a logical order and all the relevant assumptions made clear. The appraisal should include discussion of the major unquantifiable costs and benefits. In addition it is important to record such details as the price basis and the base date for discounting.

The results of an appraisal should be set out in a report covering:

• the strategic context and objectives
  
• the options considered
  
• the results obtained, in both financial and non-financial terms
  
• the preferred option and how this compares with the alternatives
  
• how the risks have been evaluated
  
• the sensitivities of the preferred option to variations in key
  
• assumptions
  
• the impact of the project on the capital and revenue budgets
  
• any procurement factors
  
• how and when the project will be monitored and evaluated

Finally, the report should show in conclusion:

• the option which is assessed to be the best value solution and the reasons for this
  
• how the preferred option compares with the important alternatives

After taking a decision to proceed with a particular option, the appraisal needs to be kept under review. The initial appraisal will of necessity be based on coarse data which can be refined as the project progresses. Initial estimates will need to be confirmed as key decision points are reached and assumptions will need to be checked to ensure they are still valid.