# 8.5 Financial Concepts and Methods of Appraisal (a)

Free Preview## By the end of this lesson you will have learned about:

- Money and time
- Methods of investment appraisal
- Total cost of ownership
- (Accounting rate of return – ARR)
**optional** - Payback period

## 1. Money and time

**The future is uncertain**

One of the more difficult aspects in understanding the economic implications of decisions is time i.e. factoring in an uncertain future and the value of money over time.

Creating future scenarios is easier for very short term investments e.g. over one or two years, and particularly difficult with long-lived things such as buildings which may last centuries. Over a long time, our values and the economic context patterns of ownership and occupation may change many times and in unexpected ways. The further forward in time we go with an economic scenario or set of assumptions, the less reliable the exercise becomes.

In this module, we generally refer to ‘short and medium’ terms as approximately up to 20 years into the future, and ‘longer term’ meaning over 20 years (for example beyond the lifetime of a typical mortgage) typically 25, or even 60 years into the future.

The potential complexity of economic analysis also means that we are susceptible to the allure of overly-simplified financial assessment methods. These may be useful for very short term decision making, but don’t factor in the economic value of other important benefits that accrue to the building owner in the short and medium term. Such simplified methods certainly don’t quantify longer-term benefits to individuals in their old age, their children and of course society in the longer term.

## 2. Methods of Investment Appraisal

Investment appraisal is the way that enterprises (and governments) assess the financial attractiveness of any investment. Business projects are normally subjected to investment appraisal in order to identify costs and benefits and the optimum way of achieving the objective. Investment appraisal is most often associated with a business approach, but it is also relevant to personal financial decision making – note that in personal decisions, non-financial factors may play a larger part in driving the decision.

There are a number of investment appraisal techniques that we will review here including:

- Accounting Rate of Return (ARR)
- Payback Period (PB)
- Discounted Cash Flow (DCF) methods:
- Net Present Value (NPV)
- Internal Rate of Return (IRR).

- The Equivalent Price of Saved Energy (EPSE)

## 3. Total Cost of Ownership

Rather than only looking at the Capital Expenditure (Capex) and simply reporting on how quickly ‘you get your money back’ a more comprehensive and insightful approach is that based on Life Cycle Costing (LCC or LC).

This requires that we take into account all the costs and revenues associated with an investment (in this case retrofit) over an agreed investment period – typically for buildings around 20 years (typical length of a loan). This approach provides a Total Cost of Ownership.

In the Life Cycle Costing approach we try to calculate and capture all costs over the life of the project. These costs can then either be subjected to a discounted cash flow (DCF) analysis – or just looked at in ‘nominal, un-discounted terms.

We look at these methods in more detail later but the CLR examples covered in the subsequent lessons of this module are based on…

**Discounted Cash Flow** (**DCF) calculations on the basis of Life Cycle Costing (LC)**.

To get round the ‘problem of time’ we need to convert all the costs and revenues (the TCO – the ‘total value generated by ownership’) into ‘today’s money, using the **Net Present Value method**.

Similarly, for Life Cycle (LC) based Internal Rate of Return (IRR) calculations, we do not factor in loan repayments – as this calculation produces a return on investment that can be compared to the cost of borrowing: if the IRR is higher than the cost of borrowing then the retrofit would be worth doing from an economic perspective.

For corporate investors, this separates out the investment decision from the ‘how to finance it’ decision. This could also apply to householders – who may decide to take out a loan or use some savings that are attracting for example less than 1% interest in their savings account, or perhaps a combination of the two.

## 4. Accounting Rate of Return (ARR)

ARR is rarely used these days and is only included here for completeness.

Accounting rate of return is a way of comparing the profits that an investment is expected to make with the investment required.

The ARR is calculated as the average annual profit that is expected over the lifetime of an investment project, compared with the average amount of capital required. For example, a project with an investment of £10,000 which is expected to produce an annual average profit over its life of £1,500 has an ARR of 15%.

The higher the ARR the more attractive the investment and the ARR can be compared to a **target rate of return**, and to the ARR of other investments.

**Disadvantages of ARR**

Unlike other methods of investment appraisal the ARR is based on profits rather than cash flow. Therefore it is affected by non-cash items such as the rate of depreciation used to calculate profits. The ARR also fails to take into account the timing of profits. In calculating ARR a profit of £1,500 which is expected in five years’ time is given just as much weight as £1,500 profit in the next year.

**In reality cash flow in the short-term is worth more than cash flow in the long-term and this is the basis of Discounted Cash Flow methods discussed below.**

## 5. Payback Period (PP)

**Payback period is a very simple method of assessing an investment – it is often the default technique for smaller businesses and individuals but as we will see it suffers from a number of disadvantages.**

The payback period is simply the length of time it would take to repay the investment. The capital investment figure used might be the total capital cost of all work (e.g. repair, refurbishment, energy efficiency and ventilation measures, remodelling, extensions etc.) or might be just be the capital cost of the energy efficiency and ventilation measures alone (the marginal cost).

For example, an investment of £5,000 which is expected to produce an annual cash flow of £1,000 per annum has a payback period of five years. Similar calculations can be used to calculate the payback period of a project with uneven annual cash flows.

Payback period is a widely used technique. It is easy to calculate and easy to understand. It also forces a focus on projects with a quick payback (high return) and avoids giving too much weight to riskier, longer-term projections of cash flows.

**Disadvantages of Payback Period**

1. Payback period calculations ignore the value of any cash flows that occur after the initial investment has been repaid. For example, two projects could both have a payback period of five years, but one could be expected to produce no further returns after five years while the other might continue to produce cash flows indefinitely. Clearly, in practice, the two projects have a different value even though the payback periods are the same.

2. Although payback period focuses on relatively short-term cash flows, it fails to take into account the time value of money. For example, a £5,000 investment that produced no cash flow until the fourth year – and then produced a cash inflow of £5,000 – would have the same four year payback period as an investment that produced an annual cash flow of £1,000. In reality, the first is likely to be a riskier and less attractive investment, even though they have the same payback.

**Simple payback calculation method**

Simple Payback

The longhand method is shown below in the example of a whole house remodelling, repair and retrofit costing £80,000 to carry out, including energy efficiency measures predicted to save £1,000/year:Total Capital Cost (£) = £80,000

Cost of Energy Efficiency Measures only = £30,000Annual Savings (£/year) = £1,000 per year

Simple Payback is calculated as follows:

Simple Payback = Capital Cost (£) / Annual Savings (£/year)Total cost is paid back in: £80,000 / £1,000 per year = 80 years

Energy efficiency measures paid back in: £30,000 / £1,000 per year = 30 years.

**The retrofit in question will pay back the investment in either 80 or 30 years, depending on the investment sum being considered.**

**Activity**

Using the total project cost & marginal cost figures from a project you are working on, and estimating the annual savings in energy bills, what might the simple payback period of your chosen project be?

(A back of the envelop estimate will do here, unless you have all the data and want to crunch some numbers! This is about getting the general gist.)

You will probably have 2 answers as in the Payback Period example above.

**Note** that these answers suffer from the disadvantages mentioned above, and you may want to use a more sophisticated analysis, as detailed in the next lesson.

## Summary

This lesson has introduced the subject of investment appraisal, and given a worked example of the Payback Period, which tends to give an oversimplified result.

### Footnotes

- Swan, J. 2005. Practical Financial Modelling. CIMA Publishing.
- Failure to do this in models used to assess the risks of complex financial products are considered to have been a contributory factor to the global financial crisis.
- For an explanation of the Monte Carlo method see: https://en.wikipedia.org/wiki/Monte_Carlo_method
- Empire State Building website: https://www.esbnyc.com/esb-sustainability/project