Chapter Preview
TopIntroduction
The term ‘project appraisal’ embraces the techniques applied to determine the financial and/or economic viability of the creation of capital assets, so that decision-makers can identify and select those projects that offer the highest probability of adding to profitability and/or social welfare. The main issues that must be addressed are how to ensure that the information on revenues and expenditures (or on benefits and costs) attached to any such capital investment can be made commensurate, so as to allow decisions to be taken on a clear and consistent basis. Three basic problems complicate this task: the need to make allowances for project outlays and returns that occur over different time periods; the lack of reliable market prices for valuing some of these outlays and returns; and the need to allow for the possibility of multiple objectives in assessing alternative capital investments. This section will consider the three main techniques used to tackle these obstacles facing the consistent project appraisal of capital investments:
- •
Discounted Cash Flow (DCF) analysis takes account of the effects of different time periods when comparing projects where all resource values and opportunity costs are fully reflected in market prices (eg the commissioning of manufacturing plants operating within competitive factor and product markets);
- •
Cost-Benefit Analysis (CBA) tackles projects with significant impacts that are inadequately priced through the market (eg provision of new infrastructure with major externalities or public good characteristics);
- •
Multi-Criteria Analysis (MCA) is applied to projects designed to deliver a number of alternative objectives, the overall assessment of which requires the establishment of a specific preference ranking system to substitute for market forces (eg choosing between strategic options which involve health and safety issues, such as the storage of radioactive material).
TopMain Focus On Dcf
Table 1 sets out a simple example of the process. We assume an initial capital investment of £100m in the initial time period (normally taken to be a year), creating a negative cash flow of £100m in that year. The project becomes operational a year later, with recurrent (operational) costs of £4m in that period, bringing in revenue amounting to £44m, so the positive net cash flow for that period is £40m. The positive net cash flows in the subsequent two years of operation are £50m and £42m. The technique of DCF provides a way of comparing the present value of all these cash flows, by applying a discount rate reflecting the cost of borrowing (which also reflects the opportunity cost of using internal funds that could otherwise be placed on deposit to earn interest).
Table 1. Example of calculation of project cash flows (£000)
Time
period | Expenditure | Revenue | Net cash
flows | NPV
conversion factor |
| Capital | Recurrent |
| t0 | 100,000 | 0 | 0 | -100,000 | 1 |
| t1 | 0 | 4,000 | 44,000 | +40,000 | 1/(1 + r)1 |
| t2 | 0 | 5,000 | 55,000 | +50,000 | 1/(1 + r)2 |
| t3 | 0 | 6,000 | 48,000 | +42,000 | 1/(1 + r)3 |
Key Terms in this Chapter
Common-Property Resources: Resources, such as fisheries located outside territorial waters and the atmosphere, over which private property rights cannot be exercised so that users enjoy free access (non-exclusion), but the consumption of which reduces the supply to others (rivalrous in consumption).
Multi-Criteria Analysis: A technique for converting any incommensurate characteristics in project options to provide a consistent means of ranking the preferences of a group.
Internal Rate of Return: The rate of discount which equates cash flows or costs and benefits over time, resulting in a net present value of zero for a project.
Net Present Value: The result of applying discounting to determine what the current net value of the project’s projected future cash flows or costs and benefits will be.
Discounted Cash Flow: A technique for converting cash flows of a project to their net present value by applying an appropriate rate of discount or interest.
Public Goods: Provision of products such as defence or public health measures for which it is not possible to exclude beneficiaries by charging a price since provision to some must entail provision to others (non-exclusion); and for which the marginal cost of provision is not affected by the numbers of beneficiaries (non-rivalry in consumption).
Dupuit’s Bridge: Refers to the concept first developed by a Swiss engineer for estimating the consumer surplus derived from the construction of an infrastructure project, which cannot be fully captured through standard pricing mechanisms.
Moral Hazard: The possibility that unethical decisions will be taken because those responsible for making a choice (between project options in this case) are not exposed to the full consequences of their actions.
Consumer Surplus: The aggregate willingness-to-pay for a product, estimated as the area under a standard demand curve.
Cost-Benefit Analysis: Applies a discounted cash flow technique to estimates of the social benefits and opportunity costs of a project to establish its net present value with regard to social welfare.
Potential Pareto Improvement: Positive net present value from a cost-benefit analysis of a project which indicates the capacity to make an unambiguous improvement in welfare by compensating losers so that no-one is worse off after implementation of the project (also known as the Kaldor-Hicks Compensation Test).