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A very important part of the CIPFA Financial Management (FM) syllabus focuses on the appraisal of capital investments. It represents 40% of the FM syllabus; it contains a number of different techniques, concepts and practical issues and will therefore be tested extensively in all FM exams.
All investments must provide a return of some sort. We normally ensure that this outcome is achieved by estimating the cash flows associated with the investment and discounting them to present value. If the net present value (NPV) is positive then…it’s a goer! If not then the project should be put to one side and never heard of again.
This article looks at whether there are other factors that need to be taken into account when making investment decisions. Measuring returns in purely financial terms can sometimes appear rather gauche. It underestimates the range and complexity of the objectives of all organisations, but in particular public service organisations. An overly financial focus can often overlook the historical, economic and political contexts in which such decisions take place. So where does that leave the NPV as one of our key tools?
There is much public debate around whether Heathrow airport should have its third runway. This decision is immense when we look at its context. The airport’s owner, BAA, clearly has strong commercial reasons for wanting the runway to be built. The airport’s capacity is limited at the moment but demand for air travel in and out of the South East continues to grow. The extra capacity will in all likelihood result in substantial financial profit. The impact of this for BAA shareholders can be readily quantified and processed through a net present value (NPV) calculation to estimate the increase in shareholder wealth resulting from the project. Nonetheless the context of this decision is rich in political, social and economic complexity. These factors are less easily incorporated into an NPV analysis.
The cost of building the runway will be between £14 billion and £18 billion, of which around a third will come from public subsidy. As if this was not enough to bring the politicians and the wider society into the debate, the non-financial factors are remarkably important too. The expansion of the airport will probably create jobs. Airline travel in and out of Heathrow may become safer. There is a plethora of arguments against the expansion too. The concerns over the disruption to the nearby infrastructure, the possible demolition of whole villages and the alleged destruction of local ecology have all been well voiced in the media recently. So how do we build these factors into the decision process? And how do we reconcile these rather intangible costs and benefits with the financial focus of our main financial appraisal. ‘Not easily’ is probably the correct answer to those questions. A lot of debate, management and political judgement must weigh all the perceived benefits and costs. This illustrates the delicate and subjective nature of cost-benefit analysis.
One possible way to reconcile the subjectivity of these decisions with the relatively black and white estimates of a traditional NPV is to use something called shadow values. This involves putting a monetary value on what appears to be a non-monetary item. For instance, if the expansion of Heathrow were to create 1,000 new long term jobs, what is the value of that to the taxpayer? There would be saved welfare benefits, increased tax yield, a more positive outlook for the individuals concerned leading to saved healthcare costs and more. It can become quite difficult and subjective to put a value on these costs and benefits but it could, when done properly, lead to richer and more considered decision-making.
The NPV as an investment appraisal tool may need to be supplemented too if there is a need felt by the investors to make socially responsible investments. My partner and I recently decided to start up a savings account and decided to each go for an individual savings account (ISA). We looked at ISAs available from the building society which services most of our financial needs. In the list of available products was something called the ‘Ethical ISA’. The managers of the ISA claimed that the funds invested by customers would be invested in companies with impeccable ethical and socially responsible track records. A suitable home for our cash was found! Investing in companies that looked after their workforces, are environmentally responsible and who did their best not to kill, injure or otherwise harm their customers seemed the right thing to do.
This is not to say that we ignored the financial performance of the ISA before parting with our cash. Financial return is still important to us. Nonetheless, the NPV was not and should not be the be-all and end-all.
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