Investment appraisal techniques

Cue 1 Two projects with identical payback and very different lifetime returns.

AMARA 00:00 Payback is the most widely used appraisal method. Is that a problem?

NADIA 00:04 Not as a first filter. It survives because everybody in the room understands it instantly, and that matters more than textbooks admit. It is blind in two directions, though.

AMARA 00:16 Name them.

Cue 2 Discounting a future cash flow back to present value, year by year.

NADIA 00:17 It ignores everything after the payback point, so a project paying back in three years then earning nothing beats one paying back in four then earning for fifteen. And it treats a pound in year four as identical to a pound today.

AMARA 00:34 Why is it not identical?

NADIA 00:36 Three reasons. Today's pound can be earning in the interim. Inflation erodes what the later pound buys. And the later pound carries the risk of never arriving.

Cue 3 Net present value calculation laid out as a table.

AMARA 00:46 Which net present value addresses.

NADIA 00:48 By discounting every future amount into today's money so figures arising years apart can be added honestly. A positive net present value means the project beats the required return, and when two techniques disagree it is the one to trust.

AMARA 01:04 Where is it vulnerable?

Cue 4 The same project at two defensible discount rates, giving opposite answers.

NADIA 01:06 The discount rate, which carries the entire answer and is chosen by a person. The same project can be made clearly worthwhile or clearly not using two rates that are both defensible.

AMARA 01:19 What controls for that?

NADIA 01:20 State the rate openly and test the decision at a higher one. If the answer reverses under a slightly more cautious assumption, the project is marginal and the board should know that before signing.

Cue 5 Sunk cost crossed out of an appraisal, future cash flows circled.

AMARA 01:34 Two hundred thousand pounds is already spent. How does it affect the decision to continue?

NADIA 01:40 It does not. It is gone under either decision, so it is a sunk cost and it belongs nowhere in the appraisal. The only question is whether future cash from continuing beats future cash from stopping.

AMARA 01:54 That is the most commonly broken rule in business.

NADIA 01:58 And it breaks for a human reason rather than a technical one. Stopping reads as admitting the original decision was wrong, and the person who made it is usually at the table. That discomfort is paid for with every further pound committed to something that should already have ended.

Cue 1 Single point appraisal beside a sensitivity range on the critical variable.

AMARA 02:17 I have a net present value and it is positive. Is that the answer?

NADIA 02:23 It is the answer to one question: is this worthwhile if everything happens exactly as forecast. Nothing ever does.

AMARA 02:31 So what is the better question?

NADIA 02:33 Which assumption is carrying the answer. Vary one input at a time and find where the decision reverses.

Cue 2 Decision reversal point at thirty per cent volume fall versus four per cent.

AMARA 02:40 Give me the two outcomes.

NADIA 02:42 If volume can fall thirty per cent before this stops being worthwhile, it is robust and you can say so. If it can fall four per cent, this is not an investment appraisal, it is a bet on the volume forecast.

AMARA 02:59 And I should say that in those words.

NADIA 03:02 In exactly those words. A board that approves a bet knowingly is doing its job. A board that thinks it approved a robust project is not, and somebody will remember that later.

Cue 3 Downside built from one variable against a coherent multi variable scenario.

AMARA 03:15 We do model a downside.

NADIA 03:17 Built how? If the downside is one number moved, it is not a downside. Real projects fail when three things go wrong together, and that combination is exactly what nobody modelled.

AMARA 03:29 Optimism bias. Is that not just pessimism dressed up?

NADIA 03:33 It is measured, across sectors and decades. Projects systematically come in later and dearer than appraised, reliably enough that public sector guidance requires an explicit uplift to correct for it.

Cue 4 Last five projects: appraised cost against actual, as the local optimism ratio.

AMARA 03:45 Our organisation is quite disciplined.

NADIA 03:47 That belief is the bias. And there is a cheap test: look at what your last five projects actually cost against what they were appraised at, and apply that ratio to this one.

AMARA 04:00 That would be uncomfortable.

NADIA 04:01 It is the most accurate estimator most organisations own, and it is sitting in their own records being ignored.

Cue 5 Business case structure in the order a board reads it, do nothing included.

AMARA 04:09 Last one. Business cases. Mine get sent back.

NADIA 04:12 Probably structure rather than numbers. A board needs the problem, the cost of doing nothing, the options including the cheap one, the recommendation, the assumption it depends on, the risks with owners, and what you want today.

AMARA 04:27 Why does the do nothing option matter so much?

NADIA 04:31 Because it forces an honest statement of the cost of inaction, and because a case with one option is not a decision. It is a request for ratification, and any experienced board can tell the difference immediately.