JSP 507 Investment appraisal and evaluation Part 2

216 Pages·2014·1.17 MB·English

JSP 507
Investment Appraisal and Evaluation

Part 2: Guidance

JSP 507 Part 2 (V6.0 Jan 14)
JSP 507 Pt.2 (V6.0 Jan 14)
Foreword

This Part 2 JSP provides guidance in accordance with the policy set out in Part 1 of this
JSP; the guidance is sponsored by the Defence Authority for Financial Management and
Approvals. It provides policy-compliant business practices which should be considered
best practice in the absence of any contradicting instruction. However, nothing in this
document should discourage the application of sheer common sense.

i JSP 507 Pt. 2 (V6.0 Jan 14)
Preface

How to use this JSP

1. JSP 507 is intended as a practical handbook on the application of appraisal and
evaluation in the MOD. It is designed to be used by staff responsible for producing
appraisals, and planning and carrying out project evaluations. It is also for those
overseeing, scrutinising, and reviewing appraisals and evaluation plans. The JSP contains
advice on the processes involved and the techniques to apply when preparing appraisals
and evaluations.

2. The JSP is structured in two parts:

a. Part 1 - Directive, which provides direction that must be followed, in
accordance with Statute, or Policy mandated by Defence or on Defence by
Central Governement.
b. Part 2 Guidance, which provides the guidance that will assist the user to
comply with the Directive.

Training

3. No guide or manual can give all the answers. Training in investment appraisals is
provided by the Defence Academy who regularly run a two-day training course called
‘Investment Appraisal Skills’ (E043). All staff tasked with undertaking an IA for the first time
should attend this or a similar course. Some TLBs operate their own IA training courses.

4. The Financial Skills Certificate (FSC) includes elements covering Investment
Appraisal and Evaluation. Ideally, all IAs should be undertaken or reviewed by an
individual with Intermediate Level FSC certificate in Investment Appraisal.

Further Advice and Feedback- Contacts

5. The owner of this JSP is Def Strat-Econ-AppEv-Hd. For further information on any
aspect of this guide, or questions not answered within the subsequent sections, or to
provide feedback on the content, contact any of the following members of the Appraisal
and Evaluation team within Defence Economics:

Job Title/E-mail Project focus Phone
Def Strat-Econ-AppEv-Hd PPP / PFI 020 7218 4538
Def Strat-Econ-AppEv-DepHd Land / Personnel 020 7218 6027
Def Strat-Econ-AppEv-1 Sea / CIS / Nuclear 020 7218 2653
Def Strat-Econ-AppEv-2 Estates / Business Change 020 7218 6404
Def Strat-Econ-AppEv-3 (AE*) Sea / CIS / Nuclear 020 7217 8949
Def Strat-Econ-AppEv-4 (AE*) Air / Centre 020 7218 6010
Def Strat-Econ-AppEv-5 Air / Centre 020 7218 7496
(* AE denotes Desk Officer is an Assistant Economist)
ii JSP 507 Pt. 2 (V6.0 Jan 14)
TLB Contact Points

6. Each TLB has a focal point to support the appraisal and evaluation process, to
produce appraisals when appropriate, and:

a. Provide the Senior Finance Officer (SFO), with an assurance that effective
appraisal and evaluation processes are in place within their management area
and staff adequately trained;
b. Provide advice and guidance to others within their management area preparing
appraisals and evaluations;
c. Review business cases, appraisals, and evaluations undertaken within their
management area to ensure compliance with TLB and departmental policy. This
will include, as a matter of course, a review of business cases, appraisals, and
evaluations that are to be submitted to a higher authority; and
d. Maintain details (and copies) of business cases, appraisals, and evaluations
undertaken within their management area and a record of when evaluations are
due.

TLB Appraisal and Evaluation Focal Points – as of December 2013
TLB E-mail Phone
Air Cmd Air-DResFPP-AAT SO1 MA 95221 7262
Head Office HOCS Fin-AHGovernance&Research 9621 70440
HOCS Fin-Governance 9621 82753
JFC JFC-Fin-Scrutiny-Mgr 9360 55844
DE+S DES CAAS-AT-DepHd 07880 785046
DES CAAS-AT-SL2 9352 34372
DIO DIO Fin-TLB DH 94421 3807
DIO Fin-SAM AH 94421 3646
Navy Navy Fin-Civpay Budman Decspt 93832 5233
Army Army Res-Inv-Plans-Asst-Hd 96770 1338

7. Further advice should be sought in the first instance from your appraisal and evaluation
focal point, and TLB guidance documentation. If they cannot help, they will refer the query to
Defence Economics.

iii JSP 507 Pt. 2 (V6.0 Jan 14)
Contents
Preface............................................................................................................................ii
How to use this JSP.......................................................................................................ii
Training...........................................................................................................................ii
Further Advice and Feedback- Contacts......................................................................ii
TLB Contact Points.......................................................................................................iii
Contents.........................................................................................................................iv
1 Building Cash Flow Models.................................................................. 1
Introduction....................................................................................................................1
Discounting ....................................................................................................................2
Time preference..............................................................................................................2
Discount rate..................................................................................................................3
The declining long-term discount rate.........................................................................6
Internal Rate of Return...................................................................................................7
Return on capital............................................................................................................7
Spreadsheet Models......................................................................................................7
Determining the time horizon for an appraisal............................................................8
Base date........................................................................................................................9
Comparing options with different lives........................................................................9
Costs and benefits to include in an appraisal...........................................................10
Relationships with other budget areas......................................................................11
Opportunity costs........................................................................................................11
Sunk costs....................................................................................................................12
Common costs.............................................................................................................12
Hidden costs.................................................................................................................13
Double counting...........................................................................................................14
Transfer payments.......................................................................................................14
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Inflation.........................................................................................................................15
Adjusting for relative price levels...............................................................................15
Contracts Subject to Variation of Price (VOP)...........................................................16
Apportioned Fixed Overhead Charges.......................................................................17
Annex A: Discounting in-year and mid-year cash flows...........................................18
Annex B: Example of Appraisal for a Small Project.................................................19
2 Cost-Effectiveness Analysis............................................................... 22
Need & Numbers (N&N)...............................................................................................22
Combined Operational Effectiveness and Investment Appraisal (COEIA)..............22
Cost-Effectiveness Analysis.......................................................................................23
Presentation of the COEIA Chart................................................................................23
Example ........................................................................................................................23
The COEIA and Affordability.......................................................................................30
Other Contributory Factors (OCFs)............................................................................30
Planning and Reporting N&N and COEIA ..................................................................31
Scrutiny and Assurance..............................................................................................32
Plan (CofA) to Initial Gate............................................................................................34
Plan (CofA) to Main Gate.............................................................................................36
Planning Notes for Initial & Main Gates.....................................................................37
Annex A: Typical Steps from Project Initiation to Main Gate...................................40
Annex B: Why Cost-Effectiveness is Not a Single-Number .....................................41
3 Infrastructure Costs ............................................................................ 44
Opportunity Cost..........................................................................................................44
Residual Value..............................................................................................................45
Land and Buildings......................................................................................................45
Cost elements: Land....................................................................................................47
Cost elements: Buildings...........................................................................................48
Separable Value of Land and Buildings.....................................................................48
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Land and Buildings used by British Forces Germany..............................................48
Options Using Service Accommodation....................................................................50
Equipment.....................................................................................................................51
Leased or Rented Assets ............................................................................................52
Annex A: The Importance of Opportunity Costs.......................................................58
4 Personnel Costs .................................................................................. 60
Introduction..................................................................................................................60
Modelling personnel numbers....................................................................................60
Modelling Personnel Costs.........................................................................................62
Redundancy costs.......................................................................................................65
Output Efficiencies.......................................................................................................65
Transfer of Undertakings (Protection of Employment) Regulations 2006 ..............66
Short-term Personnel Shortfalls.................................................................................67
Annex A: TUPE Transfers from MOD - Potential Cost & Resource Drivers...........71
5 Other Operating Costs and Benefits.................................................. 78
Operating costs............................................................................................................78
Inventories....................................................................................................................79
Deferred Consideration / Novel Financing.................................................................80
Contingent liabilities and cancellation payments.....................................................81
Losses and Special Payments....................................................................................82
Supplies from Overseas & Foreign Currency Denominated Transactions.............82
Foreign Exchange Uncertainty....................................................................................83
Third Party Revenues..................................................................................................85
Estimating the Value of Benefits.................................................................................86
Benefits Management in Business Change Projects................................................86
Non-Quantifiable Costs and Benefits.........................................................................87
Annex A: Non Quantifiable VfM Factors ....................................................................90
Annex B: Benefit Profile..............................................................................................92
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Annex C: Benefit Realisation Plan..............................................................................93
6 Optimism Bias, Risk, and Uncertainty............................................... 94
Introduction..................................................................................................................94
Optimism Bias..............................................................................................................94
Estimating optimism bias............................................................................................95
Risk..............................................................................................................................103
Three point estimating...............................................................................................108
Sensitivity analysis....................................................................................................111
Annex A: Upper bound guidance by project type...................................................114
Annex B: Optimism bias contributory factors.........................................................117
7 Evaluation........................................................................................... 120
What is the Purpose of Evaluation?.........................................................................120
What to Address in an Evaluation............................................................................120
The Focus of Evaluation............................................................................................121
When to Undertake an Evaluation............................................................................121
Consolidation of Evaluations....................................................................................122
Who is Responsible for Evaluation?........................................................................122
Planning for Evaluation.............................................................................................122
Role of Appraisal and Evaluation Teams.................................................................123
Addressing Evaluation Evidence in Appraisals......................................................123
Outturn Evaluation.....................................................................................................123
Disclosure...................................................................................................................127
Annex A: Evaluation Plan..........................................................................................128
Annex B: Evaluation Template..................................................................................129
8 Involving the Private Sector.............................................................. 132
Value for Money Benchmark.....................................................................................132
Constructing a VfMB..................................................................................................132
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Should-cost modelling...............................................................................................133
Tender Assessment and Value for Money...............................................................134
Assessing Value for Money Through-Life................................................................140
Novel Financing..........................................................................................................142
9 Non-Market Impacts & Sustainable Development.......................... 143
Non-Market Impacts...................................................................................................143
Willingness to Pay and Willingness to Accept........................................................143
Boundary Values........................................................................................................143
Valuing Time...............................................................................................................145
Valuing Health Benefits.............................................................................................149
Valuing Design Quality..............................................................................................150
Sustainable Development..........................................................................................151
Including Sustainability in Investment Appraisals..................................................151
Energy Use and Greenhouse Gas (GHG) Emissions..............................................153
Wider Environmental Impacts...................................................................................162
Effects of Climate Change.........................................................................................162
Distributional Impacts................................................................................................166
10 Real Options....................................................................................... 167
Introduction................................................................................................................167
Financial Options.......................................................................................................167
Models of Evaluation.................................................................................................169
Black & Scholes.........................................................................................................169
Investment Appraisal Options ..................................................................................172
Sequential Options.....................................................................................................173
Practical Issues Associated with Real Options Analysis.......................................173
Choice of Models........................................................................................................175
Conclusion..................................................................................................................176
Annex A: Real Options Analysis Project Checklist................................................177
viii JSP 507 Pt. 2 (V6.0 Jan 14)
Annex B: The Black and Scholes Model..................................................................178
Annex C: Hypothetical Option to Switch to Illustrate Lattice Approach...............179
Annex D: RAF Organisational Review Example......................................................182
Appendix 1: Risk analysis for an IA: Monte Carlo simulation using

Crystal Ball ........................................................................................... 185
Appendix 2: Discount tables.................................................................... 193
Appendix 3: Glossary of terms................................................................ 196

ix JSP 507 Pt. 2 (V6.0 Jan 14)