The many uses of appraisal models
Appraisal models are used to envisage, plan or manage a strategy. The model framework and arithmetic is at its heart simple, but problems arise in practice when you let the spreadsheet geek have his or her head and at worst build a very clever but inexplicable model. Possible uses of models:
Lease versus buy
Replace or refurbish
Invest or not
Value intangibles such as brands
Check for impairment.
Two examples follow.
Lease versus buy
The choices are:
- buy your own equipment, maintain it yourself and collect any scrap proceeds on disposal;
- lease, making equal payments annually over the term of the lease, payments being made at the start of a year.
The example shown in Table 11.17 assumes an increase in maintenance each year for the owned asset, and hopefully there would be reliable data to support this. Also, the terminal sales proceeds of 3,500 (negative, as all other figures are costs) is an estimate, which again needs to be as reliable as possible.
The demonstration figures show the net present costs of 30,739 when purchasing the equipment and 30,840 when leasing. Here we are looking for the lower net present cost option, which could also be termed the life-cycle cost. Purchasing the equipment is very marginally less. As is often the case, the numbers do not give a clear answer. Do other observations on the model help make a decision?
In favour of purchasing
1 You own an asset.
2 You could maintain it for less; however, the reality is likely to be that the lessor can gain from economies of scale - bulk ordering of spares etc.
3 You can own it for many years after year 5 and get value out of it; however, as Henry Ford said: 'If you need a piece of equipment and do not buy it, you pay for it for ever more.'
TABLE 11.17 Lease versus buy example
Required rate = 15%
In favour of leasing
1 Leasing requires less outlay (leasing companies are in any case likely to purchase multiple assets for less than a single purchase).
2 Annual payments are constant, which will make budgeting easier.
3 Risk of 'unknown' maintenance costs is passed to the lessor (as long as it does not go bust!)
4 There is no risk associated with the amount of residual value.
5 The asset is 'off balance sheet'.
It is number 5 that is the principal strategic driver for leasing, but also there are possibly significant taxation benefits. The taxation benefits accruing to the finance company (a bank) could be passed on to the lessee in the form of lower charges, leading to leasing having the lower net present cost.
The question of off-balance sheet financing as a financial strategy is covered in greater detail in Chapter 12.
Valuing properties is very similar to valuing companies when you have a forecast of the net expected cash flows - the likely EBITDA for the years ahead.
The example below assumes a net rental income of 7,000 increasing over the years, a 30-year review period and no residual value (Table 11.18).
With the unlikely limitation of a 30-year life and no residual value, this tells us that today the property is worth no more than 92,862, whereas the real-life case on which this is based has a property value of 150,000.
TABLE 11.18 Valuing properties example
Required rate = 11 %
If you put in a terminal resale value in year 30 of 600,000 (a fourfold increase from today's 150,000 value), the NPV is still below today's value (Table 11.19).
TABLE 11.19 Terminal resale value
Required rate = 11 %
Does this mean that a typical UK property is overvalued? Possibly, but an essential question to ask regarding the above examples is: 'Should you really expect an 11 per cent return on property over the years?' This should be a low-risk investment and therefore at 6 per cent required rate the NPV today is 265,652, indicating that today's value is too low (Table 11.20).
TABLE 11.20 NPV over 30 years
Required rate = 6%
None of the above modelling is difficult and outputs are easily comprehended. The skill is in predicting the data used - future rates of rent increase, the terminal value and the rate of return that will satisfy investors, which will be linked to bank base rates. The relative strengthening or weakening of the currency in which the rentals and property value is expressed is yet another factor.
- Project appraisal must be carried out.
- Modelling is not difficult; arithmetic is reliable.
- Reliable data and forecasts are essential.
- Investment appraisal gives answers and clear strategies when solely focusing on return over a life cycle, but there may be other strategies at play.
Investment strategies when linked to pure financial strategies are considered further in Chapter 12 and the interplay of financial strategies is considered in the final chapter.
Revision and learning pointers
It may not be relevant in your present role, but do you know what your company's investment appraisal process is?
Too often, project appraisal is coveted by the finance function.