JSS 18 (2) (1967) 150-177

THE APPRAISAL OF CAPITAL PROJECTS

by

C. G. LEWIN
(A paper discussed by the Society on 17 March 1967)

INTRODUCTION
THIS

paper covers a field in which few actuaries have been actively engaged in the past, namely the appraisal of proposed capital projects to determine their likely profitability. In recent years this subject has received increasing attention from the accountancy profession and from operational research practitioners. Various methods of tackling the problems have been proposed, including 'discounted cash flow' techniques. Most of the methods used employ compound interest and some involve probability concepts; it is surprising, therefore, that actuaries have not given the subject more attention. Furthermore, actuaries concerned with the investment of funds should also be interested in the matter from another angle: the shares which will yield the greatest return to investors may well tend to be those of the companies which carry out proper financial appraisals of the ventures in which they propose to engage. What is a capital project? A theoretical definition might be: any activity in which the community uses resources that could be devoted to current production in exchange for an increase in future production. For example, a primitive agricultural community might arrange for some of its workers to stop tilling the land for a few years and instead to dig irrigation ditches. Then production would be lower while the ditches were being dug but, on completion of the work, production would rise to a higher level than it would have been in the absence of the ditches. Examples of capital projects today are the construction of factories, roads, hospitals, ships and houses. 'Production' includes not only the creation for consumption of food and goods, but also the creation of other benefits such as transport, medical services and entertainment. A capital project need not be an entirely new activity: it may, for instance, be the replacement of an existing asset. 150

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It is conventional to measure the effort of constructing and running a capital project, and the benefits to be derived from it, in monetary terms. However, it is important to remember the true underlying situation, namely that human effort is being diverted from production to meet current needs so as to increase future production. From the point of view of the community as a whole, any calculations performed to show which are the most efficient and desirable capital projects should have regard to this underlying physical situation, and the monetary outlays and returns for the sponsors of the projects are of secondary importance. The sponsors of projects, who will normally be more interested in the financial aspects, may, therefore, tend to favour those projects which are not the best ones available for the community as a whole. In view of this possible conflict between the interests of the community and the interests of sponsors, it is necessary to be clear about the angle from which we are approaching the matter when discussing criteria for the selection of projects. In this paper we shall look at the problem from a sponsor's point of view, but we shall also discuss later the wider implications for the community as a whole. In any capital project there is an element of risk. For example, the product may become obsolete prematurely or the market might contract unexpectedly. On the other hand there is the possibility that the project might do much better than expected. The existence of risk complicates the assessment of projects and inevitably introduces subjective considerations. We shall approach the problem, therefore, in two stages. First, we shall assume that there is no element of risk and that the amount of physical effort involved in constructing and running the project, and the output of goods from the project, can be estimated with certainty; we shall put forward various criteria which can be used for choosing between projects in this situation. Secondly, we shall consider what modifications should be made to this approach in a practical situation involving risk.
CRITERIA FOR ASSESSING PROFITABILITY

Let us suppose that a large company wishes to build a new factory for the manufacture of motor cars. Capital of 2 millions is available and this can be spent in one of two ways: Project A: a traditional factory, costing 1.3 millions a year to run and producing cars worth 1.8 millions a year.

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Project B: an automated factory which is not expected to be fully efficient until after the first two years of operation. For the first two years the costs will be 1.2 millions a year and the cars produced will also be worth 1.2 millions a year. From the third year onwards the costs will be only 0.8 millions a year, while the cars produced will be worth 1.5 millions a year. Each factory will have a total operational life of ten years and will take one year to build. All the cost figures quoted represent the estimated effort expressed in terms of money values on the basis of wage levels and other costs current at the time construction of the factory is commenced. The figures quoted for the value of the cars produced represent the estimated number of cars expressed in terms of money values on the basis of the levels of wholesale selling prices at the time construction of the factory is commenced. The question is, which of the two projectsif either of themshould be undertaken? For ease of reference the problem may be re-stated thus: ( million) Capital cost Running cost, per annum Receipts, per annum A 2.0 1.3 1.8 1st 2 years 1.2 1.2 B 20 Next 8 years 0.8 1.5

A number of different criteria for assessing projects are known to be in common use at the present time and the results for these criteria in relation to the two alternative projects postulated are set out below. At this stage the element of risk is ignored and it is assumed that the above figures are true and certain estimates of the costs and receipts involved. (a) Pay-back period This is the time taken for the net profits from the project to pay back the capital invested (without allowing for any interest). The net profits will be as follows: A m 2.0 2.5 B m 1.4 2.1

Net profits, after 4 years after 5 years

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Thus, in the case of A the capital is repaid after four years whereas in the case of B it is not repaid until after nearly five years. Hence A is more attractive. The pay-back period appears to be one of the most popular methods of assessing capital projects.
(b) Yield

The yield is the rate of interest which equates the present value of all capital and running costs with the present value of all receipts. In the example being considered the yields satisfy the following equations:

These give yields of 21% and 18% respectively. This is the method advanced in most modern articles in this country on discounted cash flow techniques (e.g. N.E.D.C., 1965). The yield is the same as the 'marginal efficiency of capital' which features prominently in J. M. Keynes's well-known work The General Theory of Employment, Interest and Money (1936). The yield is also sometimes known as the internal rate of return.
(c) Net present value

The net present value is the present value of the receipts less the present value of all capital and running costs, at a given rate of interest, i.e.

Values at four particular rates of interest are as follows: Net present value Interest B rate A m m 3.60 3.00 Nil 1.87 1.68 6% 0.77 0.83 12% 005 0.25 18%
(d) Annual value rate of return

From the net profit before charging depreciation each year is deducted a sinking fund of sufficient amount to repay the capital at

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the end of the factory's life and the remainder is expressed as a proportion of the capital invested. The formulae are as follows (where the compound interest functions are calculated at the sinking fund rate of interest): First method

It will be seen that, under B, the variable net annual profits have been re-spread to a level annual amount, at the sinking fund rate of interest. Values at four particular interest rates are as follows: Annual value rate of return B A V % /o 18.0 Nil 15.0 18.7 6% 17.4 18.8 12% 19.3 18.6 18% 20.7 This method is in use in some nationalized industries. Second method The distinguishing feature of the second method concerns cases where the net profits are expected to vary from year to year. Whereas in the first method the profits are re-spread to a level annual amount at the sinking fund rate of interest, in the second method the arithmetic mean of the varying annual profits is used. The formula for A remains unchanged but the formula for B becomes as follows: and the values for A and B at four particular interest rates are as follows: Interest rate Nil 6% 12% 18% Annual value rate of return B A V V
% %

Interest rate

15.0 17.4 19.3 20.7

18.0 20.4 22.3 23.7

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(e) Surplus rate of return The present value of net profit before charging depreciation, at a particular rate of interest, ignoring the capital costs, is re-spread at the same rate of interest to give an annual return; the latter is then expressed as a proportion of the capital invested. The formulae are:

Values at four particular rates of interest are as follows: Interest rate Nil 6% 12% 18% Surplus rate of return B A V %
%

25.0 25.0 25.0 25.0

28.0 26.3 24.5 22.8

This was one of the methods used by Foster and Beesley in their Victoria Line calculations (1963). (f) ReceiptsI costs ratio The present value of the receipts is expressed as a multiple of the present value of all the capital and running costs, using a given rate of interest. The formulae are:

Values at four particular rates of interest are as follows: Interest rate Nil 6% 12% 18% Receipts/costs ratio B A 1.20 1.15 1.09 1.03 1.33 1.22 1.11 101

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We may summarize these results thus: Table 1 Project favoured by each criterion
Criterion (a) (b) (c) (d) Interest rate used in calculation Not Nil 6% 12% 18% specified A Not applicable Not applicable A B B A* A B B B B on page A* B A* B 158.
A B A A*

Pay-back period Yield Net present value Annual value rate of return: First method B Second method B (e) Surplus rate of return B B (f) Receipts/costs ratio * The meaning of the asterisk is explained

Hence 9 results favour project A and 13 results favour project B. To interpret the results the theoretical background of each criterion needs to be understood. In the following paragraphs the relative advantages and disadvantages of each criterion are discussed, the risk element still being ignored. The pay-back period has the advantage of simplicity of calculation, but there is very little else to be said in its favour as a way of choosing between two projects (though it may have some use in assessing risk see page 162). All costs and receipts after the pay-back period has expired are ignored, and this factor alone may completely distort the comparison. The yield, on the other hand, is much more difficult to calculate but it does take account of not only all receipts and costs during a project's lifetime but also their incidence in time. However, when the yield is fairly high it may give rise to misleading results on a longterm project, as there is a tendency to give insufficient weight to costs and receipts arising in a number of years' time. Also the equations to be solved may sometimes be satisfied by more than one rate of interest. This difficulty may arise in the rather unusual case when a large proportion of the capital expenditure arises in the later years of a project's life; such a situation might occur where there was an obligation to carry out certain work at a future date, e.g. land reinstatement. Duguid and Laski (1964) have suggested a method for overcoming this difficulty, but it would appear to involve rather complicated calculations in practice. The remaining methods, unlike the pay-back period and yield, involve the choice of a rate of interest at which to discount the costs

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and receipts; the considerations which should be taken into account in choosing a suitable rate of interest are discussed further below. The net present value method is useful when the capital costs of the projects being compared are the same, but it is liable to be misleading when comparing projects with different capital costs; the larger project will naturally tend to have a higher net present value even if it is rather less efficient than a smaller project. The annual value rate of return is a kind of yield on the original capital sum invested. This measure is open to the objection that if the capital expenditure of a project is reduced and the first year's working expenses increased by a corresponding amount there may be a very marked effect on the annual value rate of return. (For example, if under project B the capital expenditure had been reduced by 0-5 millions and the first year's working expenses had been increased by 05 millions the annual value rate of return by the first method at 6% per annum interest would have risen from 18.7% to 23.2%.) Where profits vary from year to year, the second version of the annual value method is easier to calculate than the first version, but it is doubtful whether any theoretical justification can be put forward for taking the arithmetic mean of the annual profits. The surplus rate of return is open to objections similar to those which apply in the case of the annual value method. The receiptsI costs ratio is the only criterion of those put forward which takes account of not only the difference between income and outgo in a particular year but also the values of the income and outgo themselves. In all the other methods a net income of, say, 5 produced by receipts of 20 and costs of 15 is regarded as being identical to the same net income produced by receipts of 30 and costs of 25, and if the latter receipts and costs were substituted for the former it would make no difference to the value of the criterion, unlike the case of the receipts/costs ratio. The latter may be regarded as a measure of the 'return on effort', counting both capital and working expenses as effort put into the project. In cases where receipts and costs do not vary from year to year once the project has commenced operation, it is possible to draw certain general conclusions from an examination of the formulae for the various criteria. Suppose there are a number of such projects which require to be ranked in order of preference. Then the pay-back period, the yield, the annual value rate of return and the surplus rate of return will always rank the projects in the same order, the best

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project being the one with the highest ratio of net annual profit to capital invested (where 'net annual profit' excludes depreciation). The net present value and the receipts/costs ratio, however, may rank the projects in a different order. If the annual value rate of return is higher than the rate of interest used in calculating it, the yield will be higher than the annual value rate of return; conversely, if the annual value rate of return is lower than the rate of interest the yield will be lower than the annual value rate of return. These conclusions do not necessarily hold, however, if receipts and costs vary from year to year. The criteria given above may be adjusted to allow for expected changes in the relationship between money and the physical activity taking place. Suppose, for example, that it is thought that the exchange value of money will fall by a constant amount of 5% each year, so that a given level of production in any year both costs 5% more and brings receipts of 5% more, in monetary terms, than the same amount of production in the previous year. It is an easy matter to adjust the formula for each criterion to take account of a 5% increase in costs and receipts each year. (For example, if the yield previously calculated is y%, the adjusted yield is (l.05y + 5)%.) All the revised criteria have been calculated for the two alternative factories A and B considered earlier. In Table 1 a comparison was made between the various criteria on the basis of no inflation; an asterisk is placed against each criterion where the assumption of 5% per annum inflation alters the ranking. Thus 5 results now favour project A and 17 results favour project B. It does not, of course, follow that if different projects were under consideration the assumption of inflation would necessarily have a similar effect; the purpose of the example is to show that an allowance for inflation can alter the result. With some projects it may be expected that both costs and receipts will be subject to inflation but that costs will be subject to inflation at a higher rate than receipts. For example, in recent years in this country earnings have increased at a higher average rate than retail prices, and there seems every reason to expect such a trend to continue in the long run, notwithstanding the 'stop-go' cycles to which our economy is subject. By way of example Table 2 shows, for the two factories A and B considered earlier, the effect on one particular criterionthe yield of making allowance for inflation. It will be seen from this table that the results are considerably affected by the inflation assumption; in fact the third assumption alters the ranking of the projects.

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Table 2 Effect of inflation on yield

Yield Assumption 1. No inflation 2. Costs and receipts each increase by 5% per annum 3. Costs increase by 5% per annum and receipts by 2% per annum A 21*% 27i% 10% B 18*% 24i% 15%

Problems arise when projects with different lengths of life are being compared. One method of tackling such problems is to assume that each project is replaced by an exactly similar project at the end of its life and that this project, too, is replaced in due course, and so on in perpetuity. The two infinite series of payments may then be compared with each other. Alternatively, it may be possible to ignore the differences in life when calculating the criteria, but the differences must be borne in mind when the results for each project are compared. The allowance to be made for taxation needs to be considered. It is suggested that corporation tax, selective employment tax and National Insurance contributions which are expected to be paid as a result of the project being carried out should be treated as part of the costs of the project, to be taken into account before making the calculations. Regard should be had to the years in which the taxes are expected to be paid, rather than the years in respect of which they fall due.
ALLOWANCE FOR RISK

In the foregoing paragraphs we have examined a number of criteria for choosing between projects on the assumption that the level of physical activity of the project is known, and that the receipts and costs each year can be estimated with certainty. We have shown how, if it is thought that there will be inflation, the criteria may be modified to take this into account. We must now consider the uncertainties which will in practice be involved and the extent to which our calculations should take these uncertainties into account. The uncertainties may be classified under two main heads: doubt about the physical level of activity of the project and doubt about the profitability of the project. The physical level of activity will be affected by such factors as the demand for the product, the availability of raw materials and labour, and the capacity of the plant installed. Profitability will be influenced by the physical level of activity of the project and also by such factors as the selling price of the product, the cost of labour and raw materials and the extent to

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which stocks must be carried. All these factors will in turn be affected by other influences, such as the extent of competition, the general prosperity of the economy, inflation, wars, the development of new goods which render the product obsolete, and the expansion or contraction of the market. It is clearly impracticable to evaluate all the possibilities with any degree of precision, and this is where the businessman's skill must come in. He must decide which are the most important factors for which allowance must be made in choosing between one project and another. Possible ways of automatically allowing for risk in the calculations are to shorten the project's expected life, to add a safety margin to the expected costs or to make 'conservative' estimates generally. In each of these methods, however, it is impossible to see how much difference has been made to the result by the arbitrary allowance for risk. The decision on a major project should take into account not only one possible 'expected' level of costs and receiptseven if this level is loaded to allow for riskbut also the possible variations about this expected level. The problem is to avoid making calculations which are so complex that they cannot be understood by the decision-makers. A possible solution is for three separate calculations to be made, the first on a wholly optimistic basis, the second on an expected basis and the third on a wholly pessimistic basis. Thus, the wholly optimistic basis would assume that everything went favourably, with no contingency margins at all. The expected basis would assume that the normal proportion of setbacks occurred and that the situation was not particularly favourable or unfavourable for the project. The wholly pessimistic basis would assume that major setbacks occurred (which would not, however, be sufficient to invalidate the project). If it is desired to investigate the effect of inflation, it is suggested that the three calculations should be performed for each inflation assumption separately. Again, if different discounting rates are to be used it is suggested that the three calculations should be performed for each different discount rate. An obvious difficulty with this approach is that of deciding on the degree of optimism or pessimism allowed. If the investigator has in mind an infinite number of possible overall outcomes ranging from the wildly optimistic to the disastrous, he may perhaps determine to exclude those outcomes at each end of the scale which have a subjective probability of occurrence of less the scale which have a subjective probability of occurrence of less than, say, 20%, and to quote the two extreme remaining possible than, say, 20%, and to quote the two extreme remaining possible

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outcomes as the optimistic and pessimistic. In theory, therefore, he would be covering the most likely 60% of outcomes. In practice the difficulties of being consistent between one project and another would be considerable. This kind of approach is discussed by B. Wagle (1967). In an interesting paper he gives the probability distributions of the yield and net present value criteria and shows how these distributions may be obtained in practice on the basis of subjective optimistic, likely and pessimistic estimates of the various elements of which the cash flows are composed. It is important before undertaking any project that a full understanding of the risks involved should be obtained. The exercise of formulating the likely variations in quantitative terms may itself assist in getting this understanding and the numerical results obtained may give an indication of the degree of risk involved. If the project were sufficiently large, the expense of using a computer might be justified. This would enable a large number of calculations to be performed for different combinations of factors, as well as calculations of the investment criteria for each set of factors. If subjective probabilities were attached to the different values of the variables, the computer could work out for each investment criterion the overall probability that project A would be better than project B, as well as giving 'disaster probabilities', i.e. the probabilities of the return from a project failing to reach fixed minimum levels. One aspect which should not be overlooked is that a firm may attach greater significance to some events than to others which appear at first sight to be of equal importance. This matter has been explored by R. M. Adelson (1965). Suppose, for example, that the choice lies between two projects, X and Y, and that for each project there are three possibilities: that the sponsor will gain 10,000, that he will break even or that he will lose 10,000, the respective probhe will break even or that he will lose 10,000, the respective probabilities of these outcomes being as follows: abilities of these outcomes being as follows: Table 3 Probabilities of various outcomes for two projects
Payoff Lose 10,000 Break even Gain 10,000 Probability of payoff Project X Project Y
.05

30 70 100

.55 .40
100

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Then the expected payoff from X is 3,500 and the expected payoff from Y is 4,000, yet many businesses in this situation would choose X in preference to Y. This would particularly apply to small businesses, where the loss of 10,000 could be serious. Large businesses, on the other hand, which would regard the loss of 10,000 as being a comparatively minor matter, might well tend to favour Y in view of its greater expected value. In practice one would expect the 'riskier' projects to be undertaken by the larger firms. The fact that greater importance is often attached to possible losses than to possible gains is another reason for not merely calculating the 'expected' profit or loss, but also the likely variations, as suggested above. A very large firm undertaking considerable numbers of independent projects can afford to take a slightly different attitude to risk from that of can the smaller firm. Sir Paul Chambers, Chairman of I.C.I., said in a recent lecture to the Institute of Actuaries (1966) that 'if a company is large enough and has enough forecasting problems which are independent, however serious they may be, they do not all come to a really critical head at the same time'. Sir Paul went on to give the results of an investigation he had made into a sample of 100 new projects undertaken by his firm, all completed in the 1950s, with an average cost per project of over 500,000. For each project the achieved return on capital in the first full year of operation was compared with that forecast when the project was sanctioned. Although the variations for individual projects were wide, the average result was that the actual return was only 9.6% below the forecast return. Many of the uncertainties associated with a project increase as we look further and further into the future. An elementary measure of risk may be obtained by the pay-back period referred to earlier, and here, no doubt, lies another reason for the popularity of this criterion in assessing projects. One way of allowing automatically for this general uncertainty is to attach less importance to costs and receipts in the distant future than to costs and receipts in the more immediate future, and this can be done by using a discount rate in the calculations. If a discount rate is already being used for other reasons, it can be increased to allow for this general uncertainty. We go on in the next three paragraphs to the general considerations behind the choice of a discounting rate for all purposes, not merely that of allowing for uncertainty.

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DISCOUNTING THE FUTURE A calculation using a discount rate may be made for either of the following purposes: (i) to determine whether a project covers its interest charges; (ii) to compare time series of estimated costs and receipts for various projects with a view to ranking the projects in order of preference. The nature of the calculations made under each of these two headings need not necessarily be the same, and we shall consider them in turn. It will usually be necessary for a sponsor to pay interest each year on the capital borrowed to finance the construction of the project. Even if the capital is borrowed by means of an ordinary share issue the dividends may be considered as interest for this purpose. The rate of interest will often be denned at the outset, as in the case of debenture stock, and this rate would then be an appropriate one for use in a calculation to determine whether the project covers its interest charges. The net present value criterion is suitable for this purpose; provided there is a positive net present value at the given rate of interest, the project will cover its interest charges. Moreover, if several projects with the same length of life are being considered, the one with the highest net present value will have the highest accumulated return to the company, after deducting interest payments, by the end of the period for which the project is in existence, assuming that profits can be reinvested at the same rate of interest. The calculations of this paragraph deal with what may be termed the financial aspects of each project. It is important that any project being considered should cover its interest charges and a project which failed this test would almost certainly be dropped. It often happens, however, that there are several possible projects under consideration, all of which more than cover their interest charges. We then come to the calculations of the second kind mentioned above. When ranking projects we should remember that, although the future costs and receipts of each project have been expressed in monetary terms in today's money values, they are in reality a measure of the physical effort which the community will have to put into the project in the future and of the physical benefits which the community will derive from the project in the future. Why should these be discounted and valued at less than the corresponding effort and benefits today ? Two possible reasons are as follows:
D

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(i) the uncertainty referred to earlier; (ii) the preference of the community as a whole for benefits which will accrue in the next few years rather than benefits of the same amount which will not accrue for many years. The discount rate for ranking projects should be determined according to these considerations. As no objective measures of either consideration exist, it is necessary for the discount rate to be fixed arbitrarily by the decision-maker. In the author's view an appropriate discount rate for a normal project might be as low as 4% per annum (i.e. 3% per annum for uncertainty plus 1% per annum for time preference). For a project where general uncertainty is greater than normal a higher discount rate might be used and for a project where the outcome is extremely predictable a lower discount rate might be used. These suggested rates are lower than current market rates of interest but one suspects that the latter reflect considerations which are irrelevant for the present purpose, such as income tax, the demand and supply of capital and investors' expectations regarding inflation. In the author's view the market rate of interest or the firm's 'cost of capital' is irrelevant when determining a discount rate for calculations to rank projects in order of preference. The reason for using a discount rate is merely to give different weighting to the future compared with the present. Because the choice of a discount rate is so arbitrary, it may well be desirable in the case of large projects to do separate calculations for a range of discount rates (e.g. nil, 4% and 8%).
IMPLICATIONS FOR THE COMMUNITY

As mentioned earlier, the project which offers the best estimated financial return to its sponsor may not be the project which is best for the community as a whole. There are three possible reasons for this. First, a project may generate benefits (positive or negative) to sections of the community other than those which purchase the product; in this case the selling price of the product will not reflect these additional benefits. Secondly, the financial return to the sponsor may be distorted by factors which have no real relevance to the underlying physical situation. Thirdly, the sponsor may take insufficient account of factors which will affect his financial return in the long run. As far as the first of these points is concerned, attempts have been

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made with certain proposed public sector projects to evaluate the social benefits which would accrue to the community and to use these as the project's receipts, instead of the actual cash receipts. Such exercises have been carried out {inter alia) in relation to various irrigation schemes and harbour works in America and certain motorways and underground railways in this country. One of the main difficulties has been that of expressing social benefits in monetary terms and many arbitrary assumptions have had to be made to obtain numerical results. For example, Foster and Beesley (1963), in their Victoria Line calculations, found that much of the benefit took the form of time savings: it was necessary to value these time savings and an arbitrary figure of 5s. per hour was selected. It was also necessary to place a monetary value on passengers' comfort and convenience. The general problem probably arises to a lesser extent with private sector projects but its existence should not be overlooked. The second point, namely that the financial return may be distorted by factors which do not reflect the true balance of advantage to the community, is one which arises in many forms. For example, the market in the product may be imperfect or affected by purchase tax. The desire to minimize the amount of tax payable by a company or its shareholders may influence the company in considering the most desirable spread of payments and receipts over a number of years. The likelihood of a general decline in the value of money may influence a company in choosing one project rather than another. Should the sponsor of a private sector project act in such a way as to maximize his own financial return, even though he suspects it may not be to the community's advantage? The third point mentioned above is that the sponsor may take insufficient account of factors which will affect his financial return in the long run. There may be situations where the sponsor makes the wrong decision because of this, although the correct decision from his viewpoint would also have been correct for the community. Probably the most important matter which is liable to be overlooked is that labour is likely to become more scarce, and hence more costly relative to the value of the product, as time goes on. This results solely from technological progress. Suppose, for example, one considers a hypothetical closed community with a constant population where total production is rising at a given constant rate per annum. The increase in production could well be achieved not by increasing

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the production of existing factories from year to year but by replacing factories as they become obsolete by much more efficient ones. Then if all the money earned by the workers in that community in a year is spent in that year, the general level of wages must rise relative to the general level of prices, at the same rate as the increase of production. For example, prices might remain stable and wages increase by the same annual percentage as production. Alternatively, both prices and wages might increase, the increase in wages being greater than the increase in prices by the annual amount of the increase in production. As another alternative, wages might remain constant, in which case prices would have to fall. What cannot happen in a situation of increasing productivity is that both prices and wages remain stable, but one suspects that many capital projects are assessed on the assumption that such will be the case. It is essential to take into account, when appraising a long-term project, the fact that labour will become more and more costly: this means that an appropriate allowance for this factor should be made both in the direct labour costs of the project and also in the costs of raw materials in so far as these include labour costs. One of the principal long-term problems facing the United Kingdom economy during the last few years has been a shortage of man-power to operate existing assets. Could this shortage be eased to some extent in future if we adopted criteria for choosing between proposed capital projects which gave greater preference to projects using less man-power in future years ? In Appendix 1 a very simple theoretical model is presented in order to highlight the conflict between the interests of sponsors and the interests of the community as a whole. It is not intended that this model should represent any actual economy: indeed it is much too crude for such a purpose. Nevertheless it can be employed to demonstrate the following points which, the author feels, are probably true of economies in real life:
(i) There is an optimum level of capital investment for each com-

munity. If too little capital investment is undertaken there will be a wasteful use of resources in the future. If too much capital investment is undertaken it will not all reap its full potential benefits because the community will have insufficient resources in the future to operate all its capital assets. (ii) There is no real difference between capital expenses and working

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expenses, since both involve the commitment of the community's resources to the production of goods. (iii) A sponsor may sometimes obtain the greatest profit by choosing the least capital-intensive of the available projects, even if this is also the least efficient project in the use of resources. From the community's point of view, the author feels that the receipts/costs ratio, calculated at a relatively low rate of interest, will give the best method of ranking projects.
PROCEDURE FOR SELECTING AND TIMING PROJECTS

Having examined the question from a number of different practical and theoretical points of view, we must come to some conclusion about the methods which a sponsor should actually use when selecting capital projects. Merrett and Sykes (1962) recommend that the project with the highest yield should normally be the one accepted, provided that this yield is greater than the firm's weighted average cost of capital. A considerable amount of work has been done in recent years on the return which has actually been obtained from equity shares in this country over the last 40-50 years. In a recent article (1966) Merrett and Sykes state that if a constant real sum (i.e. adjusted for inflation) had been invested each year from 1919-65 in the shares represented by the De Zoete and Gorton Index, the overall yield up to January 1966 would have been 8.1 % in money terms and 5-8% in real terms, counting both dividends and capital appreciation. While the approach recommended by Merrett and Sykes in their book has the advantage of simplicity, it is doubtful whether it will always give the best appraisal of the situation to the decision-maker. Bierman and Smidt (1960), for example, recommend the net present value method, which they consider is superior to the yield method. In our present state of knowledge we cannot say that any one measure is the only true criterion for ranking projects. As pointed out earlier, all the measures have their advantages and their disadvantages. For large projects, therefore, where the necessary time and effort can be justified, it is suggested that a rather more extended analysis should be made, showing the results of using several different criteria. This will enable the situation to be considered in much greater depth. The first stage would be to prepare financial estimates for each project on the basis of 'expected' costs and receipts, and calculations

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would be made to determine whether or not the projects covered their interest charges. For the projects which satisfied these tests, calculations would be made for a number of different investment criteria, on the basis of optimistic, expected and pessimistic estimates of costs and receipts. Two or three different inflation assumptions might be used. The author would calculate: (i) pay-back period (ii) yield (iii) net present value, at nil interest and at the market rate of interest (iv) receipts/costs ratio, at nil interest and at, say, 4% per annum interest. (i) and (ii) are of less importance than (iii) and (iv). If some of the results show one project to be best and other results favour a different project the matter will have to be carefully investigated before a decision can be made: in other words, there is no automatic way of making a decision from the calculations. The risks will have to be carefully weighed up and the final result will depend on the decisionmaker's personal judgment. Intuitive judgment may sometimes play a large part, i.e. judgment based on past experience but not formalized. When a decision has been made as to which is the best project, consideration must be given to the problem of timing. It is often the case that technical improvements are likely shortly which will decrease costs if the project is delayed a while; the likely advantages of waiting must be weighed against the likely disadvantages. This kind of decision must often be made when an existing asset nearing the end of its life is due to be replaced. Mathematical theories of replacement have been developed, using discounting techniques, which help such decisions to be made, given certain assumptions about the rate of technological advance.
CONCLUSION

It is clear that the community must itself decide, by one means or another, just how much of its current consumption it is prepared to forgo in order to obtain benefits in the future. Similarly the community must decide how much importance it attaches to getting an early return on its capital investments as opposed to getting a larger return in the more distant future. In this country today a most

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complicated system has been built up of financial and political controls on the rate of capital investment and on the nature of the projects undertaken. In private industry a decision is normally made on financial grounds. In the public sector a decision is based partly on financial grounds but also on the needs of the community. It is to some extent a matter for speculation whether, taking them as a whole, the decisions being made in both sectors under this system are those which will give the best results for the nation. We have considered in detail some of the methods at present used to appraise capital projects and to choose between them. Appendix 2 gives a short bibliography which may be of assistance to those readers who wish to study these methods in more detail. It is tempting to over-simplify the problems and to try to make calculations which will 'automatically' rank projects in order of attractiveness. One of the main aims of this paper is to put forward the view that a whole range of calculations should be made on various bases and that these calculations should be used not as the one deciding factor but merely as aids to the decision-maker. One suspects that too much is sometimes expected of a criterion at the moment and that it is asked to do too many jobs at once. This paper has outlined some of the theoretical questions to be considered when appraising proposed capital projects. No attempt has been made to suggest a solution to all the difficulties involved. It may well be, however, that further research will help to resolve some of these difficulties and that more techniques will be developed to assist decision-makers. This is an interesting and exciting field where actuaries might well be able to make a useful contribution. Will they take up the challenge ?

ACKNOWLEDGMENTS

The author would like to thank the numerous people who have helped him during the course of the paper's preparation. In particular he is grateful to his wife, and to Mr J. E. Ager, Mr R. A. Dennis, Mr D. L. Greenbaum, Mr E. Wood, Mr J. D. Wymer and Mrs J. M. Wymer. However, responsibility for the opinions expressed remains the author's own.

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APPENDIX 1

Investment Appraisal for the Community as a Whole Constantia is a recently discovered community in a part of the world hitherto thought to be uninhabited. In fact the community has been in existence for many years, although completely cut off from the rest of the world. The most remarkable characteristic of Constantia is its stability; many demographic and economic factors which in most countries vary considerably from time to time are, in Constantia, constant. This facilitates the study of its economy, although it may well be that any conclusions drawn from such a study do not apply to other, more complex, economies. By careful control of its affairs Constantia manages to maintain its working population at exactly 100,000 persons; in addition there is a fixed number of other persons who are dependent on the working population. For many years the community has been building factories to cater for all its needs. Each factory has a 10-year operating life, and the total number of factories (F) has been constant for many years. Every year F/10 of the factories have to be replaced by new ones; it requires C men to construct each factory and they take exactly a year to do it. A factory employs E men throughout its operating life (including any men engaged on producing raw materials for the factory). Production from a factory depends on its type and on the year in which it was built. Technological improvements are continually being introduced, so that a factory of a certain type built in a particular year will produce 100a% more goods than a factory of the same type built in the previous year. The production from a factory built in year r is denoted by Pr (units of goods). The economy of Constantia is such that 100x% of all personal incomes is derived from employment, the remainder being derived from the dividends paid by companies owning the factories. Companies distribute all their earnings as dividends, with no retentions. All personal income received in a year is spent on the consumption of goods in that year. No taxes are paid. The supply of money increases at 100a% per annum (the same rate as the increase of production) and wages and the total of other incomes rise at the same rate; the selling price per unit of goods produced remains unchanged from year to year at S. In any one year all employees receive the same wage; the wage per employee in year r is denoted by Ir.

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From the time that the building of factories commenced, three types have been available as shown in Table 4. Table 4 Factory data
Factory of type Construction labour force

1 2 3

(C)
500 500 500

Operating labour force (E) 300 100 20

Production if built in year r (Pr)

1000(l+a)rr 450(l+a) 240(1+a)'

However, only factories of type 3 have been built. This was the correct decision for the community to make, because the total production is thereby maximized, as will be seen from the following considerations. Since the work-force is 100,000 men and one-tenth of the factories are replaced each year we have

and the total annual production from all factories existing in year r (say Tr units) is given by

We may evaluate these quantities for each of the three types of factory, as shown in Table 5. Table 5 Total factories and production
Factories all of type 1
2 3

Total number of factories CF) 286

667

Total production (Tr) 28,600 (1+ a)' a^ 30,000(1+ a)' a^

1429

34,300 (1+aya^

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It is clear, therefore, that the decision to build type 3 factories in the first place was correct, and that type 3 factories should continue to be built. Following its discovery by the outside world, Constantia is now being introduced to the modern methods of investment appraisal outlined in the paper. Let us consider how some of these methods might be applied. In the first place we assume that, no matter what type of factory is chosen, all the factories built are of the same type. When applied to factories of types 1 or 2 (which are not being built at present) the formulae we shall develop apply only after the whole community has changed to types 1 or 2 and a state of equilibrium has again been reached. We must determine the capital cost, the income from sales and the working expenses of each type of factory, for a factory built in year r. First, however, we must find an expression for Ir, the amount of an employee's wage in year r. In any year the community's total income from employment plus total income from dividends is equal to the total selling price received by companies for their goods. That is to say,

We then have, for each type of factory built in year r: Capital cost: Income from sales: Working expenses: Pr S each year EIr+i, EIr+2, EIr+1om successive years. in

If it can be assumed that employees' incomes in the future will continue to rise at the same rate as in the past,

The formulae for some of the various methods of appraisal then simplify to the following expressions:

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Pay-back period: n years, where

Yield:100/% per annum, where 100/% per annum, where

where

Net present value:at rate of interest 100K% per annum, this is where Annual value rate of return (first method): at rate of interest 100K;% per annum, this is where Receipts Icosts ratio: at rate of interest 100K;% per annum, this is where It is interesting to note that if x = 1 the yield becomes 100a% per annum. If x = 1 and k = a, the net present value becomes zero, the annual value rate of return becomes 100a% per annum and the receipts/costs ratio becomes unity. Calculations according to these formulae have been made for each of the three types of factory available. In the case of the last three methods, where a rate of interest must be chosen, this has been taken successively at nil, 6%, 12% and 18% per annum. A numerical value of .8 was assigned to x, and .03 to a. In all cases except one the result was to show type 1 as the best, type 2 as the next best and type 3 as the worst. In most cases the difference between the types was large; for example, the yields were 34% (type 1), 16% (type 2) and 9% (type 3). The one exception was the receipts/costs ratio at nil interest, which ranked the types in the reverse order. Calculations have also been made on the basis of different formulae which do not allow for future increases in working costs caused by wage increases. Similar results were obtained. In all cases except one, type 1 was shown to be best, type 2 next and type 3 worst; the

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exception was again the receipts/costs ratio at nil interest which this time ranked the types equally. As stated earlier, all the formulae developed so far have been based on the assumption that all the factories built by the community are of the same type. Perhaps of more interest is the marginal case where one individual sponsor is considering changing to type 1 or 2 and he assumes that the remainder of the community will continue to build type 3. The resulting formulae are of a similar form to those already given but they include a term to make them dependent on the relative production of the factory being considered and the production of the type of factory being built by the rest of the community (i.e. type 3). Calculations based on these formulae show that for the numerical values of a and x mentioned earlier (x = .8, a = .03) the pay-back period and yield criteria would favour type 1, whereas the other criteria would favour type 3 at rates of interest of nil and 6% and would favour type 1 at rates of interest of 12% and 18%. If the value of x is assumed to be -75 throughout (instead of 8), all the criteria favour type 1 except the receipts/costs ratio at nil and 6%. It appears, therefore, that type 1 is the most profitable factory for a sponsor in financial terms and that type 3 is the least profitable, in spite of the fact that the reverse is the case from the point of view of the community as a whole. This applies both for the case where all the factories are of the same type and for the marginal case where one individual sponsor considers changing to a different type, provided the parameters of the community fall within certain limits. The reason for this is apparent from Table 5, where it is clear that the community can afford to build only a much smaller number of type 1 factories than it can of the other types. Hence the profitability of each type 1 factory is greater, because the total 'profit cake' is shared among a smaller number of factories. In the case of Constantia, therefore, the methods of investment appraisal will show which type of factory is likely to prove most profitable to an individual sponsor. If sponsors choose the most profitable factories, however, the community as a whole will suffer.

THE APPRAISAL OF CAPITAL PROJECTS APPENDIX 2 Bibliography

175

This short bibliography does not pretend to be complete. The works referred to in the text are shown, as well as some others which may be of assistance to anyone who is new to the subject.
SMITH, ADAM (1776). Enquiry into the Nature and Causes of the Wealth of Nations. Much of the content of this book is as true today as when it was written. It sets out very clearly the effect of economic activity on the well-being of the community and distinguishes the physical activity from the financial transactions involved. The book is easily understood by non-economists (unlike many modern writings on the subject!). KEYNES, J. M. (1936). The General Theory of Employment, Interest and Money. Macmillan. This important book should be read by everyone who is concerned with the behaviour of the country's economy. Of particular relevance to the subject matter of this paper are Chapters 11 and 19. BIERMAN, H. Jr. and SMIDT, S. (1960). The Capital Budgeting Decision. Macmillan (New York). This American book is very interesting and readable and is strongly recommended. It advances arguments in favour of using the net present value method. A bibliography of some of the extensive American literature on the subject is given. MERRETT, A. J. and SYKES, A. (1962). The Finance and Analysis of Capital Projects. Longmans. This book might be said to be the standard British text-book on the subject at present. Most of the relevant considerations are treated in great detail, although the reader may find some danger of losing sight of the wood for the trees. DRYDEN, M. (1964). Capital budgeting: treatment of uncertainty and investment criteria. Scottish Journal of Political Economy, XI, November 1964. This article surveys from an economist's point of view part of the literature on the subject which has appeared during the last 15 years. The author prefers the net present value to the yield method. DUGUID, A. M. and LASKI, J. G. (1964). The financial attractiveness of a project a method of assessing it. Operational Research Quarterly, December 1964. A rather complicated theoretical approach to a generalized yield method. N.E.D.C. (1965). Investment Appraisal. H.M.S.O. A short booklet which discusses the application of the yield method in practice, with allowance for tax reliefs where appropriate. Financial Times: correspondence which appeared on 8, 15, 22 and 26 February and 9 March 1965. This correspondence gives a number of different views on the 'philosophy' of various discounted cash flow methods. ADELSON, R. M. (1965). Criteria for capital investmentan approach through decision theory. Operational Research Quarterly, March 1965. A very interesting paper, which concentrates on problems of decision-making under conditions of uncertainty. BROSTER, E. J. (1965). Investment criteriathe annual value method. Accountant's Magazine, June 1965. This article, which contains a lengthy bibliography, compares the annual value method with the yield and net present value methods. FOSTER, C. D. and BEESLEY, M. E. (1963). Estimating the social benefit of constructing an underground railway in London. J.R.S.S. Series A {General), 126, Part 1. BEESLEY, M. E. and FOSTER, C. D. (1965). The Victoria Line

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social benefit and finances. J.R.S.S. Series A (General) 128, Part 1. These two papers discuss the social benefit calculations made when the construction of the Victoria Line was under consideration. The reader should note the arbitrary nature of many of the assumptions made. PREST, A. R. and TURVEY, R. (1965). Cost-benefit analysisa survey. Economic Journal, December 1965. This stimulating paper covers cost-benefit studies in a number of fields throughout the world. CHAMBERS, Sir PAUL. (1966). Problems of forecasting in the chemical industry. J.I.A. 92, 117. The 1966 Alfred Watson Memorial Lecture, which discusses some of the practical difficulties in appraising proposed new chemical plants. MERRETT, A. J. and SYKES, A. (1966). Return on equities and fixed interest securities, 1919-1966. District Bank Review, June 1966. The article gives factual data of the performance of equity shares and fixed interest securities since 1919. WAGLE, B. (1967). A statistical analysis of risk in capital investment projects. Operational Research Quarterly, March 1967. The paper shows how to obtain probability distributions in practice for the yield and net present value criteria and indicates how these distributions can be combined with utility functions so that proposed investments can be ranked according to their expected utilities. DISCUSSION

It was generally agreed in the discussion that there was no single criterion which could be used as an infallible indicator of the viability of a capital project. Of those criteria considered by the author, net present value, yield, and receiptsjcosts ratio gained the most support. The receipts / costs ratio was evidently an unfamiliar one, and the author was asked to give a fuller interpretation of this index. The remaining criteria came in for some criticism, although several speakers claimed that pay-back served a useful purpose as a short-term index of political or catastrophe risk. One new index was introduced, defined as the ratio of {present value of net cash inflow) to {present value of net cash outflow); it was said that this index was of particular use in the evaluation of research projects. The fixing of an interest rate for those indices which required one was the subject of some comment. One speaker remarked on the need for a high rate for projects which were labour-intensivea need which had been recognized in that N.E.D.C. report which had called for the increased use of discounted cashflow techniques. It was stressed that the calculation of indices was only a part of the process of decision-making. It was most important that these indices should be used as a supplement to, and not as a substitute for, managerial experience. Several speakers remarked on the need to review progress throughout the life of a project. In some circumstances, the

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best policy might be to bring a project to an end prematurely, provided that contractual obligations did not stand in the way. Some attention was given to those aspects of decision-making which could be quantified only imperfectly or which could not be quantified at all, and in this context the author's predilection for the social benefit approach was remarked on. One speaker thought that social benefit assessment had interesting implications in connection with the settingup of pension schemes.