Whole life science

Investment decisions that require a higher initial capital cost (the up-front cost incurred before the investment generates cost savings) are often rejected because they put pressure on a firm's balance sheet, even if it is profitable in the long run. If you can justify the need for extra investment by demonstrating the economic merits of the project, it may be more likely that funding will be made available.

When comparing alternatives, they must be acceptable alternatives. They must perform the same functions of the system being evaluated in terms of physical and technical performance, safety, functionality, legal and also aesthetics.

Having identified the alternatives, you can then calculate the whole life costs (WLC) of each option using the same project assumptions (study period, discount rate, units of measure, etc). Each alternative is likely to have different initial costs and operational costs and therefore different WLC. The best way of comparing alternatives is to calculate their WLC and then to select the option with the lowest WLC. However, there are supplementary economic measures you can use to demonstrate the cost effectiveness of additional investments and to justify the financial benefits of extra spending.

Here comes the science bit...

The most common economic measures are the payback (PB) on additional investment, Net Savings (NS), the Savings-to-Investment Ratio (SIR), and the Internal Rate of Return (IRR).

1. Payback

The PB period is the time needed to recoup the initial investment of the alternative relative to the base case. Practitioners use PB to decide between two or more projects by accepting the project that has the shortest PB period. If the cashflows are discounted to allow for the time-value of money, then the PB is referred to as the Discounted Payback (DPB). If it does not allow for the time-value of money, it is called Simple Payback (SPB). PB is a simple calculation:

Payback period = initial payment / annual cash inflow.

If a project will cost £4m more than the base case option but will earn additional savings of £500,000 per year, the PB period is calculated as:

PB = £10,000,000 / £500,000 = 10 years.

Payback is popular because of the simplicity of the calculations. Furthermore, in a business environment of rapid technological change, plant and machinery (even whole buildings) may need to be replaced sooner than in the past, so a quick payback on investment may be preferred.

2. Net Savings

In a business environment of rapid technological change, plant and machinery may need to be replaced sooner, so a quick payback may be preferred

Net Savings are generally expressed in present values (they are discounted) and in the unit of currency, say pounds. NS is the difference between the WLC of two options less the additional investment related costs attributable to the alternative. For a project alternative to be cost effective with respect to the base case, it must have NS greater than zero. We use NS to help show a project's cost effectiveness. It is a simple tool to use and interpret - alternatives are effective if the NS is positive.

You can also rank the options by their NS values and choose the most cost-effective option, which is the alternative with the highest NS. This technique works well if there is a combination of interdependent systems. The combination of alternatives with the highest NS will be the most economically viable option and should be chosen.

3. Savings-to-Investment Ratio

The Savings-to-Investment Ratio is a dimensionless measure of performance so, unlike PB which is expressed in years or NS which is expressed in pounds, it has no units.

To calculate the SIR, we express the ratio of savings to costs by dividing the future savings by the increased capital investment (i.e. it is the ratio of savings during operation of the asset and the increase in initial cost of the alternative).

If the SIR is greater than one, then the alternative is cost effective. This means that for each extra pound spent, the amount saved will be greater. For example, if the SIR for an alternative was 2.0, then by specifying the alternative for every additional pound spent, the project will save £2.

The SIR is useful when prioritising several projects, perhaps if there are limits on budgets to fund all cost-effective projects. In this instance, we can rank projects in descending order of their SIRs, and this ranking can be used as a guide to choosing a group of independent projects that will maximise overall savings for the limited budget.

4. Internal Rate of Return

The Internal Rate of Return measures the economic performance of an investment as a percentage yield. It is the discount rate that equates the present value of expected future cash flows of the alternative relative to the base case. IRR can be compared against an investor's minimum acceptable rate of return, also known as the hurdle rate, and if the IRR is higher than the hurdle rate, the investment should be accepted.

This technique is useful as practitioners can assess the level of interest a project can withstand. In addition, where several projects are competing for selection, the most resilient project (the highest IRR) can be chosen.

The IRR is solved by an iterative process whereby the practitioner has to test various discount rates until he or she finds the discount rate that equates the present value of expected future cash flows to the initial cost of the project.