6.3 If a full cost benefit analysis has been undertaken, the best option is likely to be the one with the highest risk adjusted net present value. To the extent that all costs, benefits and risks have been robustly valued, this guideline can be applied with more certainty. In cost effectiveness analysis, the option with the lowest net present cost should be the best, again assuming that the cost estimates are as accurate and reliable as possible.
6.4 If there is a budget ceiling, then the combination of proposals should be chosen that maximises the value of benefits. The ratio of the net present value to the expenditure falling within the constraint can be a useful guide to developing the best combination of proposals.
BOX 19: EXAMPLE - PROJECT CHOICE
Consider the investment costs and expected net benefits of the following proposals:
(a) If the budget were constrained to £10 million, proposals B and C would achieve the highest return, rather than proposal A, even though proposal A has the highest individual NPV. (b) If it is possible that elements of proposals A, B and C could be combined, within the constraint, to produce a significantly higher return, this should be investigated. |
6.5 Other decision criteria can be used to help select options where risk is an important consideration. The 'maximin-return' option is the most important to consider. It is the most risk averse option, as it is the option that provides the least bad outcome if the worst possible conditions prevail.
BOX 20: EXAMPLE - MAXIMIN RETURN
Two government services are being considered, which are mutually exclusive. Their NPVs under different market conditions are shown below:
The maximin criteria points to Service A, as it provides the highest value in the worst market conditions. |
6.6 In practice, other factors will also affect the selection of the best option, in particular the consideration of unvalued costs and benefits. Weighting and scoring techniques are useful in comparing different options in terms of the same criteria. However, as scores are not expressed in monetary terms, judgment is then required to compare the results of weighting and scoring with the cost benefit or cost effectiveness analysis. The two analyses should complement each other, and may indicate that further analysis is required before a decision can be reached. Annex 2 provides further information on how weighting and scoring can be brought into the decision making process. Fully involving stakeholders is very important in making judgments between monetised and non-monetised effects.
6.7 There is always a value imputed by decisions to proceed, and this value should always be clearly identified and analysed.
BOX 21: EXAMPLE - SELECTING THE BEST OPTION
Two lead options are being considered, with net present costs of £1 million and £3 million respectively, after taking into account valued benefits. To select the £3 million option, a decision maker would need to judge that the unvalued benefits of the project must be worth at least £2 million. He or she needs to judge whether this is reasonable. Several considerations could help inform this judgment. Are there any measures of the unvalued benefits that could be used to derive unit values, which could help assess whether the £2 million is in fact worthwhile? Have values for this kind of benefit been estimated in other studies? Or are there better opportunities elsewhere for using the £2 million? What do the stakeholders think? And importantly, what do the stakeholders representing the opportunity of using the £2 million elsewhere think? |
6.8 The 'pay back period'1 is sometimes put forward as a decision criterion. But payback ignores the differences in values over time, and the wider impacts of proposals. These drawbacks mean it should not generally be used as a decision criterion.
6.9 Similarly, the 'internal rate of return'2 (IRR) should be avoided as the decision criterion.Whilst it is very similar to NPV as a criterion, there are some circumstances in which it will provide different, and incorrect, answers. For instance, IRR can rank projects that are mutually exclusive differently from NPV.
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1 A pay back period is the number of years before a project breaks even; when total (discounted or undiscounted) benefits (net of on-going costs) equal capital costs. This technique ignores all benefits and costs arising after the break-even date and is likely to distort project choice.
2 The internal rate of return (IRR) is the discount rate that would give a proposal a present value of zero. IRR can be used to rank proposals. In the private sector, hurdle IRRs are often used to test whether a proposal should go ahead. The riskier the project is, the higher the hurdle IRR.