A2.7 Commercial Appraisal shares some of the characteristics of Economic Appraisal but is much narrower in scope. Its purpose is to establish whether a proposed activity will be viable in a commercial sense. A proposal may be considered commercially viable if, over its useful life, it is expected to earn sufficient revenue to cover its costs and yield an acceptable financial rate of return. Although it generally reflects the perspective of a private company rather than Government, Commercial Appraisal is relevant to the public sector in some circumstances.
A2.8 Firstly, assessment of commercial viability is a necessary element of the appraisal of proposals to provide grant assistance to commercial activities. As indicated in section 4.5 of the Option Appraisal Guide, commercial viability (or "project viability") should be assessed to help ensure that public money is not wasted on projects that will fail prematurely. Secondly, there exist some public trading bodies that sell goods or services into private markets or are subject to financial targets which require them to undertake Commercial Appraisal. Thirdly, some activities which are promoted primarily for social or other non-commercial purposes may include commercial elements and it is appropriate to seek to establish these on a firm commercial basis, to help avoid premature project failure.
A2.9 Commercial Appraisal undertaken to establish a project's viability covers several elements including analysis of projected cash flows, examination of the financing, marketing and management arrangements for the specific proposal in view, and assessment of the historical performance and general financial position of the relevant company or public sector trading body. Commercial Appraisal may address several of the steps at 1.4 of the Option Appraisal Guide, but will usually do so from a perspective of self-interest. Thus, for instance, it may take no account of the impact of its own activities upon other players in the market, and may ignore environmental and other wider costs and benefits to the UK.
A2.10 It is specifically in the assessment of cash flows and calculation of Net Present Values (NPVs) that confusion most often arises over differences in approach between Economic and Commercial Appraisal. Both types of appraisal include identification of streams of costs and benefits over time and calculation of NPVs. Some of the figures used in the Economic Appraisal streams may be identical to those used in the corresponding Commercial Appraisal streams. This happens when economic costs and financial values coincide. For example, this is often the case with annual operating costs. However, the fundamental basis for measurement of costs and benefits is substantially different, and this is where confusion often arises.
The crucial differences of substance are that costs and benefits are generally estimated:
■ based on economic cost values in Economic Appraisal, but financial values in Commercial Appraisal;
■ for the UK or NI as a whole in Economic Appraisal, but only for an individual public sector trading body or private company in Commercial Appraisal.
A2.11 Many of the mistakes made in appraisals arise from failure to recognise these differences. Some of the more common errors are listed below under Common Errors in Economic Appraisal.
A2.12 Confusion can also arise through misuse of terminology. In Commercial Appraisal, an NPV calculation is often referred to as a Financial Appraisal. This can confuse in two ways.
■ Firstly, the term Financial Appraisal is sometimes used to describe the NPV calculations in an Economic Appraisal, which is misleading because NPVs in an Economic Appraisal are not based on financial values.
■ Secondly, Financial Appraisal may be used to describe a variety of financial assessments, including, for example, an affordability assessment, or an analysis of sources of funds.
A2.13 The distinction between Economic and Commercial Appraisal is well illustrated by their use in projects involving assistance to industry, such as inward investment projects and industrial expansions. In these cases Economic Appraisal is used to assess the "national efficiency" of the project, that is, its VFM from the perspective of the national interest; and Commercial Appraisal is used to help assess "project viability". These cases demonstrate how Economic and Commercial Appraisals should complement each other in the process of assessing the overall soundness of a project. However, a Commercial Appraisal should not generally be used as a substitute for an Economic Appraisal.