Financial Appraisal Tools and Methodologies - Case Study Example

Financial Appraisal Financial Appraisal A financial appraisal is a term commonly used in finance and accounting and as such, it refers to a method of a financial decision mostly applied in such economic aspects as policies, projects or programs. These three financial aspects must be that, in order to run or execute them, it necessitates substantial inputs in terms of costs and they must entail a wide range of benefits upon their execution (Kirkpatrick & Weiss 2006). As such, the costs and the subsequent benefits must be subjugated in terms of money or they should be such that, their worth can be estimated considering the monetary terms. Further, it can be said as a systematic process by which alternative utilization of wide variety of resources are examined with a great focus on assessment of factors, which are likely to influence a decision (Gupta 2011). They include; benefits, affordability, goals, risks, costs, funding, needs and options among others. In some cases, it is used to mean the same thing as economic appraisal. It entails methodologies, which are put in place in an effort to assist in establishing and defining problems and thereby finding ways to solve them. As such, these solutions should be those that aim at offering the best value for money (Carroll 2006). This is ideal when it comes to matters concerning public expenditure. In this context, it is mostly used as a catalyst for planning as well as public investment approval relating to the three notions of financial aspects. This paper aims at establishing a good financial appraisal that best gives a good value for money taking into account, projects, policies as well as programs (Lock 2007). Financial appraisal tools and methodologies A good financial appraisal is the one that incorporates the use of various financial appraisals tools. As such, these tools are used in different stages involved in the process of development and by differentiated individuals who have a stake in the business (Lefley & Ryan 2011). For instance, there are situations where, a financial appraisal tools developer or applicant tends to appraise the site using such approach as residual land. In such a case, the costs, value, as well as returns maybe used to establish the potential value of the land, which they are ready to give out in exchange with the land but must be subjected to a negotiation. In this example, there are assumptions made and as such, before they are applied, it must be ensured that they are tested. This test is usually done against a framework associated with planning as well as the extant policy (Dayananda 2009). The developer, in most cases, is likely to have come up with appraisal tools that are more of an in-house nature. This is important as the in-house appraisal tools, aided by commercial accounting software, they do reflect the processes related to accounting and of which are internal (Nagarajan 2004). Moreover, there exist other financial appraisal models used in the public sector. These models are exclusively designed to suit a particular use usually in the process of planning. As such, they are used primarily in situations in which the impact of finance involving the affordable housing aimed at assessing the contribution of grant as well as additionality, if any, that affordable housing may achieve, are to be considered (Tosh & Rayburn 2003). Both the Affordable Housing Development Control Toolkit as well as Development appraisal tools are spreadsheet based financial appraisal models and as such, they are effective if utilized to see these functions through. Again, the HCA is also efficient as it produces an appraisal model commonly known as Area Wide Viability. This kind of an appraisal model has the capability to test the viability of alternative sites that differ in terms of their characteristics (Morden 2007). There are other projects that involve expenditure considering the public sector. Considering these projects and expenditures, there is a great deal of likelihood that there will be a necessity that they pass through a separate process of financial appraisal. The key reason for this is that, the value for the money is delivered by these public projects. Again, it ensures that these projects are taken into account in a transparent as well as a consistent way. The main guidance, spelled out in a book held by the treasury, is responsible for the definition of the goals, the various ways to examine as well as the weigh up such aspects as; uncertainties, risks and the cost benefits of the various options in order to advice the process of the decision making concerning the investments on the public sector (Bagby 2005). Sometimes, a dispute may arise involving the viability of financial appraisal viability and the capabilities of a project to accomplish some sets of objectives. This should not be taken lightly as it may result to an application’s potential refusal. As such, there should be a priority in the use of options. The first option that should be made use of is the willingness of financial appraisal tools developer to ensure that he goes open-book in regard to their figures as well as the adopted appraisal processes (Harrison & Lock 2004). Services of an independent assessor should be sought where the developer, who has been given the mandate to facilitate the appraisal tools development, shows a reluctance to follow this route in situations where there is a hindrance by the financial viability on the project’s ability to meet the goals of the project and the planning policy (Barnes 2004). As such, the external developer should be given the duty to conduct an analysis of the viability of the scheme as well as its ability to meet the objectives as set in planning or the disputed obligations associated with planning. The most efficient method available to solve these kinds of disputes which revolve around the negotiations in the planning obligation is known as the Circular 05/05 (Moulton & Ko 2006). Approaches to Financial Appraisal The most common approaches to performance appraisal include; cost, comparison as well as the income approaches. Comparison approach to financial appraisal This kind of approach in most cases seeks to gather information in regards to the recent initiated projects or the recent sale of properties that are in nature comparable. Usually, there is a high likelihood that the projects or the properties are not identical. As such, the appraiser is able to make suitable adjustments in the sale price of the respective other properties. These adjustments are necessary if the appraiser intends to establish or calculate what the selling price would have been in the case where the property was identical to the original or subject property, usually referred to as a comp property (Halcrow 2002). A good example is where an original item had no garage but the comp contained a two car garage, there would be a subtraction amounting to $ 45,000 from the price of sale of the comp property. $ 25,000 might then be added. The reason for this is that the subject property might have contained a finished attic, which gives the subject property a superiority as it provides it with more livable square footage. Still, the appraiser could add further another $ 10,000 since the original item was made framed with a brick layer while the comp was made using a wooden frame and thus the latter require new painting (Lock 2011). As such, a residential financial appraiser would typically tend to make use of three comps. This would be a different case regarding a commercial appraiser as he would tend to employ more comps. This is because, generally, there is a degree in difficulty associated with finding those properties that are truly or rightfully identical and thus, necessitating more adjustments. In conducting a financial appraisal on a property, a comparison approach is adopted as more and more adjustments are made (Hitchner 2011). Cost approach to financial appraisal In this approach, a financial appraiser makes use of the estimates concerning the costs associated with the replacement or the reproduction in improvements, decreased depreciation as well as the value of the property. The amount necessary to come up with the building identical to another building is what is referred to as reproduction cost. On the other hand, costs of replacement represent those expenditures, which facilitate building of an improvement. Those improvements should be substantially of deliver the same usefulness and as such, they should be enhanced while making use of the recent techniques and materials. Even though this is the case, it should be considered that, these materials and techniques should not necessarily own the same characteristics (Greenhalgh 2011). Income approach In this approach, an assumption that the value of a real estate relates directly to the amount of returns generated by office buildings, apartments or real estate is made. The financial appraiser usually does calculations using the net operating income as presented by the property. He does this by gathering all possible incomes generated by the asset in the course of that financial year and then deducting such expenditures as operating expanses, certain percentage of perceived vacancies in the near future, taxes reserve for bad debts, insurance and sometimes, an amount related to the supervision as well as management by the owner of an entity (Morden & Matt 2008). Techniques used in financial appraisals Value of Money over time A variety of techniques used in financial appraising exists. As such, they range from being too simple to those, which are by far sophisticated. However, in financial appraisal, only those techniques, which are relevant, are used to aid in the process of making decisions in a range of areas within the design of a building, its evaluation and during the period in which the building will be put into an economic or commercial use. Among the techniques used, the simplest one, which tends to be a straightforward kind of a technique, is not adequate as it fails to consider the time value of money (Syms 2010). This technique usually has two dominant sub techniques and they include; i. Present Value of Money If one is offered today cash amounting to $ 1100, or the same amount of money in a year time, it is recommendable that the person takes the money today provided that he invests in order to ensure that it increases in the future. If that amount is subjected to an interest rate of 10%, it will result it $ 1100 in a year time. A deep insight on this will lead one to think that, the amount got in a year time, $1100 can be said to have a present value of $1100. Practically, an amount amounting to $1000, which is to be received in within the next one year can be said to have a present value of; $1000*100/110=$909.10. In financial appraisal, the present value of money is usually derived using the following financial formulae; I=1/ (1+i) n ii. Net Present Value It represents the difference between the cash flow’s present value and the present value of the outflows of cash. It is mainly used in budgets associated with capital whereby, it analyzes a project’s or investment’s profitability. The Net Present Value is very sensitive to the future cash inflows reliability that a project or an investment will yield. NPV is represented by the following formula; (Syms 2010) In this technique, all future cash flows are discounted to a common base year. Internal rate of return This technique is derivative in nature. The objective of this technique is to determine the rate of interest rate required to produce discounted costs that are equivalent to the benefits that have been discounted (Davies 2009). In trying to establish this, all future cash flows, whether negative or positive should be considered. Practically, when determining the internal rate of return, the NPV of a number of cash flows discounted at various rates within a year, is determined and then plotted onto a graph. From here, it becomes easy to find the IRR. Sinking Funds This is a technique usually made use of in situations where an allowance is necessary in order to meet a known capital expenditure that will come in the future. As such, it is preferred since it incorporates prudency. A regular amount of financial resources are set aside such that, if that amount is invested, then it will accumulate and thereby adequately meeting that future expenditure committed. An example of this course of action could be the housing associations requirements whereby, they are supposed to allow for major renewal programs. As such, the requirement entailed is determination of the amount of money, which should be set aside regardless of the prevailing rate of interest, to accumulate to the capital requirement in certain period of time, usually more than one year (Gybsey 2004). This analysis finds it necessary that firms should conduct and have a consistent financial appraisal system. The most important reason for this is that, it is a vital tool under which important decisions concerning finance are made. If a financial appraisal is incorporated, then there is a big possibility that the decisions made will be of quality and capable of taking the business in the right direction in regard to the course of actions taken. It is also evident from the discussion that there are people who specialize in financial appraising and as such, no other person should be left to execute the performance appraisal process. They use specific tools, techniques, approaches as well as methodologies in ensuring that the financial decision made are adequate and not misleading (Harris 2009). References Bagby. J.R. 2005. Real estate financing desk book.Cengage Learning: Mason, OH. Barnes, M. 2004. Financial control. Prentice Hall: New York, NY. Carroll, T. 2006. Project delivery in business-as-usual organizations. Ashgate Publishing: Farnham, FH. Davies, D.G. 2009. The economic evaluation of projects: papers from a curriculum development. Cengage Learning: Mason, OH Dayananda, D. 2009. Capital Budgeting: Financial Appraisal of Investment Projects. Cambridge University Press: Cambridge, MA. Greenhalgh, B. 2011. Introduction to Building Procurement. Taylor & Francis: London, UK Gupta, S. 2011. Financial Appraisal and Comparative Analysis of Icici Bank Ltd and Sbi. Lambert Academic Publishing: Saarbrücken, SA. Gybsey, M. 2004. Accounting Made Easier. Springer: Oklahoma, OK Halcrow, 2002. Airports: Financial Appraisal. Cengage Learning: Mason, OH Harris, E. 2009. Strategic project risk appraisal and management. Ashgate Publishing: Farnham, FH. Harrison, F. L. & Lock, D.2004. Advanced project management: a structured approach. Springer: Oklahoma, OK. Hitchner, J.R. 2011. Financial Valuation, + Website: Applications and Models. John Willey and sons: London, UK Kirkpatrick, C.H & Weiss, J. 2006. Cost-benefit analysis and project appraisal in developing countries. Springer: Oklahoma, UK. Lefley, F. & Ryan, B. 2011. The financial appraisal profile model. Palgrave Macmillan: London, UK. Lock, D. 2007. Project Management. Cengage Learning: Mason, OH. Lock, D. 2011. A good Financial Appraisal. John Wiley and Sons: London, UK Morden, T. & Matt, H. 2008. Financial and Economic Appraisals. Cengage Learning: Mason, OH Morden, T. 2007. Principles of strategic management. Cengage Learning: Mason, OH. Moulton, H.G. & KO, J. 2006. Japan, an economic and financial appraisal Brookings Institution: Massachusetts, MA. Nagarajan, K. 2004. Project Management. New Age International: Massachusetts, MA Syms, P. 2010. Land, Development and Design. John Willey and sons: London, UK. Tosh, D.S & Rayburn, W.B. 2003. Uniform Standards of Professional Appraisal Practice. Prentice Hall: New York, NY. Read More