Academics are unequivocal in the advice they give to practitioners about how to appraise large-scale capital investments, including ICT projects. The net present value (NPV) rule, based upon the discounting of decision contingent cashflows at the firm’s opportunity cost of capital, is regarded as the definitive investment appraisal technique. On this, the academic literature is clear. However, although managers are faced with a variety of financial models when appraising capital projects, not all managers accept the theoretical consensus about which ones to use. While there are strong theoretical justifications for the use of discounted cashflow (DCF) based models, managers continue to use non-DCF appraisal techniques (such as payback and, to a lesser extent, the accounting rate of return), irrespective of their theoretical shortcomings. While academics continue to argue that the NPV method has the greater theoretical validity, managers prefer the internal rate of return (IRR) criterion. The use of sophisticated risk assessment models is also disappointing, with many organisations ignoring risk altogether or simply adopting a naive approach.²

In addition, organisations that have used DCF techniques are now placing greater reliance on the qualitative dimensions of their investment decision-making, such as judgement and intuition.³

There is a growing recognition by management that the strategic implications of many of today’s capital investment decisions are not adequately addressed by traditional approaches to capital investment appraisal. Although attempts are being made to quantify, in financial terms, the strategic benefits from a given investment, it appears that many perceived benefits are left out of the appraisal process because they lack precise financial quantification. It is this under-specification of the strategic benefits associated with given capital investment decisions that we seek to address in this book.

We argue that managers are not forced to choose either an economic/normative approach or a strategic/managerial approach to capital investment decision-making. This we believe is a false choice and that a hybrid approach, including both the economic and strategic dimensions of choice, is required.⁴ Indeed, empirical evidence strongly suggests that superior corporate performance is strongly linked with the use of a rational approach to strategic investment decision-making coupled with broader management participation in the decision-making process.

In this chapter, we justify the need for a new, more pragmatic, approach to capital investment appraisal. We briefly review the strengths and weaknesses of existing approaches to financial appraisal and risk assessment as well as the strategic models that have been developed to evaluate capital investment projects and look at the interface between finance and risk. The subject of a judgmental approach to decision-making is also explored. In Chapter 2, we investigate the perception that ICT capital projects are different from ‘other’ capital projects, while in Chapter 3, we present the results of research from a study of the current practices of UK organisations with respect to the appraisal of ICT and non-ICT capital projects. Chapter 4 presents valuable insights into the treatment of risk with regard to ICT and non-ICT capital project.

In Chapter 5, we outline the elements of the FAP model, which we describe as both pragmatic and multi-dimensional. The development, conceptual reasoning, and research path of the FAP model are discussed, and we position the model within a project evaluation matrix. At the managerial level, we emphasise the importance of a team approach to capital investment appraisal. In Chapter 6, we explore the basics of conventional investment appraisal, and in chapters 7–9, we deal with the three sub-models of the FAP model. In Chapter 10, we look at the advantages of the FAP model as an aid to management decision-making, and in Chapter 11, we present the results of empirical research, based on a detailed case study, into the application of the FAP model to the appraisal of an ICT capital project.

Considerable theoretical and empirical work has been undertaken, through questionnaire surveys, case studies, and other research methods, to try to understand why managers do not fully accept the advice of academics on the subject of capital investment appraisal (or capital budgeting as some accountants prefer to call it). However, no conclusive answer has been reached. We postulate that the answer may be that although the NPV model under very limited conditions provides a measure of the value added to the firm by a given investment decision, other techniques such as accounting rate of return and payback have something to offer the corporate analyst.

Although attempts have been made to link the use of sophisticated⁵ financial appraisal models with improved firm performance, this has, in the main, proved inconclusive, with managers continuing to support basic financial models with intuitive judgement.⁶ There is, however, some evidence to suggest that adopting both a strategic and an economic approach, rather than relying solely on either a strategic or an economic approach, does result in higher project success rates and hence greater efficiency in project selection.⁷ On this basis, it can be argued that improved efficiency in project selection should lead to improved firm performance. While economic and strategic considerations are important elements of any investment decision, it is also important to consider a third element, namely that of project-specific risk. By linking together, into one appraisal model, the financial, risk, and strategic elements of an investment decision, it should be possible to improve the quality of that decision-making and, as a result, lead to improved firm performance. Greater management commitment to a project should also follow from a team approach to the investment appraisal process and by basing decisions on a consensus of opinion rather than adopting a dictatorial approach.

Arguments have been raised that managers favour those financial appraisal models that are, to some extent, perceived to be biased towards short-term results. This, it is argued, is an example of the agency loss that arises through adverse selection as managers seek to increase their own financial rewards and to improve their career development through assessment and reward systems that weigh heavily on immediate financial returns.⁸ The volatility in economic life, with its continuing demand for change, is also seen by some to discourage a long-term business approach. Others argue that financial appraisal models have, in some way, failed and that managers may abandon them altogether and rely only on intuition and subjective judgement.⁹ All of these arguments identify and support what can only be described as a cry for help from practising managers. Managers want to do, and be seen to be doing, the ‘right’ thing, but if, for whatever reason, they are not using the models or approaches recommended, then there is clearly a need to identify the problem as to why this is the case and seek to find a solution.

Considerable evidence is available to support the claim that financial appraisal models on their own are perceived to be inadequate for today’s high-technology business environment, since they fail to capture many of the strategic benefits from important projects, such as investments in new technology.¹⁰ Such projects are often complex¹¹ and offer benefits that are more of a strategic nature and are difficult, if not impossible, to quantify in financial terms. Although strategic ‘score’ models have been developed in recent years, they tend to be based on a progressive multi-staged approach, with managers, in some cases, still having to quantify in financial terms the value of these strategic benefits in order to justify project acceptance. It must be accepted that strategic benefits are an integral part of an investment’s profile and that some of these benefits are not susceptible to financial quantification. It is therefore important to determine the strategic profile for each capital investment opportunity, as all major capital investments have, in varying degrees, strategic implications.

Despite all the arguments against the use of the PB and ARR (the so-called unsophisticated, naive, or inferior models), they still continue to be widely used in industry. In fact, the PB has been shown to be the most popular and important of all the models.¹² The IRR (which together with the NPV are referred to as the sophisticated models) has been shown to be more popular than the NPV, despite the fact that the NPV has greater academic support.¹³

The PB is said to have a number of failings including the assertions that it does not measure the profitability of a project, it ignores the returns after the PB period, it ignores the residual value of an asset, and it does not take into account the timing of the returns from a project.

The ARR appears to go under many guises, with many definitions as to its calculation (the reader is referred to Appendix 1 for a fuller discussion on this topic). Comparisons are made on the basic assumption that one is comparing like with like. This is commonly a false assumption. Although a distinction is sometimes made between the ARR based on initial investment and average investment, there is no generally accepted basis of calculating the figures to be used for the investment in, or the returns arising from, a project. As a result, management may select whichever formula suits them. The ARR is said to arrive at a ‘crude’ accounting return of profit, but again it does not take into account the timing of the returns and, as a result, it is possible to arrive at the same accounting rate of return for two projects which have vastly differing patterns of profits.

The IRR is said to be defective in that it assumes that the cashflows from an investment can be reinvested at the same rate as the IRR of a project. It does not allow for variations in the cost of capital over the life of a project, and, due to high discounting towards the end of a project’s life, it is biased towards projects with a short PB period or those with large initial cash inflows. Another failing of the IRR is that it may not rank some projects in the same order as the NPV, which is said to be more theoretically correct. The NPV also has its faults, in that it does not distinguish between projects of high- and low-value capital cost, and is also biased, but not to the same extent as the IRR, towards projects with short PB periods, or those with relatively higher initial cash inflows.

In order to overcome some of the deficiencies in the various financial models, a discounted PB (DPB) has been introduced which takes into account the time value of money; a modified internal rate of return (MIRR) overcomes, to some extent, the reinvestment and multiple rates issues of the IRR, and a present value index (PVI) has been applied to the NPV which takes into account the level of the discounted cash outflows from each project. Other modifications to the NPV have been made, for example: the adjusted present value (APV) and generalised adjusted present value (GAPV) models.

Yet still, despite all these modifications, there is no single model that, in practice, is universally accepted to the exclusion of all others, although, in theory, the NPV is argued to be the more superior model.

The financial appraisal models are all mathematical models and therefore produce a ‘figure’, whether it is an absolute figure or a percentage figure, which is used in the appraisal process. But what do the various figures represent? In basic terms, the PB identifies the length of time that it takes to recover the capital cost of a project. The ARR shows the average percentage return from an investment based on historical accounting concepts. This return may be calculated on the initial cost of the investment (ARRi), or the average cost (ARRa) over the life of a project. The IRR calculates the discount rate at which the sum of the cash inflows and outflows from a project is zero and shows this discount rate as the rate of return on a project as a percentage, while the NPV, using the same cashflows as the IRR, but adopting a predetermined discount rate, is expressed as an absolute figure. Both the IRR and NPV are said to identify those projects that, if accepted, will maximise shareholders’ value.

All of the financial appraisal models give some information that is of value when making capital investment decisions. It is useful to know what the payback period is, as this will tell us something about the liquidity of a project – how long it will take to recover the initial cost of a project and place the company back in its original position from an historical accounting point of view. It will also tell us something about the time-risk¹⁴ of a project, in that the longer the PB period the greater the time-risk involved. It is also useful to know the average return from a project because it is expressed in accounting terms and is simple to calculate and understand by non-financial managers. The PB will answer the liquidity and time-risk questions, while the ARR will give information on the average accounting return from a capital investment. In commercial and industrial organisations, where the primary economic goal is profit maximisation, it is also important to know how the owners’ or shareholders’ wealth will be affected by an investment decision as represented by the NPV or IRR.

When considering the NPV, it is usually assumed that the discount rate used in its calculation is the same as the company’s cost of capital. If this is the case, then the figure arrived at will be the economic return on a project expressed as an absolute figure, one that is based on cashflows rather than accounting profit and that takes into account the time value of money. In practice, however, an adjustment to the discount rate may be made to include, for example, an allowance for risk and infrastructure costs, and so on. Under such circumstances, the end figure does not reflect the economic return but changes its whole meaning. It then becomes a benchmark against which mutually exclusive projects can be compared or it can be measured against a predetermined acceptable benchmark. This benchmark figure is the negative/positive value after discounting the cashflows at the appropriate rate for each project. If the NPV is positive, the value shown is the excess above that which is required to cover the cost of capital and an allowance for project risk, and so on.

There are therefore two elements to the NPV. On the one hand (assuming a positive NPV), you have the percentage return (which is equivalent to the discount rate used in the calculations), and on the other hand, you have the ‘excess’, expressed as an absolute figure. It is this two-part ‘answer’ which may be confusing and may also be one of the reasons why managers prefer the IRR.

The actual calculation o...