Using cost-benefit analysis to appraise investments
An United Utilities case study

Page 3: External factors affecting investment appraisal

Any investment requires initial capital expenditure (capex). Appraising an investment project involves weighing up the likely future return on that investment (ROI) against the expenditure. Methods often used include calculating the Accounting Rate of Return and the Payback period:

  • United Utilities 17 Diagram 2Accounting Rate of Return (ARR) is calculated as the average annual profit that is expected over the life of the investment project compared with the amount of capital invested. For example, if the investment in a project is £200,000 and the expected profit is £15,000 a year, then the ARR is 7.5%.
  • United Utilities 17 Diagram 3Payback calculates the length of time needed to recover the money originally invested from the cash generated by the project. For example, if an investment of £200,000 is expected to lead to cash flows of £25,000 per year, then the payback period is eight years.

Cost-benefit analysis

United Utilities 17 Image 5 However, United Utilities, when appraising any investments, needs not only to consider the financial return on the investment but also to assess the benefits to communities and the environment. These are called external benefits. For United Utilities, the private benefits consist of the revenues from domestic and business customers. The wider external benefits include the benefits to local communities, to nature lovers, to the environment (including bird and animal life), as well as cleaner water.

Capital investment projects incur costs that need to be quantified. Internal costs are easy to determine, a major one being the cost of borrowing money (for example, the interest on a loan). Added to this are the direct project costs – these include materials, labour etc.  However, projects can have negative effects on the locality. To arrive at the best decision for all relevant stakeholders, any project that United Utilities engages in requires a careful assessment of both the commercial costs and revenues and the external costs and benefits. The bases for decision making using cost-benefit analysis are summarised in the following formulae:

United Utilities 17 Diagram 4

 

 

Benefits of investment

United Utilities is keenly aware of the social costs and benefits of its investments and always seeks to maximise the social benefits whilst minimising the social costs. Since 1990 United Utilities has invested more than £4,000 for every household in the North West. The benefits of these investments include:

  • halving leaks from water networks
  • improved compliance with bathing water standards from 30% to 90% across the North West
  • improving water quality to the best that it has ever been.

As a project always has the potential for both positive and negative external effects, United Utilities seeks to quantify these to help select the best overall decision from its range of options. The following sections show the basis for such decisions relating to the Millom project. These include the costing criteria and how the options specifically met stakeholder needs.

United Utilities | Using cost-benefit analysis to appraise investments

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