FINANCE BY DAVID WALKER ACCOUNTANT & DATABASE EXPERT
The field of Investment Appraisal is a most fascinating one. It essentially involves assessing the relative merits of a range of investment options in a situation where investment capital is limited. In reality, no organisation has access to limitless capital so the practice of Investment Appraisal applies to all. Even when there appears to be only one option, the alternative of doing nothing or discontinuing an existing investment must be considered.
Investment Appraisal uses a bewildering array of mostly mathematical-based tools to make better decisions than would be possible otherwise. Yet, it is based on several simple principles that are well understood by all of us. Most people can grasp the issues involved in what might seem a very complex investment appraisal. For some reason, however, our leaders never express their decision-making in terms that the general population can relate to.
Today I’m challenging you to follow the logic of a particular investment decision facing our leaders. I will present you with the central issue by way of an analogy, the logic of which I hope you can then apply to a billion-dollar investment decision. Ready?
Imagine that you’re living in a housing development that is seven years old. As an entrepreneurial type, you’ve started a small type shop catering for vehicle owners in the area. Things have gone well after a rocky start. You’ve paid off the money you borrowed to get started and make a profit of about 10,000 dollars most months. You would love to earn more, but you’re fairly contented with your lot.
Along came the government who made an announcement a year ago that they plan to expand the housing scheme and add a school. This is great news as you estimate that there would then be three times the number of vehicles in need of your services.
You would have to borrow a large sum of money to finance your proposed expansion but you know the business well and are confident about the profit margins you will make. Because of your track record over the past three years, the bank is willing to lend using your house as security. You’re confident that you will be able to meet the loan payments and still have enough left to continue withdrawing 10,000 per month until the loan is repaid and you can reward yourself a bit more for your efforts. Discussions with the bank are progressing nicely and you’re eagerly anticipating your expansion.
Fate, however, can be unkind
Fate can, however, be unkind. For whatever reason, the government has unexpectedly reversed its decisions about both the expansion of the development and the construction of the school. No plans have even been announced as to whether they’re still on the drawing board for possible consideration at a later date.
You did your investment appraisal that estimated the returns from the expansion of your business based on increased demand. That demand is now known not to be materialising. Do you simply press on regardless or do you reassess the situation based on these revised expectations? Would you still proceed with the loan and the expansion of capacity?
That is not all. New technology for later model vehicles is now available that your garage cannot deliver presently. The result is that more than half of your existing business is about to disappear because of this new technology that vehicle owners prefer if it works on their vehicles. Faced with the reality of reduced demand for these two reasons I suspect that I could confidently predict the decision that most rational persons would make.
We’ve explored a very simple Investment Appraisal decision. The facts, in this case, are straightforward and easy to grasp. Arriving at the correct decision is a simple task that is within the capacity of most citizens. Are our big decisions any more complex? I invite you to move now from this analogy to a very real situation.
A distant dream
The government told us about four years ago that they anticipated a large increase in the number of visitors to Tobago as a result primarily of a hotel development project by Sandals. As a result, we would be undertaking a billion-dollar upgrade to the Crown Point Airport. They suggested that apart from the Sandals effect, their promotional work would add significantly to the number of visitors. Clearly, to service this new demand, and to benefit financially from it we would be well advised to undertake the airport expansion.
For reasons never fully disclosed, and of no bearing to the airport investment appraisal, the Sandals project has now been terminated. I invite you to consider the same question as in our analogy. Do we press on as if nothing has changed or do, we reassess the viability of the project?
Further, in a similar vein to our analogy, a matter outside of our control has decimated our client base for the foreseeable future. COVID-19 has negatively impacted the travel industry like nothing ever before. Airlines are flying at less than 10% capacity and the expectation globally is that 2019 levels of international tourism will not return for at least five years.
It is with that backdrop that we must view the Prime Minister’s statement last week that he assures the population that the airport upgrade will not be stopped. He is reported to have said that “The $1.2 billion airport expansion project is going full speed ahead”, and he noted that funding is in place and covid19 has not hindered the project. “It is on the front burner. Everything is in place for that, the work is going on apace”. Dr Rowley made the statement during an interview on Tobago Channel 5 on Tuesday last.
So, there you have it. The anticipated massive increase in traffic is but a very distant dream. We are being led to expect a sharp drop in traffic from the already anaemic levels we have had over the past few years. With that backdrop, the Prime Minister is determined to lumber the nation with yet another loan, this time for 1.2 billion dollars according to reports.
Looking at other investment options
I’m not going to say what I think should be the correct Investment Appraisal decision here. I’m confident that you understand the issues. You can probably also make a very good assessment of the outcome of this project over the next decade. Of course, it would help if you had access to the underlying assumptions like interest rate and repayment terms on loans, anticipated traffic, income and expenditure (especially maintenance and security) to name just a few.
As with the analogy, we will have to repay this loan well into the future. As in the analogy, if the project fails to yield suitable returns, the carrying cost of the loan will have to be borne by the rest of the economy.
After this short and simplified treatise in Investment Appraisal, what would your decision be about the continuation of this project? Investment Appraisal isn’t all that difficult, is it? Why won’t our leaders walk us through their decision-making process in like manner?
Often though, we face situations with multiple possible courses of action from which we seek the optimal one. For example, in the analogy, we could evaluate the results of using the loan from the bank to upgrade your operations to include the new technology. That would likely enable you to attract business from other garages in nearby districts. Similarly, if 1.2 billion of loan capital is available to the government to develop Tobago’s tourism, should they not be looking at other investment options that ideally could repay the loan directly from income generated?