Discounted cash flow critique
Paragraph 3.9 in the December 2004 report to the Executive Board contains a discounted cash flow analysis of the alternative proposals. There are four separate problems with this work:
1)the financial model is completely implausible
2)the inputs were not correctly transcribed from the source
3)there is a serious arithmetical mistake in the spreadsheet itself
4)the results were not correctly transcribed into the finished report
1) financial model:Asset values are derived (incorrectly) from recent valuations, and make no allowance for the new investment. The effects are to produce an absurd rate of return on capital of 72% per year in option 4, while maintenance costs bear no relationship to the true value of the property. It is highly unlikely that the Council will achieve 100% occupancy of the incubator units at St. Ann’s Mills at full market rents, and the tenants would in any case require a substantial continuing subsidy from public funds to afford these inflated prices.
It is not realistic to expect small struggling start-up companies, which require the services of an incubator unit, to paythe anticipated rent in option 4 of £156 per square metre per year. No evidence is included anywhere in the financial model or the December 2004 report to support this estimate, which has a crucial effect on the outcome of the modelling process. The rents in option 3 are only about £30 per square metre per year.
2) input data:The most recent valuation of St Ann’s Mills in its current run-down condition was only £75,000. The financial model uses the industrial valuation of £375,000 (based on industrial rents) after completing backlog maintenance totalling £433,000. But the Council proposes to invest an additional £1.4 million in the main mill building in option 4, and the total cost of this scheme would be £2.85 million. At Abbey Mills the corresponding industrial valuation was £300,000 but the financial model uses the residential valuation of the mill, plus the council houses next door, of £1.65 million. The council house sale has subsequently been abandoned. This has knock-on effects on the projected maintenance costs, calculated as 2.5% of notional asset value. The effect is to massively load the dice in favour of option 4.
The “backlog maintenance” estimates in the December 2004 report to the Executive Board already includedallowances for building improvements and future maintenance over the next 25 years. Bothelements have been counted twice in the financial model, inflating both the initial expenditure in years one to three and the ongoing maintenance costs.
3) arithmetic: In option 3, the investment is entered as a credit in cells C9:I9 when it should be a debit. As a result the model records an overall profit of £2.12 million, when on these (highly questionable) figures it should be a loss of £568,000.
4) output results: Option 1 actually produced a loss of £1.37 million on the financial model but this was incorrectly transcribed as a profit in the December 2004 report.
The discounted cash flow analysis contains so many errors that the results in paragraph 3.9 of the December report are completely worthless. However the approach is valid, and should be repeated with the correct property valuations, realistic improvement and maintenance costs, affordable market rents and realistic occupancy rates.Any need for ongoing public subsidies must beproperly identified, and the option of investing in the vacant units at Abbey Mills included in the appraisal.
Cllr John Illingworth
27 September 2005