Lecture-Note1.pptx

UNIVERSITY OF GONDAR INSTITUTE OF TECHNOLOGY CONSTRUCTION TECHNOLOGY AND MANAGEMENT DEPARTMENT DEVELOPMENT AND CONSTRUCTION ECONOMICS Lectur e By Getahun Fetene (...

UNIVERSITY OF GONDAR INSTITUTE OF TECHNOLOGY CONSTRUCTION TECHNOLOGY AND MANAGEMENT DEPARTMENT DEVELOPMENT AND CONSTRUCTION ECONOMICS Lectur e By Getahun Fetene (M.Sc.)  1. The Concept of Development 2 Hydropolis Underwater’ Resort Hotel - Dubai UAE, 22m underwater 200 Guest Suites US$5,500 per night  Cont… 3 Bedroom in Hydropolis Underwater’ Resort Hotel, Dubai  Cont… 4 Restaurant in Hydropolis Underwater’ Resort Hotel, Dubai  Cont… 5 Burj Dubai (worlds tallest building with 160 storey and a total height of 829.8 m) It contains a total of 57 elevators and 8 escalators. 6  Fky  Cont… 7  Development has d/t different definitions from different perspectives.  In economic terms, development has been understood as achieving sustainable rates of growth to enable the nation to expand its output faster than the population.  This definition fails to take into consideration:  Problems of poverty  Discrimination  Unemployment and  Income distribution 8  In sociological terms, the term ‘development’ is used to mean industrialization, economic growth and the living standards associated with prosperity, such as increased life expectancy, health-care, free education, etc.  Those countries that have not yet achieved these objectives are said to be ‘less developed countries’ (LDCs).  But not all sociologists agree with this definition. Because it reflects the view that Westernization is the only worthwhile and desirable direction development.  For example, some regard liberation from oppression as more important to progress than industrialization. 9  Religious view on development consider it as a positive change in the whole of human life:  Materially  Socially and  Spiritually  Generally from the three definitions above, development and underdevelopment can be sum up using three key questions:  What has been happening to poverty?  What has been happening to unemployment?  What has been happening with inequality? 10  If the three of these have declined from higher levels, then beyond doubt, this has been a period of development.  If one or more of these problems have been growing worse, especially if all the three have, then that would be a period of ‘underdevelopment.  ECONOMICS OF DEVELOPMENT 11  After the Second World War, the poverty and backwardness of some of the world countries became extremely noticeable. Because,  colonial exploitation,  devastation by war,  war-induced inflation and the like, were responsible for such a sad state of affairs in many countries.  It is precisely at this time that the subject of development economics came into being to study the problems of backwardness and underdevelopment of these nations. 12  The purpose of DE has been mainly to study the phenomenology of underdevelopment, and to prescribe appropriate policies to eradicate it.  ECONOMIC GROWTH Vs ECONOMIC DEVELOPMENT 13  Economists often tend to use the two terms economic development and economic growth interchangeably, as they appear to be synonymous with each other.  Economic development is aimed at the overall well-being of the citizens of a country. It implies an increase in the per capita income of every citizen.  Economic growth on the other hand, is a narrower concept than economic development.  It is defined as the increase in the value of goods and services produced by every sector of the economy. 14  Economic development is measured in four ways:  Gross National Product (GNP)  GNP per capita  Welfare  Social Indicators  ECONOMIC GROWTH AND INCOME DISTRIBUTION: THE KUZNETS HYPOTHESIS 15  There has been much controversy over the issue of whether economic growth increases or decreases income distribution.  Professor Simon Kuznets was the first economist to study this problem empirically. He observed that :  In the early stages of economic development relative income/inequality increases, then  Stabilizes for a time and  Then declines in later stages 16  The Kuznets curve  PROPERTY DEVELOPMENT ECONOMICS 17  Property development is the continual reconfiguration of the built environment to meet society’s needs (Michael Yardney, 2016).  In economics, property is usually considered to be ownership and control over a resource or good.  Many economists effectively argue that property rights need to be fixed and need to portray the relationships among other  PROPERTY DEVELOPMENT PROCESS 18  Property Development involves a wide range of activities and processes from:  Purchasing land,  Building and developing high rise apartment buildings and everything in between.  Property developers follow a sequence of steps from the moment they first conceive a project to the time they complete the physical construction and begin ongoing asset management. 19  While the sequence may vary slightly, usually the development is broken up into the following elements:  Coming up with the idea  Refining it  Testing its feasibility  Negotiating contracts  Making a formal commitment  Constructing the project  Completing the project and finally  Managing the new project  THE RISKS OF PROPERTY DEVELOPMENT 20  property development you need to realize that there are potential risks.  Successful development is simply a matter of understanding the risks and managing them.  A downturn in the property market leading  Finance Risks: not having enough finance during construction  Increases in construction costs during construction  Unexpected disputes with contractors, unions, etc.  Changes to the laws relating to property development  Changes in the supply & demand ratio depresses property values and reduces profit margin 21  Many of these mistakes occur because of the inexperience of the developer.  Even though many of these risks are outside the control of the developer, be aware of the risks helps to minimize them.  It is also necessary to learn from what went wrong and what went right.  1.3. HISTORICAL DEVELOPMENT OF THE CONSTRUCTION INDUSTRY 22 ANCIENT CIVILIZATION  Exactly what constitutes as “construction” throughout history can be misty.  Can we consider pit-houses construction?  What about grass shelters?  One thing is for certain: building activities are as old as humans themselves. 23 Construction during primitive times consisted of mud huts and stone monoliths. The tools of the trade include animal bones, copper plates, and axes. 24 As humans abandoned nomadic life, these societies built permanent shelters. This activity eventually lead to cities. Over time, humans refined their construction practices and started building more permanent structures. Traditional construction began to take shape in Ancient Egypt and 25 Ancient Ethiopian Civilization 26 As the population grew and urbanization took over, construction quickly became a staple of civilization and laid the foundation for modern construction. 27 WONDERS OF MODERN CIVILIZATION  Through time construction has put its remarkable footage in different times at different places.  In the modern world there are a lot of amazing engineering temples in different regions of the world. 28 This is an amazing sample of the Modern Engineering. This tunnel start from England and End in France. The interesting thing is that this is in water. The length of this tunnel is 31 miles and 23 of which is in the sea. 29 The 553.33m-high CN Tower is found in downtown Toronto, the largest city in Canada. CN Tower is the Western Hemisphere’s tallest free- standing structure and the iconic symbol of Toronto’s skyline and Canada. More than two million visitors visit the CN Tower every year. 30 The Golden Gate Bridge is a suspension bridge spanning the 1.6 km wide, 4.8 km long. The bridge links the city of San Francisco to the less densely populated Marin County. The Golden Gate Bridge has been called the most photographed bridge in the world. 31 CHAPTER TWO CONSTRUCTION AND THE ECONOMY  2.1. INTRODUCTION 32  As we have seen above construction has been developed through time from the primitive mud huts and monoliths to the current wonders of civilization.  In the next sections we will try to discuss the economic role of the construction sector in the economy a nation.  2.1. ECONOMIC ROLE OF THE CONSTRUCTION SECTOR 33  The construction industry is an important sector of the economy and plays a key role in national social and economic development.  Construction industry contributes significantly in terms of  scale and  share in the development process for both developed and developing countries.  The construction products provide the necessary  public infrastructure and  private physical structures for many productive activities such as services, commerce, utilities and other industries. 34 The industry is not only important for its finished product, but it also employs a large number of people directly and indirectly. Output from the construction industry is a major and integral part of the national output in the Gross Domestic Product 35  The construction outputs can be classified as  A major component of investment and  Part of fixed capital  Products of construction require a long period of development and are expected to supply services for a period of time.  Investments in construction assume major importance since any expansion in the economy requires infrastructure investment as a precondition for potential 36  The construction industry is frequently used as a tool by government to manage the local/national economy.  For example, when it is recession and the number of unemployment is high, government uses the construction sector to increase the public expenditure.  Therefore the detailed way in which the construction sector interacts with the national/local economy and wealth of people involved is not well understood.  It needs methods to investigate the detail interaction between the construction industry and the national/local economy. 37  Investment in the construction sector can be defined as construction-related to the Gross Fixed Capital Formation (GFCF).  GFCF is an expenditure on fixed assets (buildings, vehicles, machineries, etc) either for replacing or adding to the stock of fixed assets.  These fixed assets are continuously used in the production process. 38  The construction sector constitutes about 40%-60% of GFCF in most developing countries (Ganesan, 2000).  In developed countries, the construction industry accounts for approximately one third of the total investment in physical assets in the economy (Ashworth, 2002). 39  The construction industry in Ethiopia is the major sector where public and private sectors are investing huge amount of fund.  The percentage contribution to growth from construction in general to GDP rose from 3.3% in 1994/95 to 7.2% in 2004/05.  REAL ESTATE DEVELOPMENT 40  Real estate refers to land and associated elements (fixtures) made permanently a part thereof. Land:  Earth surface and everything on/under it  Mineral right, water right , air right  Vertical development of a building  Land and improvement on land  Road  Water  electricity 41 Fixture  Fixture is anything attached to land  Natural and manmade fixtures  Improvement in real estate includes land escaping and structure Traded Fixture  An item owned and attached to a rental space / building by a tenant-used for business purpose.  If tenant places an item- there should be an agreement  If there is no agreement – the law will decide 42  Tenants usually remove the fixture before the end of the lease period.  Should be removed without damaging other premises  Traded fixture that is not moved will be the property of the landlord.  Law and Real Estate 43 Business  The real estate business is related to law  Any activity is involved certain legal restrictions  Those involved - know the law / legal system  Its multidimensional aspect and increases the need for number of professionals  Property 44  Legal rights that an individual possesses  The right includes – the right to use, sell, dispose etc.  Tenant in commercial building for example, has a right to occupy space  Property also refer to rights which are intangible E.g.. Contract, trademarks, patent  Property Protection 45  Property is protected by government  The law provides protection and guarantee to the bundle of rights on property  It is dynamic continually changing to meet the social and economic needs  Legal action that protect real property is known as real actions  That is why we call real property or real estate 46  Those law action that involves on movable items refers to personal property.  Personal property refers to movable properties and normally transferred by a bill of sale.  Factors that Affects Real Estate Market 47  Every parcel of real estate is unique (can not be interchangeable to other parcel)  Buyers and seller lack information  Buyers and sellers frequently moves away from equilibrium  Real estate is immobile while price is volatile  Location is the most important single factor  Market analysis 48  Demographic factors are important  The overall market area further defined by “segmentation”  Based on consumers preferences  Based on Market Segmentation 49  Segmentation based on consumers preference is according to:  Income  Work  Leisure and  Other lifestyle patterns  Segmentation based on market  Possible to predict the probable demand  Demand of various types  Absorption Analysis 50  It is a study of the number of units of residential or non-residential property that can be sold or leased over a given period of time in a defined location.  Absorption is performed as part of feasibility study  Functions of the Real Estate 51 Market  To allocate existing real property resources and interests  land is scarce resource – must be allocated b/n the various uses – needs and requirement – arriving at equilibrium price  the market reflects preferences and allocates the available supply  different people prefer different types of interest 52  To indicate changes in demand for land resources and interest.  Expectations of future yields  Taxation  Income  Institutional factors  To prompt supply to adjust to change in demand  Developing real property  Changing existing interest 53  To indicate changes in the conditions upon which land resources can be supplied  Improving the technique of construction  To “reward” the owners of land resources  Return on capital – profit  Economic rent  Investment in Real estate 54  Economist distinguishes two meaning for “investment”  Expenditure on the purchase of existing assets = Property investment  Expenditure on the creation of new fixed assets = Property development  TYPES of Investment 55 I. Freeholds II. Leasehold III. Freehold ground rent IV. Mortgages  I. Freeholds 56  Holder of freehold (owner occupied/renter) – takes full financial risk of ownership.  If rent increases he gains and lose when it falls  Freehold investment needs management, collecting rent, tenants obligations and maintenance cost  The management cost has to be deducted from the rent received to reach at net income  II. leasehold 57  The freeholder may rent the premise he own to somebody.  Usually the owner will rent the premises for fixed period of time in return to capital sum of premium or rent or both  These lease has value and can be exchange in the market  At the end of the lease period, it will be returned to the freeholder  Yields in lease will be higher than that of freehold  III. Freehold Ground Rent 58  FGRs refer to annual payments received on long term lease  Originally charged for land leased for development  FGRs are like long term government stock  Because of inflation they required periodic rent revision  For less than 50 years – equity character- value tend to rise  IV. Mortgages 59  Mortgages are long term money loans secured on real property.  Interest payment are the charge  Risk of non payment of interest are low  Unlike leasehold Capital are prepaid  Mortgages are like government bonds  Mortgages on commercial and industrial property are less attractive- due to inflation  Real Estate Finance 60  Real estate finance is the process of borrowing or lending, most often involving a third party that is neither the buyer nor seller of the property in question.  From the borrower’s point of view a loan is a debt and liability.  From the lender’s point of view a loan is an investment and an asset with the property serving as collateral for the loan.  Financing a real estate transaction involves significant risk to both the borrower and to the lender.  Source of Capital for Development 61  Finance by cash  Paid before acquisition  Paid after acquisition  Finance by Sub-letting land interest  Sale and lease back  Joint venture  Sale of land promises (Roof-top Antenna, External Wall Advertisement, etc.) 62 Finance by Loan Bank/institutional loan Issuance of shares/bonds 63 CHAPTER THREE SUPPLY AND DEMAND IN CONSTRUCTION  INTRODUCTION 64  The price of any transaction agreed b/n buyers and sellers reflects forces at work in the economy.  These economic forces must be taken into account for a proper understanding of why prices are as high or as low as they are.  So this chapter deals with the price mechanism, or the laws of supply and demand.  Analysis of factors influencing demand and supply is very important.  Then the inter-relationship b/n these factors will be described.  Effective Demand 65  Effective demand is the quantity of goods or services people are willing and able to buy in a given period of time at a given price.  In the construction industry effective demand is the quantity of building projects and services which clients wish to buy.  Clients may come from the private or public sectors.  The demand for buildings may be seen as a form of investment as the products of the building industry tend to take one or more years to construct where as the benefits which flow as a result may last for many decades.  Derived Demand 66  Plants, Equipments, and materials needed to manufacture final goods are called intermediate goods.  The demand for intermediate goods depends on the demand for final goods.  For example: Demand for factory buildings, is derived from the demand for products made in the factories.  Generally, demand for construction services is derived demand.  Factors Affecting Quantity of Demand 67 Price The price of a building is perhaps the most important single factor influencing demand. Assuming everything else stays the same, the higher the price the lesser will be the demand; the lesser the price the more will be the demand. 68 Interest Rate  Interest rates have a key role in property and construction markets, because these markets are heavily financed through borrowing.  High interest rates deter people from borrowing and make difficult to invest in development.  This high interest rates will depress both property prices and the profits that can be made.  This in turn will have an adverse effect on the 69  It is important to distinguish b/n nominal and real rates of interest.  Nominal rates are quoted by banks or lenders.  Real rates of interest is approximately equal to the nominal rate of interest minus the rate of inflation.  The more accurate formula used to find real interest rates is: R r= nominal rate of interest i= inflation rate 70 Prices of Other Products  Demand also depends on the price of other products, some of which will be:  Substitutes (can be used instead of others. E.g. Wood frames instead of metal ones. The price of one type of frame affects the quantity demand on the other)  Complements (goods used in conjunction with each other. E.g, doors and door handles. An increase in demand for one leads to an increase for the other).  Independents ( goods that have no direct relationship with each other. Change in price of one does not affect price of the other). 71 Income As stated earlier, effective demand is dependent on the ability to pay, which is in turn dependent on Income Normal goods are those which consumers tend to purchase in a greater quantities. Inferior goods are those goods which 72 Size of Population  The quantity demanded tends to vary directly with the sizes of the population. Individuals Preference  Preferences from individuals as well as companies for a particular styles or types of buildings will affect demand. Government Policy  Government policy is another determinant of demand. e.g the government may decide to 73 Price Expectation  Expectations of price changes will affect the quantity demanded at any one time. E.g, the demand for housing may rise if the population anticipates that house prices will rise.  Shifts of the Demand 74 Curve When price changes there is a movement along the demand curve. Depending on the type of market and the nature of the change, demand curve will either shift outwards or inwards. Alternatively, the curve may shift upwards or downwards, indicating that consumers demand the same as before but are now willing to pay a  Elasticity of Demand 75  If a real estate consisting of 3 bedroom houses is built and sales are slow, should the prices be reduced?  And if sales are rapid, should prices be raised?  Elasticity of demand measures the responsiveness of demand to a change in something else.  Price elasticity of demand, therefore, is a 76 For example:  if price rises, consumers will buy less, but how much less?  The lower the price, the more will be demanded. The question remains, however, will the increase in demand be sufficient to compensate for the reduction in price? 77  The value of price elasticity of demand will always be negative reflecting negative down slope of demand curve.  However for the purpose of interpreting the result, the minus sign maybe ignored.  In mathematical terms we are interested on the modulus, ignoring whether it is positive or negative.  If calculation produces a modulus greater than one, then the price elasticity of demand is said to be elastic. If it is less than one it is 78  When the proportionate change in the price is equal to the proportionate change in the demand , the elasticity of demand is equal to one, resulting in no change in total revenue when price is altered. 79  Three examples of price elasticity of demand are illustrated in the figure below. 80  The vertical line (price elasticity of demand=0) represents a perfectly inelastic demand curve, since the quantity demanded remains the same regardless of any price changes there might be.  The horizontal demand curve (price elasticity of demand= , is perfectly elastic , since an infinitely small increase in price will result in absolutely no demand for the product or service.  The curve (price elasticity of demand =1), a  Income elasticity of demand & cross elasticity of demand 81  Fro other variables which may cause demand to change are:  Changes in income  Changes in the prices of some other products or services  Income elasticity of demand measures the responsiveness of demand to changes in income. 82  Cross elasticity of demand measures the responsiveness of demand to a change in the price of something else.  Supply 83  It is of course extremely difficult to quantify the service an architect, quantity surveyor, lawyer, or any professional practice supplies.  Nevertheless the supply of a professional service may be indicated by the amount of time devoted to particular projects by a number of professionals.  Supply is the quantity of the service professionals are willing and able to offer clients over a given period of time. 84  Like the quantity demanded, the supplied also depends on the combined effect of a variety of factors.  Some of these factors are:  Prices/Fees charged  Cost of premises  Labor costs  Price of other services provided by the practice  State of technology  Aims of the practice 85 Price and fees  The quantity supplied depends on the price of the product or service.  Hence the quantity of the service supplied by, say, architects is determined by the fees they can charge.  Assuming that everything else remains constant, the higher the fee, the greater quantity of time architects are in a position to supply.  The lower the fee, the fewer the number of 86 Supply curve  Shifts of Supply 87  Hm,kl Movement along the supply curve occurs if price changes but everything else remains the same. However, if something other than price changes, the whole supply curve will shift  Products in Competitive 88 Supply  From other factors influencing supply in a particular period are the amount, price and profitability of alternative works.  When price of work on alternative sites goes up, firms will concentrate their efforts there rather than on the current site on which they may be working.  As a result, even though the price and work on particular site might not have changed, the willingness of firms to work on a site can go down. 89  The supply Ghkj line shifts to the left from S2 to S1 when alternative sites higher wages and profits attract workers away from a particular job. So that, at P2 the supply of labor goes down Q2 to Q1 workers.  Price Elasticity of Supply 90  Price elasticity of supply measures the responsiveness of the quantity supplied to changes in price.  That is, price elasticity of supply relates changes in price to the quantity offered for sale.  When elasticity of supply is greater than 1, supply is said to be elastic. 91  When elasticity of supply is less than 1, supply is said to be inelastic. S0 Pric Notice that the price e elasticity of supply is S1 always positive, reflecting the positive S slope of the supply curve. perfectly elastic supply is horizontal, while inelasticity of supply is Quanti ty shown as a vertical line. Unit elasticity applies to  Inflation and the use of index numbers 92 Having discussed the economic influence of supply and demand, we now see the influence of inflation and unemployment on the economics of the construction industry.  Inflation is the rate at which prices rise on average.  It is a major economic factor affecting the construction industry, adding uncertainty to budget forecasts.  Costs can rise more than expected and affect cash flows adversely. 93  Broadly speaking there are two types of inflation, distinguished from each other by their causes rather than their effects.  Cost push inflation  Demand pull inflation  Cost push inflation occurs when rising costs are passed on to customers as firms raise their prices to maintain their profit margins.  Demand pull inflation occurs when there is excess demand in the economy resulting prices to go upwards. 94  The rate of inflation is measured each month by the office for National Statistics by calculating the annual rate at which consumer prices rise, using the retail price index (RPI).  The RPI is based on the value of weighted average basket of consumer goods and services.  The weighted results are then aggregated to give a total value.  This is then compared to the base year total 95  The base year is always equals to 100. if the increase between the base year and thee current year is say, 36%, the index number is 136.  Thus, if the total value of a weighted average basket of goods was 300 in the base year, it would be given the value 100. I  If the value of the same basket of goods rose to 330 in the following year, then the new index number is calculated as: 96  The annual inflation rate is therefore 10 percent. Note:  The RPI reflects price movements, usually upwards, facing the average consumer.  All goods and services are taken into account, but not all people buy all goods. If the price of, say, cigarettes goes up, the rise will only affect smokers.  D/t categories of people buy d/t baskets of goods. 97  The RPI is only an indicator of the general movements in consumer prices.  Similarly, construction cost and price indices take into account the movement of prices affecting construction.  These specialized construction industry indices are necessary because the RPI refers to consumer goods and services and may not reflect price increases facing clients, builders, 98  If building prices rise at the same rate as the rate of inflation, the real cost of building does not change in terms of the average basket of goods.  However, building costs have been rising faster than the rate of inflation for most of the past hundred years.  The building cost index (BCI) and the tender price index (TPI) are used to measure the 99  The BCI includes movements in the prices of basic materials, and agreed wage rates and contractors on-costs.  This cost index can be used to anticipate a rise in prices in the period between the date a tender is submitted and the completion of a project, especially on large projects and those taking several months or years to construct. 100  To estimate the final building costs of a project, first find the total costs of a project from suppliers and subcontractors.  This figure then forms the current total cost used as a the basis for the tender price or bid price for work.  The expected final building cost is calculated using the following formula. where,  Total current building cost = total current t building costs at tender 101  BCIt = building cost index at tender date  BCIt+1 = building cost index at expected completion date. 102 CHAPTER FOUR PROJECT APPRAISAL  Introduction to Feasibility 103 Study  The purpose of this chapter is to introduce feasibility studies, project appraisal, and investment analysis.  The purpose of feasibility study is to understand the cost implications of a project. Feasibility studies set budget limits and can be used to monitor costs during construction.  On completion, building users or facilities managers can use feasibility studies to monitor running costs and maintenance by comparing actual with expected figures.  Financial Vs Economic 104 Viability  Feasibility studies may be used to deal with several different questions concerning the financial and economic viability of projects.  Financial appraisals are concerned with cash flows, though reference may be made to non- monetary issues, but these are usually quite separate from the financial calculations.  Financial viability in the private sector is concerned with the requirement that a building must generate sufficient funds to enable a developer to undertake a proposed 105  Banks or other financial institutions only fund projects if the proposals are expected to generate a rate of return greater than the cost of borrowing.  Internal sources of finance come from within the client’s organization, while external sources of finance range from private-sector banks and investors to public-sector sources such as government sponsored bodies and local authorities.  In public sector profit is not the motive, and financial viability involves ensuring that sufficient funds will be available to meet the cost of providing a given public service. 106  Economic appraisals recognize that the total cost is not always reflected in the market prices paid for resources.  The economic aspects of a construction project are concerned with the built structures’ ability to meet its aims and objectives.  Judgment is always required when carrying out financial or economic appraisals, especially when deciding what to include or exclude from an economic model. 107  For instance, in financial appraisals where, where the purpose of the exercise is to establish the total cost of projects, the costs relating to the site must, of course, be included.  Nevertheless, a financial analysis of the cash flow would only include those items for which cash flowed into or out of an account.  If the site was owned and paid for by the developer before the decision to build, the value of the land would be excluded from the 108  However, if the purpose of an appraisal to compare alternatives, only those cost elements which differ from option to option need be included. The cost of the site, for example, is clearly a major item of expenditure.  However, if a project is to be built on a given site, the costs themselves would not normally enter into a cost comparison of the designs for a building, because the identical site 109  Financial feasibility studies only consider financial costs and benefits, while economic feasibility studies also take non-financial considerations into account.  Economic viability therefore involves both financial aspects and broader issues, such as spillover effects and opportunity costs. 110  The significance of the difference between financial viability and economic viability is demonstrated in the following set of decision rules.  If a project is economically and financially viable, then it can proceed.  If it is economically but not financially viable, the project will not go ahead, because it is anticipated that there will be insufficient inflows of money from all sources to pay for the construction, maintenance and running of the proposal although the benefit will be greater than the costs.  If it is financially but not economically viable, then the project should not go a head, though it may nevertheless proceed depending on the interests and responsibilities of the decision maker.  FINANCIAL APPRAISAL 111  The basic questions facing every investor are whether or not the investment will be worth more than the amount invest, and if so, by how much?  In order to answer these questions there are available a number of financial techniques, which use discounting.  However, because of the simplifying assumptions, uncertainty and unavoidable errors of feasibility study techniques it is often advisable to treat the mathematical  The Principle of Discounting 112  A financial investment is an expenditure in one period with a view to receiving a flow of money in the future.  But money in the future is worth less than money in the present, even without inflation.  One could deposit the money in the bank and earn interest on it. This is the earning power of money over time and is called time value of money.  If the interest rate is 10%, then $100 today will be worth $110 one year from now. 113  Compound interest converts a present day amount of money into a future value.  A discount rate is the same as a compound interest rate except that, whereas compounding moves from the present to future, discounting moves from the future back to present.  Discounting calculates the present value of a future amount. For example:  $110 in one years time is worth $100 today, assuming a discount rate of 10% 114  Future value of a sum of money using compound interest is given by: Where: F= future value P= Present Value r = interest rate n = number of periods  The formula for discounting is derived by transposing the terms. where r = is the discount rate  Net Discounted Present 115 Value  The net discounted present value(NDPV) is used to answer the basic investment question of how much more or less an investment is worth compared to the amount invested.  The value of an asset (a proposal) is derived from the stream of revenues and less costs generated in the future.  It is necessary to take the following assumptions:  A given building cost to complete (initial Investment cost)  Annual running costs (operational cost)  Annual income generated (annual revenues generated )  There is no inflation Discount Factors and Equivalence 2 9 Present Worth Analysis of Different-life Alternatives  When the present worth method is used to compare mutually exclusive alternatives that have different lives, then the PW of the alternatives must be compared over the same number of years and end at the same time  A fair comparison can be made only when the PW values represent costs (and receipts) associated with equal periods  The equal-period requirement can be satisfied by comparing the alternatives over a period of time equal to the least common multiple (LCM) of their lives Example  Perform a present worth analysis of equal-service machines with the costs shown below, if the MARR is 10% per year. Revenues for all three alternatives are expected to be the same Cost Type Electric- Gas- Solar- Powered Powered Powered First cost, Br 2,500 3,500 6000 Annual 900 700 50 operating Cost, Br Salvage Value, 200 350 100 Br Life, years 5 5 5  Solution  The salvage values are considered a “negative” cost, so a + sign precedes them  The PW of each machine is calculated at i = 10% for n = 5years PWE = – 2,500 – 900(P/A,10%,5) + 200(P/F,10%,5) = – 5,788Br PWG = – 3500 – 700(P/A,10%,5) + 350(P/F,10%,5) = – 5,936Br PWS = – 6000 – 50(P/A,10%,5) + 100(P/F,10%,5) = – 6,127Br The electric-powered machine is selected since the PW of its costs is the lowest; it has the numerically largest PW value  Example  A project engineer is assigned to start up a new office in a city where a 6-year contract has been finalized  Two lease options are available, each with a first cost, annual lease cost, and deposit-return estimates shown below Location A Location B First cost, $ 15,000 18,000 Annual lease 3,500 3,100 cost, $ Deposit return, $ 1,000 2,000 Lease term, 6 9  Determine which lease option should be selected on the years basis of a present worth comparison, if the MARR is 15% per year Solution Solution  Since the leases have different lives, compare them over the LCM of 18 years  Repeat the first cost in year 0 of each new cycle  Calculate PW at 15% over 18 years  PW = – 15,000 – 15,000(P/F,15%,6)+1,000(P/F,15%,6) A – 15,000 (P/F,15%,12)+1,000(P/F,15%,12) + 1,000(P/F,15%,18) –3,500(P/A,15%,18) = $ – 45,036  PW = – 18,000 – 18,000(P/F,15%,9) + 2,000(P/F,15%,9) + B 2,000(P/F,15%,18) – 3,100(P/A,15%,18) = $ –41,384  Location B is selected, since it costs less in PW terms; that is, the PWB value is numerically larger than PWA  Capitalized Cost Calculation and Analysis  Capitalized cost (CC) is the present worth of an alternative that will last forever  Public sector projects such as bridges, dams, irrigation systems, and railroads fall into this category  The CC value can be computed from the following equation where A is the annual worth  If 10,000 birr earns 20% per year, compounded annually, the maximum amount of money that can be withdrawn at the end of every year for eternity is 2,000 birr, or the interest accumulated each year  This leaves the original 10,000 birr to earn interest so that another 2000 birr will be accumulated the next Example  A new computer system will be used for the indefinite future, find the equivalent value now if the system has an installed cost of $150,000 and an additional cost of $50,000 after 10 years. The annual maintenance cost is $5,000 for the first 4 years and $8,000 thereafter. In addition, it is expected to be a recurring major upgrade cost of $15,000 every 13 years. Assume that i = 5% per year.  Solution  Draw a cash flow diagram for two cycles  Solution  CC1 = -150,000 - 50,000(P/F,5%,10) - 5,000(P/A,5%,4) - (8,000/0.05)(P/F,5%,4) = -150,000-50,000(0.6139)-5,000(3.5460)- 160000(0.8227) = $ -330,057  Convert the recurring cost of $15,000 every 13 years into an annual worth A1 for the first 13 years.  A1 = – 15,000(A/F,5%,13) = $ –847. The same value, A1 = $ –847, applies to all the other 13-year periods as well  CC2 =  CC = $ -330,057+ $ -16,940 = $ -346,997 FUTURE WORTH ANALYSIS  The future worth of an alternative (FW) can be used to compare alternatives  FW analysis is suitable for projects that will not come online until the end of the investment period  Once the FW value is determined, the selection guidelines are the same as with PW analysis  For one alternative, if FW ≥ 0 means the MARR is met or exceeded  For two mutually exclusive alternatives, select the one with the numerically larger FW value Example  A company purchased a store chain for $75 million three years ago. There was a net loss of $10 million at the end of year 1 of ownership. Net cash flow is increasing with an arithmetic gradient of $+5 million per year starting the second year, and this pattern is expected to continue for the foreseeable future. Expected MARR of 25% per year  The company has just been offered $159.5 million to sell the store. Use FW analysis to determine if the MARR will be realized at this selling price  If the company continues to own the chain,  Solution  Find the future worth in year 3 at i = 25% per year and an offer price of $159.5 million  FW = – 75(F/P,25%,3) – 10(F/P,25%,2) – 5(F/P,25%,1) + 159.5 = –168.36 + 159.5 = $ –8.86 million  No, the MARR of 25% will not be realized if the $159.5 million offer is accepted  Solution Determine the future worth 5 years from now at 25% per year  FW = – 75(F/P,25%,5) – 10(F/A,25%,4) + 5(A/G,25%,3)(F/A,25%,3) = $ –246.81 million  The offer must be for at least $246.81 million to make the MARR Annual Worth Analysis  In this method, all receipts and disbursements are converted into an annualized cost series  Annual cost is the cost pattern of each alternative converted into an equivalent uniform series of annual cost at a given interest rate  The alternative that yields the least cost is chosen  Advantages of the Annual Worth Analysis  Eliminates the LCM problem  Only you evaluate one life cycle of a project  The result is reported in terms of birr/period  If two or more alternatives possess unequal lives then one need only evaluate the AW for any given cycle Analysis for Different Cycles 6-year project Find the AW of any 6 – year cycle 9-year project Find the AW of any 9 – year cycle Example  Consider a project with a $3,000 annual operating cost and a $5,000 investment required each 5 years. Assume i = 10%  For one cycle: AW = 3,000 + 5,000(A/P,10%,5) = $4,319/yr  For two cycles: AW = 3,000 + 5,000(A/P,10%,10) + 5,000(P/F,10%,5)(A/P,10%,10) CFD For one cycle For two cycles Example  Two pumps are being considered for purchase. If interest is 7%, which pump should be bought? Pump A B Initial Cost 7000 5000 Salvage Value 1500 1000 Useful Life, yrs 12 6 AWA = -7,000(A/P,7%,12) + 1,500(A/F,7%,12) AWB = -5,000(A/P,7%,6) + 1,000(A/F,7%,6) AWA = -797 AWB = -909 >>>>> Choose Pump A Rate of Return Analysis  Another method for evaluation of different competing alternatives, especially in the area of investments  In general, rate of return may be regarded as an index of profitability.  The following terms are commonly encountered  MARR (minimum attractive rate of return),  IRR (internal rate of return),  IRoR (Incremental rate of return), and Steps for Computing IRR Step 1 : Assume a trial rate of return (i*).  Step 2 : Counting the cost as negative and income as positive, find the equivalent net worth of all costs and incomes Step 3 : If the equivalent net worth is positive then the income from the investment is worth more than the cost of investment and the actual percentage return is higher than the trial rate, and vice versa Step 4 : Adjust the estimate of the trial rate of return and go to step 2 again until one value of i is found that results in a positive equivalent net worth and another higher value of i is found with negative equivalent net worth Step 5 : Solve for the applicable value of i* by interpolation. Computation of IRR (PW)benefits – (PW)cost = 0 Let IRR be i*  NPW = -1000 + 400 (P/F, i*,1) + 370 (P/F, i*,2) + 240 (P/F, i*,3) + 220 (P/F, i*,4) = 0 Assuming i* = 10%  NPW = -1000 + 400 x 0.9090 + 370 x0.8264 + 240 x 0.7513 + 220 x 0.6830 = 0  We find that i*= 10% in the above example is a special interest rate which has reduced the net present worth of given cash flow to zero. Thus i*=10% is the Internal rate of return for this example Important Point  It is not possible to calculate the rate of return for the cash flows involving cost alone or revenue alone  IRR method should not be used for ranking of projects as it may give erroneous results, not in line with the results obtained from other methods of analysis  For such cases, we need to evaluate alternatives using incremental rate of return method Example Calculate the IRR for the following cash flow diagram? Solution  Assuming i = 20%  NPW = - 1050,000 + 317500 * (P/F,20%,1) + 630000 * (P/F,20%,2) + 630000 * (P/F,20%,3) = 16660.48  Now, assuming i = 21%  NPW = - 1050,000 + 317500 * (P/F,21%,1) + 630000 * (P/F,21%,2) + 630000 * (P/F,21%,3) = - 1677.13  (P/F,20%,1) = 0.8333, (P/F,21%,1) = 0.8265,  (P/F,20%,2) = 0.6944, (P/F,21%,2) = 0.6830,  (P/F,20%,3) = 0.57870, (P/F,21%,3) = 0.5645,  Thus, the exact value of i lies somewhere between 20% and 21% which can be found out by interpolation, as i = 20 + (21 – 20)* 16660.48/(16660.48– (- 1677.13)) i = 20.908% Payback Period Analysis  The payback period (np) for an investment may be taken as the number of years it takes to repay the original invested capital  It is understood that the shorter the payback period, the higher the likelihood of the project being profitable  The payback period analysis should provide initial screening or supplemental information in conjunction with an analysis performed using present worth or another method  In order to find np, the initial investment should equal the present worth of net present value of all estimated cash flows Example  An engineering firm has just approved an $18 million design contract. The services are expected to generate new annual net cash flows of $3 million; Contract period is 10 years. If i = 15%, compute the payback period Solution  The initial investment = $18 million  The present value of the expected return = A(P/A,i,n) when considering that A = $3 million  3(P/A,15%,n)  The two amounts ought to be equal  18 = 3(P/A,15%,n) This gives a value of np = 16.47 years Example Two machines are being considered for purchase by a company. Machine 2 is expected to be versatile and technologically advanced enough to provide net income longer than machine 1 The quality manager used a return of 15% per year and a PC-based economic analysis package. The manager recommended machine 1 because it has a shorter payback period of 6.57 years at i = 15%. Is this right?  Solution For Machine 1  12,000 = 3,000(P/A,15%,np) which gives a payback period of 6.57 years For Machine 2  8,000 = 1,000(P/A,15%,5) + 3,000(P/A,15%,np-5)х(P/F,15%,5) which gives a payback period of 9.52 years  If we would like to use PW analysis to compare the machines, then the following procedure ought to be considered: For Machine 1  PW1 = -12,000 – 12,000(P/F,15%,7) + 3,000(P/A,15%,14) = $663 For Machine 2 BENEFIT-COST RATIO METHOD General equation of Benefit- cost analysis is;..  Bt   Mnt    1  i  t    1  i  t  B/C       C t   C t    1  i  t    1  i  t      Strong side of B/C Ratio  Criteria can be used to rank projects According to degree of acceptability  Criteria can be used to decide whether a project should be financed or funded.  Criterion which enable to make decision among different alternatives.  Remember the example below;  Assume that the available budget is $800,000 only Project PVC PVB NPV B/C(10%) A 10,000 13,000 3,000 1.3 B 40,000 43,300 3,300 1.08 C 20,000 30,300 10,300 1.52 D 40,000 49,400 9,400 1.24 E 50,000 55,800 5,800 1.11  When the projects ranked based on NPV and B/C approach, it looks like as follow:  NPV C, D, E, B and A  B/C C, A, D, E and B  Example: A flood control project is proposed for a certain area. There is a question as to the location of the dam and the numbers of alternative sites have been narrowed down to two, site A and site B. estimate of the costs associated with each of the site are listed below. The funds to construct the projects are available from bonds bearing interest rate of 6%. The expected life of the project at either site is 40 years and no salvage value is expected.  Cash Flow descriptions Description Existing Site A Site B Situation Cost of 0 3,000,000 8,000,000 construction Annual O&M 0 56,000 94,000 cost Annual cost of 620,000 290,000 120,000 flood damages Annual loss due 0 20,000 46,000 to land is lost to reservoir  Solution  Site A Un = 620,000-290,000-20,000 = 310,000 Mn = 56,000 Cn = 3, 000, 000 (A/P,6%,40) =199,384.6 Un  Mn 310,000  56,000 Modified B / C   Cn 199,384.6 =1.274 Solution  Site B Un = 620,000-120,000-46,000 = 454,000 Mn = 94,000 Cn = 8, 000,000 (A/P,6%,40) = 531,692.3 Un  Mn 454,000  94,000 Modified B / C   Cn 531,692.3 = 0.677 Therefore, Site A is selected because of its higher value of B/C ratio.  Sensitivity Analysis 154  Sensitivity Analysis is an approach to project evaluation that can be used to gain better understanding of how uncertainty or error affects the outcome of the economic evaluations by examining how sensitive the outcome is to changes in the uncertain parameters.  The parameters to be considered during sensitivity analysis may different from project to project.