Financial appraisal in construction

Financial appraisal in construction is one of the most important stages of the construction project planning process. The purpose of the financial appraisal is to determine whether the project is worthwhile, comparing its costs with its expected benefits. It stands as a key element for deciding whether to proceed or not with a constuction project and any project in general. Also, it stands as a key element for choosing between alternative construction projects. Financial appraisal adresses not only the adequeacy of funds, but also the financial vialibity of the project, estimating in the end if and when the project returns a profit or not. This article explains at first the elements, such as construction funding, construction cost, and overall costs and benefits of a construction project that the reader has to be familiarized with, in order to understand the concept of this stage. Then, some methods of financial appraisal are presented, highlighting the Net Present Value, which is one the most common criterion for project decision and selection. Finally, the considerations and limitations about the financial appraisal of construction are mentioned in this article, referring also to strategic misrepresentation. The financial appraisal of construction projects represents the potential benefits that they will arise after a specific project is undertaken.

Introduction

The purpose of the financial appraisal is the justification that the return will exceed the estimated construction cost of the project. Through this procedure the investment capital or the resources required for the construction of the project can be estimated, after the utility and the benefits of the asset can be estimated. In the construction industry, the problem of deciding the amount of investment and the allocation of resources to the project is actually the capital budgeting problem. The benefits from the project are estimated, and then the client- investor can estimate the budget which is necessary for the completion of the project and decide if he would proceed with the construction of the project or abandon it. The financial appraisal, which acts as abovementioned, as a decision-making tool for the client-investor, depends, mostly, on:

• The size of the potential construction project
• The time period over which the cost and benefits are going to be calculated

Introduction

Construction project funding

Project funds are the resources which are available to a client-investor in order to successfully fund a potential construction project. Project funds may be provided from various sources as the private sector, the public sector and individual investors. Many projects also funded by grants, which are often available to investors in order to promote and encourage development and enhance the economic development. Also, construction projects are also funded through borrowing money from financial institutions, by of course this procedure reduces the return profit of the project, due to interest rates of the loans, which are needed to be repaid. Example of funding options for construction projects are listed:

• Government, State through tax renevue
• Housing associations
• Pension funds
• Insurance companies
• Bank loans for companies or individuals
• Cash allocation through reserves
• Mortgages

Construction Costs

The construction costs consist of the initial investment that the client-investor has to pay to the contractor for the building or structure. The construction costs need to be estimated as precisley as possible in the early design stage of the project, so that the overall financial appraisal of the constuction can be done. The larger amount of the construction costs consist of the purchase of land and the actual construction works of the new facilities. As the design stage is developed through time, the construction costs can be estimated more accurately. However, the available budget should not overrun from the early estimation, as this could lead to a negative overall return of the porject and sometimes could also lead in cancelling it. The estimation for the cosntruction costs needs to include the following major cost elements:

• Time-as an element for labour and construction activities
• Materials
• Capital equipment as machinery
• Indirect expenses as transportation, training
• Overheads
• Contingency
• VAT(Value-Added Tax)

Overall costs and benefits of construction projects

The overall cost and benefits of the construction project need to be evaluated and calculated for the financial appraisal of it. This appraisal include the cost from the inception of the project to the lifecycle cost and income. The precise identification will confirm is the project will pay back during its lifetime against the initial investment from the client. Costs and benefits that have to be taken into consideration during the justification of the investment of the project are:

• Purchase of land
• Constuction works
• Professional fees
• Marketing cost - Advertisement of the investment
• Income from renting - sale or exploitation of the construction
• Cost of finance - interest rate flunctuations due to inflation
• Environmental cost
• Continguency cost

To evaluate the profitability of new projects To assist in choice between investment projects Life cycle costing

Once the utility of the asset has been identified, the benefits thereby generated need to be valued so that the resources required for the investment can be justified. The problem of the allocation of resources to projects is the capital budgeting problem – how does the client choose for investment those projects that will yield the greatest return? It is through solving the capital budgeting problem that the mission objectives for the project schedule and budget are set.

Application

This return can be estimated and presented through some principles of capital budgeting:

Payback analysis – payback period

Video 1:Internal Payback Analysis

The payback period is the exact length of time needed for a company /client to have a positive return of its initial investment as it is calculated by the cash flows. The income that will be generated from a construction project is compared with the overall cost of the project(construction cost, maintenance cost e.t.c). The payback analysis is the least precise of the capital budgeting techniques, because the time values of money is not taken into consideration.

Example

Discount cash flow – Net present Value Internal rate of return Time of value

Discounting

The value of money today is greater than the value of money at a future point in time. (1). Discounting are the techniques applied so that this time value of money can be calculated. (2). The basis of discounting is the comparison between the value of the return of an investment and the value of the same amount of money deposited in a bank account for the same period of time. Discounting considers the opportunity cost of the project.

Discounted cash flow

Cash flows in a construction project at future points in time need to discount to their present value so that it can be determined whether or not a construction project is worthwhile for investing. More specifically, the outflow of cash which is necessary for the investment of the construction project, i.e the project cost is compared with the discounted inflow of cash, i.e benefits arising from the explotation of the project. This concept is referred as discounted cash flow.

Discount rate

The discount rate values can be calculated with many methods. The project managers have usually discount rate for their organizational policy, so that the project can be evaluated in financial terms. Three factors are essential for calculating the discount rate value - Interest rate: It is the rate charged for the use of capital and it is arranged between the borrower and the lender. - Inflation rate: It is the rate due to inflation, raising of prices. Inflation rate has to be taken into consideration, so that there is no reduction in the purchasing power. - Minimum Attractive Rate of Return (MARR): This rate is a factor corresponding to the risks of the project, as the investment amount of money can never be repaid. 000 (presentation). The overall discount rate is calculated as: Overall rate=(1+a)(1+b)(1+c). This effect that the discount rate is larger than the interest rate, more specifically sometimes in construction companies can reach almost 20% (kitrino vivlio).

Net Present Value

Video 1:Net Present Value

The Net Present Value Is a capital budgeting technique that calculates the discounted cash flows against the investment. In mathematical terms, The minimum criterion for investing in a project is that the NPV is greater or equal than zero at a given discount rate and a specific time period in the future(kitrino vivlio). The effect that the discount rate can be in some cases, according to the selection of the construction consultant manager and the project accountant, almost 20%, makes the compliance with the minimum criterion of having a NPV equal to zero a very difficult and demanding task.

Internal rate of return

The internal rate of return (IRR) is more complex capital budgeting technique and more difficult to calculate than Net Present Value(NPV). The internal rate of return is the discount rate for which NPV is equal to zero. In other words, it is the discount rate for which the cash inflows are equal to the initial invesment. In mathematical terms,

Video 1:Internal Rate of Return

$\sum_{t=1}^{n}\Big[\frac{FV_t}{(1+IRR)^t} \Big] - II = 0$

where,

$FV_t$ is the future value of the cash inflows in t year hence

$IRR$ is the Internal Rate of Return

$II$ is the initial investment

The calculation of IRR is done mathematically through a number of iterations, based on the trial-and-error solution. A variety of discount rates are used and gradually leading to the point, value of IRR, for which NPV is equal to zero.

Considerations

NPV calculation

The calculation of the NPV requires a very accurate estimation of the cash inflows and outflows, especially a precise calculation of the potential benefits in terms of money that they will be arised from the project completion. Especially with the construction projects, this is a very difficult task, as the NPV calculation is a quantitative method (MIT). It is not possible to value all the benefits in terms of money. For instance, in many cases, the client/investor is in a not-for-profit sector as the government.

Uncertainty

Both the cost and the benefits of an investment construction project are uncertain. As it is concerns the benefits of a project:

• There is an uncertainty on the operational cost of the project.
• The construction project – facility has to operate as planned so that the estimated benefits can be acquired.
• A late project delivery changes the income stream. This may eventually lead to missing of market opportunities, resulting eventually of minimizing the potential benefits of the project.

Uncertainty also is taken into account for the cost of the project

• The cost of the project – investment maybe be higher than expected (budget overrun).
• Late delivery of a facility (builing, railway, road e.t.c ) results in more operational costs in the existing facility (for instance old road).

Optimism Bias

Research has shown that 'there is a demonstrated systematic tendendy for project appraisers to be overly optimistic'