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 costs that need to be taken into consideration for an financial appraisal of a construction project. Then, some methods of financial appraisal are presented, highlighting also the Net Present Value, which is one the most common criterion for project decision and selection. Finally, the considerations about the financial appraisal of construction are mentioned in this article, referring also to strategic misrepresentation and optimism bias, which compose challenges that lead to false financial appraisal. The financial appraisal of construction projects represents the potential benefits that they will arise after a specific project is undertaken.

Introduction

Background

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

Financial appraisal

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.

• IRR represents a rate of the profit-not a size of the profit
• IRR calculation does not require to discount rate assumption or calculation
• IRR cannot cope with the rapid changes of the discount rate over time
• IRR may not be unique as the benefit and cost increases.

If two projects have the same IRR, the NPV of the projects is compared. The project with the higher NPV is chosen. The best way for deciding or comparing different projects is the use both of the NPV and IRR together, in order to calculate both the size of and the rate of the return, respectively. However, NPV is the only criterion that ensures wealth maximazation.

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).

Challenges

Optimism Bias

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

Strategic misrepresentation of financial appraisal

Research has shown that decision-makers project managers act in bad faith when estimating financial project appraisals. Strategic misrepresentation is closely related with the NPV calculation. One of the main uses of NPV calculation is to provide a tool for choosing the most profitable project. As the NPV calculation projects cost and benefits for the project in the future, some benefits and costs are judgements not facts. Also, some benefits can be interpreted in real prices, but instead they are based in shadow pricing techniques which represent the willingness to pay for obtaining the value of a good or asset. Inevitably, it is clear that the NPV calculation is subjective, a fact that managers who want to promote certain construction projects tend to take advantage of it. Research has shown also that strategic misrepresentation is happening not only in private projects, but also in the public sector, as construction projects are intepreted as an act of collecting votes. Consequently, strategic misrepresenation are one of the major factors for budget overruns and inaccurate financial appraisals in the construction industry..

Annotated bibliography

1. Winch, G. M. (2010), "Managing Construction projects". Second edition

Summary: The book presents a holistic approach of construction management from inspection to completion. The basic principles of construction project management are presented along with different tools and techniques that aims to improve construction performance. The use of information and communication technologies is also a point of interest in the book.

2. Kerzner, H., Ph.D., (2006), "Project Management: A systems approach to planning, scheduling and controlling". Ninth edition

Summary: The book illustrates the basic principles of project management. The book is targeting for enhancing the project skills of not only students, but also executives, pointing out that project management can be related to every profession apart from engineeering, including information systems and business.

3. Maylor, H. (2010), "Project Management". Fourth Edition

Summary: