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Project Management for Construction(2)

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Project Management for Construction(2)

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    6. Economic Evaluation of Facility Investments

    6.1 Project Life Cycle and Economic Feasibility Facility investment decisions represent major commitments of corporate resources and have serious consequences on the profitability and financial stability of a corporation. In the public sector, such decisions also affect the viability of facility investment programs and the credibility of the agency in charge of the programs. It is important to evaluate facilities rationally with regard to both the economic feasibility of individual projects and the relative net benefits of alternative and mutually exclusive projects.

    This chapter will present an overview of the decision process for economic evaluation of facilities with regard to the project life cycle. The cycle begins with the initial conception of the project and continues though planning, design, procurement, construction, start-up, operation and maintenance. It ends with the disposal of a facility when it is no longer productive or useful. Four major aspects of economic evaluation will be examined:

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    1. The basic concepts of facility investment evaluation, including time preference

    for consumption, opportunity cost, minimum attractive rate of return, cash

    flows over the planning horizon and profit measures.

    2. Methods of economic evaluation, including the net present value method, the

    equivalent uniform annual value method, the benefit-cost ratio method, and

    the internal rate of return method.

    3. Factors affecting cash flows, including depreciation and tax effects, price level

    changes, and treatment of risk and uncertainty.

    4. Effects of different methods of financing on the selection of projects,

    including types of financing and risk, public policies on regulation and

    subsidies, the effects of project financial planning, and the interaction between

    operational and financial planning.

    It is important to distinguish between the economic evaluation of alternative physical facilities and the evaluation of alternative financing plans for a project. The former refers to the evaluation of the cash flow representing the benefits and costs associated with the acquisition and operation of the facility, and this cash flow over the planning horizon is referred to as the economic cash flow

    or the operating cash flow. The latter refers to the evaluation of the cash flow representing the incomes and expenditures as a result of adopting a specific

    financing

    plan for funding the project, and this cash flow over the planning horizon is referred to as the financial cash flow. In general, economic evaluation and

    financial evaluation are carried out by different groups in an organization since economic evaluation is related to design, construction, operations and maintenance of the facility while financial evaluations require knowledge of financial assets such as equities, bonds, notes and mortgages. The separation of economic evaluation and financial evaluation does not necessarily mean one should ignore the interaction of different designs and financing requirements over time which may influence the relative desirability

    of specific design/financing combinations. All such combinations can be duly considered. In practice, however, the division of labor among two groups of specialists generally leads to sequential decisions without adequate communication for analyzing the interaction of various design/financing combinations because of the timing of separate analyses.

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    As long as the significance of the interaction of design/financing combinations is understood, it is convenient first to consider the economic evaluation and financial evaluation separately, and then combine the results of both evaluations to reach a final conclusion. Consequently, this chapter is devoted primarily to the economic evaluation of alternative physical facilities while the effects of a variety of financing mechanisms will be treated in the next chapter. Since the methods of analyzing economic cash flows are equally applicable to the analysis of financial cash flows, the techniques for evaluating financing

    plans and the combined effects of economic and financial cash flows for project selection are also included in this chapter.

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    6.2 Basic Concepts of Economic Evaluation A systematic approach for economic evaluation of facilities consists of the following major steps:

    1. Generate a set of projects or purchases for investment consideration.

    2. Establish the planning horizon for economic analysis.

    3. Estimate the cash flow profile for each project.

    4. Specify the minimum attractive rate of return (MARR).

    5. Establish the criterion for accepting or rejecting a proposal, or for selecting the

    best among a group of mutually exclusive proposals, on the basis of the

    objective of the investment.

    6. Perform sensitivity or uncertainty analysis.

    7. Accept or reject a proposal on the basis of the established criterion. It is important to emphasize that many assumptions and policies, some implicit and some explicit, are introduced in economic evaluation by the decision maker. The decision making process will be influenced by the subjective judgment of the management as much as by the result of systematic analysis.

    The period of time to which the management of a firm or agency wishes to look ahead is referred to as the planning horizon. Since the future is uncertain,

    the period of time selected is limited by the ability to forecast with some degree of accuracy. For capital investment, the selection of the planning

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    horizon is often influenced by the useful life of facilities, since the disposal of usable assets, once acquired, generally involves suffering financial losses. In economic evaluations, project alternatives are represented by their cash flow profiles over the n years or periods in the planning horizon. Thus, the interest periods are normally assumed to be in years t = 0,1,2, ...,n with t = 0

    representing the present time. Let B be the annual benefit at the end of year t,x

    t for a investment project x where x = 1, 2, ... refer to projects No. 1, No. 2, etc., respectively. Let C be the annual cost at the end of year t for the same t,x

    investment project x. The net annual cash flow is defined as the annual benefit in excess of the annual cost, and is denoted by A at the end of year t t,x

    for an investment project x. Then, for t = 0,1, . . . ,n:

    (6.1)

    where A is positive, negative or zero depends on the values of B and C, t,xt,xt,x

    both of which are defined as positive quantities.

    Once the management has committed funds to a specific project, it must forego other investment opportunities which might have been undertaken by using the same funds. The opportunity cost reflects the return that can be

    earned from the best alternative investment opportunity foregone. The foregone opportunities may include not only capital projects but also financial investments or other socially desirable programs. Management should invest in a proposed project only if it will yield a return at least equal to the minimum attractive rate of return (MARR) from foregone opportunities as envisioned by the organization.

    In general, the MARR specified by the top management in a private firm reflects the opportunity cost of capital of the firm, the market interest rates for

    lending and borrowing, and the risks associated with investment opportunities. For public projects, the MARR is specified by a government agency, such as the Office of Management and Budget or the Congress of the United States.

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    The public MARR thus specified reflects social and economic welfare considerations, and is referred to as the social rate of discount.

    Regardless of how the MARR is determined by an organization, the MARR specified for the economic evaluation of investment proposals is critically important in determining whether any investment proposal is worthwhile from the standpoint of the organization. Since the MARR of an organization often cannot be determined accurately, it is advisable to use several values of the MARR to assess the sensitivity of the potential of the project to variations of the MARR value.

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    6.3 Costs and Benefits of a Constructed Facility The basic principle in assessing the economic costs and benefits of new facility investments is to find the aggregate of individual changes in the welfare of all parties affected by the proposed projects. The changes in welfare are generally measured in monetary terms, but there are exceptions, since some effects cannot be measured directly by cash receipts and disbursements. Examples include the value of human lives saved through safety improvements or the cost of environmental degradation. The difficulties in estimating future costs and benefits lie not only in uncertainties and reliability of measurement, but also on the social costs and benefits generated as side effects. Furthermore, proceeds and expenditures related to financial transactions, such as interest and subsidies, must also be considered by private firms and by public agencies.

    To obtain an accurate estimate of costs in the cash flow profile for the acquisition and operation of a project, it is necessary to specify the resources required to construct and operate the proposed physical facility, given the available technology and operating policy. Typically, each of the labor and material resources required by the facility is multiplied by its price, and the products are then summed to obtain the total costs. Private corporations

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    generally ignore external social costs unless required by law to do so. In the public sector, externalities often must be properly accounted for. An example is the cost of property damage caused by air pollution from a new plant. In any case, the measurement of external costs is extremely difficult and somewhat subjective for lack of a market mechanism to provide even approximate answers to the appropriate value.

    In the private sector, the benefits derived from a facility investment are often measured by the revenues generated from the operation of the facility. Revenues are estimated by the total of price times quantity purchased. The depreciation allowances and taxes on revenues must be deducted according to the prevailing tax laws. In the public sector, income may also be accrued to a public agency from the operation of the facility. However, several other categories of benefits may also be included in the evaluation of public projects. First, private benefits can be received by users of a facility or service in excess of costs such as user charges or price charged. After all, individuals only use a service or facility if their private benefit exceeds their cost. These private benefits or consumer surplus represent a direct benefit to members of

    the public. In many public projects, it is difficult, impossible or impractical to charge for services received, so direct revenues equal zero and all user benefits appear as consumers surplus. Examples are a park or roadways for which entrance is free. As a second special category of public benefit, there may be external or secondary beneficiaries of public projects, such as new jobs created and profits to private suppliers. Estimating these secondary benefits is extremely difficult since resources devoted to public projects might simply be displaced from private employment and thus represent no net benefit.

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    6.4 Interest Rates and the Costs of Capital Constructed facilities are inherently long-term investments with a deferred pay-off. The cost of capital or MARR depends on the real interest rate (i.e.,

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    market interest rate less the inflation rate) over the period of investment. As the cost of capital rises, it becomes less and less attractive to invest in a large facility because of the opportunities foregone over a long period of time. In Figure 6-1, the changes in the cost of capital from 1955 to 1985 are illustrated. This figure presents the market interest rate on a 20-year treasury bond, and the corresponding real interest rate over this period. The real

     is calculated as the market interest rate less the general rate of interest rate

    inflation. During the last decade in this figure, the real interest rate has varied substantially, ranging from 10% to -4%. The exceptional nature of the 1980 to 1985 years is dramatically evident: the real rate of interest reached remarkably high historic levels.

    Figure 6-1 Nominal and Real Interest Rates on U.S. Bonds, 1955-1985

    (Reprinted by permission of the Wall Street Journal, ? Dow Jones &

    Company, Inc. 1985. All rights reserved.)

    With these volatile interest rates, interest charges and the ultimate cost of projects are uncertain. Organizations and institutional arrangements capable of dealing with this uncertainty and able to respond to interest rate changes effectively would be quite valuable. For example, banks offer both fixed rate and variable rate mortgages. An owner who wants to limit its own risk may choose to take a fixed rate mortgage even though the ultimate interest charges may be higher. On the other hand, an owner who chooses a variable rate mortgage will have to adjust its annual interest charges according to the market interest rates.

    In economic evaluation, a constant value of MARR over the planning horizon is often used to simplify the calculations. The use of a constant value for MARR is justified on the ground of long-term average of the cost of capital

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    over the period of investment. If the benefits and costs over time are expressed in constant dollars, the constant value for MARR represents the average real interest rate anticipated over the planning horizon; if the benefits and costs over time are expressed in then-current dollars, the constant value for MARR reflects the average market interest rate anticipated over the planning horizon.

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    6.5 Investment Profit Measures

    A profit measure is defined as an indicator of the desirability of a project from the standpoint of a decision maker. A profit measure may or may not be used as the basis for project selection. Since various profit measures are used by decision makers for different purposes, the advantages and restrictions for using these profit measures should be fully understood.

    There are several profit measures that are commonly used by decision makers in both private corporations and public agencies. Each of these measures is intended to be an indicator of profit or net benefit for a project under consideration. Some of these measures indicate the size of the profit at a specific point in time; others give the rate of return per period when the capital is in use or when reinvestments of the early profits are also included. If a decision maker understands clearly the meaning of the various profit measures for a given project, there is no reason why one cannot use all of them for the restrictive purposes for which they are appropriate. With the availability of computer based analysis and commercial software, it takes only a few seconds to compute these profit measures. However, it is important to define these measures precisely:

    1. Net Future Value and Net Present Value. When an organization makes an investment, the decision maker looks forward to the gain over a planning horizon, against what might be gained if the money were invested elsewhere. A minimum attractive rate of return (MARR) is adopted to reflect this

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    opportunity cost of capital. The MARR is used for compounding the estimated cash flows to the end of the planning horizon, or for discounting the cash flow to the present. The profitability is measured by the net future value (NFV) which is the net return at the end of the planning horizon above what might have been gained by investing elsewhere at the MARR. The net present value (NPV) of the estimated cash flows over the planning horizon is the discounted value of the NFV to the present. A positive NPV for a project indicates the present value of the net gain corresponding to the project cash flows. 2. Equivalent Uniform Annual Net Value. The equivalent uniform annual net value (NUV) is a constant stream of benefits less costs at equally spaced time periods over the intended planning horizon of a project. This value can be calculated as the net present value multiplied by an appropriate "capital recovery factor." It is a measure of the net return of a project on an annualized or amortized basis. The equivalent uniform annual cost (EUAC) can be obtained by multiplying the present value of costs by an appropriate capital recovery factor. The use of EUAC alone presupposes that the discounted benefits of all potential projects over the planning horizon are identical and therefore only the discounted costs of various projects need be considered. Therefore, the EUAC is an indicator of the negative attribute of a project which should be minimized.

    3. Benefit Cost Ratio. The benefit-cost ratio (BCR), defined as the ratio of discounted benefits to the discounted costs at the same point in time, is a profitability index based on discounted benefits per unit of discounted costs of a project. It is sometimes referred to as the savings-to-investment ratio (SIR) when the benefits are derived from the reduction of undesirable effects. Its use also requires the choice of a planning horizon and a MARR. Since some savings may be interpreted as a negative cost to be deducted from the denominator or as a positive benefit to be added to the numerator of the ratio, the BCR or SIR is not an absolute numerical measure. However, if the ratio of the present value of benefit to the present value of cost exceeds one, the project is profitable irrespective of different interpretations of such benefits or costs.

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    4. Internal Rate of Return. The internal rate of return (IRR) is defined as the discount rate which sets the net present value of a series of cash flows over the planning horizon equal to zero. It is used as a profit measure since it has been identified as the "marginal efficiency of capital" or the "rate of return over cost". The IRR gives the return of an investment when the capital is in use as

    if the investment consists of a single outlay at the beginning and generates a stream of net benefits afterwards. However, the IRR does not take into consideration the reinvestment opportunities related to the timing and intensity of the outlays and returns at the intermediate points over the planning horizon. For cash flows with two or more sign reversals of the cash flows in any period, there may exist multiple values of IRR; in such cases, the multiple values are subject to various interpretations.

    5. Adjusted Internal Rate of Return. If the financing and reinvestment policies are incorporated into the evaluation of a project, an adjusted internal rate of return (AIRR) which reflects such policies may be a useful indicator of profitability under restricted circumstances. Because of the complexity of financing and reinvestment policies used by an organization over the life of a project, the AIRR seldom can reflect the reality of actual cash flows. However, it offers an approximate value of the yield on an investment for which two or more sign reversals in the cash flows would result in multiple values of IRR. The adjusted internal rate of return is usually calculated as the internal rate of return on the project cash flow modified so that all costs are discounted to the present and all benefits are compounded to the end of the planning horizon. 6. Return on Investment. When an accountant reports income in each year of a multi-year project, the stream of cash flows must be broken up into annual rates of return for those years. The return on investment (ROI) as used by accountants usually means the accountant's rate of return for each year of the project duration based on the ratio of the income (revenue less depreciation) for each year and the undepreciated asset value (investment) for that same year. Hence, the ROI is different from year to year, with a very low value at the early years and a high value in the later years of the project.

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