Construction Economics

Dr. D A Patel
dap@ced.svnit.ac.in

Civil Engineering Department

Sardar Vallabhbhai National Institute of Technology
SURAT-395007
1
 Contents

3.1 Introduction
3.2 Economic decision-making
3.3 Time value of money
3.4 Cash-flow diagrams
3.5 Using interest tables
3.6 Evaluating alternatives by equivalence
3.7 Effect of taxation on comparison of Alternatives
3.8 Evaluation of public projects: discussion on
Benefit-cost ratio
 3.1 Introduction

 Construction Economics: Allocation of scarce resources

profitably
 Construction Finance: Allocation of financial resources
profitably
 3.2 Economic decision making

Common evaluation methods when time value of money is

not considered are:
1. Out of Pocket Commitment
2. Pay Back Period
3. Average Annual Rate of Return
 3.3 Time value of money

 The real worth of a certain amount of money is not invariant

on account of factors such as inflation, dynamic interactions
between demand and supply, etc.
 Time value of money is a simple concept, which accounts for
variations in the value of a sum of money over time.
3.3 Time value of money (Contd…)
 Interest
 Simple and compound
 We consider compound interest for our purposes.
 Example: Interest on the deposit will be payable at the rate
of 8% compounded quarterly.
 8% represents Nominal Interest
 Quarterly means interest is added to principal every
quarter i.e. three months.
 Rs 100 becomes 108.24 in a year. 8.24% is the effective
interest.

m
 inom 
ieff  [ 1    1]  100
 m  100 
3.4 Cash Flow Diagram

Figure 3.1 Typical Cash Flow Diagram

3.4.1 Revenue dominated cash flow
diagram

Figure 3.2
3.4.2 Cost dominated cash flow
diagram

Figure 3.3
3.4.3 Project Cash-Flow & Company
Cash-Flow Diagrams
 The project cash flow is basically a graph (pictorial
representation) of receipts and disbursements versus time.
 The gross bill value and its time of submission
 Measurement period – It is usual for the contractors to be
paid on a monthly basis. The payment can be made
fortnightly or sometimes bimonthly as well. These
conditions can be found under ‘terms of payment’ given in
the tender document.
 Certification time taken by the owner – In normal
conditions owner takes about 3-4 weeks time to process the
bill and release the payment to the constructor or contractor.
 The retention money deducted by the owner and the time to
release the retention money.
 3.4.3.1 Project Cash-Flow

 The mobilization advance, plant & equipment advance, and

material advance & the terms of their recovery.
 The details of cost incurred by the contractor for raising a
particular bill value. This break up of cost should be in terms
of labour cost, materials cost, plant & equipment cost,
subcontractors cost, and project overheads.
 The credit period (delay between incurring a cost and the
actual time at which the cost is reimbursed) enjoyed by the
contractor in meeting the cost towards labour, materials, plant
& equipment, and overheads.
3.4.3.2 Factors affecting project
cash flow
 Advances such as mobilization advance, etc.
 The margin in a project,
 Retention,
 Extra claims,
 Distribution of margin such as front loading or back loading;
 Certification type such as over-measurement and under-
measurement,
 Certification period,
 Credit arrangement of the contractor with labour, material, and
plant & equipment suppliers, and other subcontractors.
3.4.4 Company Cash-Flow Diagram

 Head office outgoings such as rents, electricity charges,

water charges, telephone and tax bills, hire charges for
office equipments, payment to shareholders, taxes, etc.
 Head office incomings such as claims made in past
projects, realization of retention money not settled for
past projects, etc.
 The company cash-flow diagram is an aggregation (sum)
of all the outgoings and incomings for all the projects that
the company is executing, besides the head office
outgoings and incomings.
3.4.4.1 Using Cash-Flow Diagrams

 Determine Capital Lock Up

 Determine the cash requirement for a project
 Equivalence of Alternatives
 Formulations for interest computations
 3.4.5 Captim
 A measure of the interest payable is obtained by calculating
area between cash-out and cash-in.
 The area under negative cash flow period is used to calculate
the financing charges for the project by contractor.
 The total area would have a unit of Rs x Months and is also
known as Captim, standing for capital x time.
 Interest on capital required for the project = (Captim in Rs
Month x interest charges per annum)÷12
 For a captim value of Rs 10,000 Month, and the interest rate =
12% per annum; the interest charges for financing the project
would be Rs 100.
 3.4.6 Equivalence of Alternatives

 In economic comparisons, very often there are situations

wherein a comparison has to be made between alternatives,
involving payments (or receipts) of different amounts of
money at different points in time.
 Drawing cash-flow diagrams makes such comparisons easy to
understand. The principle used is that of equivalence, which
reduces different alternatives to a common baseline.
3.4.7 Formulations for interest
computations
 3.5 Using Interest Tables
10% interest factors

n F/p, I, n P/F, I , n F/A, I, n A/F, I , n P/A, I ,n A/P, I, n A/G, I, n

1 1.100 0.9091 1.000 1.0000 0.9091 1.1000 0.0000
2 1.210 0.8264 2.100 0.4762 1.7355 0.5762 0.4762
3 1.331 0.7513 3.310 0.3021 2.4869 0.4021 0.9366
4 1.464 0.6830 4.641 0.2155 3.1699 0.3155 1.3812
5 1.611 0.6209 6.105 0.1638 3.7908 0.2638 1.8101
6 1.772 0.5645 7.716 0.1296 4.3553 0.2296 2.2236
7 1.949 0.5132 9.487 0.1054 4.8684 0.2054 2.6216
8 2.144 0.4665 11.436 0.0874 5.3349 0.1874 3.0045
9 2.358 0.4241 13.579 0.0736 5.7590 0.1736 3.3724
10 2.594 0.3855 15.937 0.0627 6.1446 0.1627 3.7255
 3.6 Evaluating alternatives by
equivalence

1. Present Worth Comparison

2. Rate of Return Method
3. Future Worth Comparison
4. Annual Cost and Worth Method
5. Prospective Value Method
 3.6.1 Present Worth Comparison
Types of problems in Present Worth Analysis

Figure 3.4
 3.6.2 Rate of Return Method
 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:
1. MARR (Minimum Attractive Rate of Return),
2. IRR (Internal Rate of Return),
3. IRoR (Incremental Rate of Return), and
4. ERR (External Rate of Return)
3.6.2.1 Cash Flow to illustrate IRR

Figure 3.5
3.6.2.1.1 Steps for computing IRR
1. Assume a trial rate of return (i*).
2. Find equivalent net worth of all costs and incomes.
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
trial rate, and vice versa.
4. Adjust the estimate of 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.
5. Solve for applicable value of i* by interpolation.
3.6.2.2 Steps involved in Incremental
Analysis
1. List out all alternatives in ascending order of their first cost
or initial investment. It may be pointed out here that in most
cases, alternatives with lowest investment are likely to turn
out to be ‘do nothing’ alternative.
2. Compare the rate of return of all alternatives with the
assumed MARR, and check if rate of return is at least equal
to MARR or not. If not, the alternative is dropped and not
considered in further analysis.
3. Prepare the cash flow diagram on incremental basis between
the alternatives, which is being examined, and the current
alternative (to begin with, we have taken alternative with the
lowest initial investment).
3.6.2.2 Steps involved in Incremental
Analysis (Contd…)
4. In case, rate of return is less than MARR, the alternative
under examination is ruled out and the current alternatives
remains a lucrative one. The current best is compared to
the next higher investment.
5. When an alternative, which has just been examined is
acceptable (rate of return is more than MARR), it
becomes the current best, replacing the earlier one. The
new best is examined with the next higher investment
alternative.
6. The process mentioned through steps 1 to 5 is repeated till
all the alternatives have been looked into and the best
alternative is selected.
3.7 Effect of taxation on comparison
of alternatives
S. No Item $ A B Comments

1 Gross earnings 150 150

2 Admissible expenses 50 25
(AE)

3 Pre-tax profits 100 125 (1) – (2) *

4 Tax payable 40 50 40 % of (3)
5 Net profit 60 75 (3) – (4)

Table 3.2
3.8 Evaluation of Public Projects

 Public projects here mean those, which are funded by

Government (State or Centre)
 The Government has a responsibility towards public welfare.
Some examples of Public projects are:
 Dams
 Defense projects
 Highways
 Education
 Health
 Unlike private projects, many Government projects cannot be
evaluated strictly in commercial terms. Profit, taxes, payoff
periods take a back seat in public projects.
 3.8.1 Benefit-Cost Ratio
 One of the most commonly used criteria to evaluate public
projects is Benefit-Cost Ratio (B/C).
 B/C ratio is defined as the ratio of benefit to public and cost to
Government.
 B/C ratio can be obtained using PW analysis, FW Method and
AE method.
 Due care is required to determine the numerator &
denominator, since some confusion may arise in a problem.
 However, if the definition is clearly understood, the ratio can
be correctly obtained. When comparisons of several
alternatives are to be made, basis of incremental analysis
should be made.