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Chapter 7 - Finanacial Project Apprisal
Chapter 7 - Finanacial Project Apprisal
CHAPTER 7
FINANCIAL PROJECT APPRAISAL
7.1 Understanding financial statements
Basic definitions: -
A. Assets – represents how much a company owns at a given time of reporting
usually, it is within the budget year.
Assets are divided into:-
i. Current assets – include cash at hand other assets which can easily be
converted into cash in less than a year
E.g. cash at hand, accounts receivable.
ii. Fixed assets – permanent properties which can’t be easily converted into cash
within a year
E.g. land, equipment, buildings.
iii. Other assets – include other investments and good will.
Liabilities – represents what the company owns like loans, depts.
B. Liabilities are divided into: -
i. Current liabilities – debts to be settled in a short period of time.
ii. Other liabilities – includes long term loans, performance bonds, wages, etc.
C. Stakeholders equity (capital):- represents the capital provided by owners of the
company.
D. Profit: - an earning of a given period concerned whether or not they have been
received menus the expenses of the same period whether or not they have been paid.
Important Finance Notes:-
1. The balance sheet: - is a statement which shows the financial position of the
company at the end of the reporting period. It shows assets, liabilities and capital
based on:
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AAU, FoT, Department of Civil Engineering Instructor: Abraham Assefa
CEng 572 – Construction Management Lecture Note
110 130
In order to view problems clearly, cash flow diagrams are drawn in such a way that
horizontal lines show time and vertical ones represent cash flows.
Receipts
Time
E.g. How much will be the future value of 10.00 Birr at the end of the first year if i =
10% but compounded monthly?
i 10.1 12
F12= P (F/P, ,12) = 10x (1+ ) = 11.05 birr
12 12
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AAU, FoT, Department of Civil Engineering Instructor: Abraham Assefa
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= F (P/F, i, n)
II. Uniform series cash flow
a) Calculating F knowing A, i, n
n
A A … A Multiplying both sides by (1+i)
F ((1+i-1)) = A ((1+i)n-1)
((1 + i ) n − 1) (1 + i ) n − 1
F=A Æ - Uniform series compound amount factor
i i
F = A (F/A, i, n)
E.g. What will be the future value of a deposit of 1,000 birr at the end of each year for
five years with i=10%?
F5 =A (F/A, 10%,5)
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AAU, FoT, Department of Civil Engineering Instructor: Abraham Assefa
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((1 + 10 / 100) 5 − 1)
= 1,000 = 6,105.10
10 / 100
b) Calculating A knowing F, i, n or P, i, n
⎧ (1 + i ) n − 1⎫
F=A ⎨ ⎬
⎩ i ⎭
⎧ i ⎫
A=F ⎨ ⎬ , but F = P(1+i)n
⎩ (1 + i ) n
− 1 ⎭
⎧ (1 + i )i ⎫ (1 + i ) − 1
ÆA =P ⎨ ⎬, - Uniform services present worth factor.
⎩ (1 + i ) − 1⎭
n
(1 + i )i
(1 + i ) n − 1
Or P = A
(1 + i )i
E.g. A building contractor signed a lump sum contract agreement. The terms of
payment were as follows:-
i. 2x106 birr immediately.
ii. 3x106 every year for five years (effective from the 1st year on wards)
iii. 2.5×106 every year there after for five years
If i = 10% , how much is the contract value?
Solution: - According to the payment terms the following cash flow diagram is
developed. 2.5 × 106
3 × 106
2 × 106
0 1 2 3 4 5 6 7 8 9 10
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AAU, FoT, Department of Civil Engineering Instructor: Abraham Assefa
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Where
(1 + 0.1) 5 − 1
(P/A, 10%, 5) = = 2.2201 and
(1 + 0.1) × 0.1
1
(P/F, 10%, 5) = = 0.6209
(1 + 0.1) 5
Thus,
CV = 2×106 + 3×106 ×5.550x + 2.5×106 ×5.5501 ×0.6209
CV = 27.26×106 birr
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AAU, FoT, Department of Civil Engineering Instructor: Abraham Assefa
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B) Payback Method
This method uses the number of years it takes to pay back the initial investments
from profits of the investment. It doesn’t consider the time value of money.
E.g. For a dozer purchased at a cost of 3.0×106 birr determine the pay back period if
the hourly rental rate is 900 birr/hrs and the cost for fuel, operator and maintains is
150 birr/hrs.
Solution:-
Yearly profit = (900-150) ×8×6×52 = 1,872,000
Year Cash Flow
0 -3,000,000
1 1,872,000
2 1,872,000 ÆPay Back Period = 2yrs
3 1,872,000
C) Rate of Return method
This method uses percentage of the average annual return to the initial investment as:-
E.g. If the above dozer can have a life span of four years, determine the rate of return.
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AAU, FoT, Department of Civil Engineering Instructor: Abraham Assefa
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Solution:-
S
PW costs = Ci + CSn(P/A, i ,n)
In
PW incomes = In (P/A, i, n) + S (P/F, i, n)
t
CSn Net PW= PW incomes - PW costs
Ci
E.g. Two mutually exclusive alternatives are being considered for the water supply of a
small town with a constant water demand of 2×106 m3/yr for 20yrs. Both alternatives
are equally attractive from the technical, social & political point of view.
Alternative A
The water can be supplied by a neighboring town at a price of 0.40 birr /m3
Alternative B
Water can be supplied from wells and will be treated and transported to town.
This requires a total investment of 5.5×106 birr. The investment will have a value
of 1×106 birr at the end of 20yrs period. Annual maintaince and operation costs
are 260,000 birr and remain constant during the 20 yrs period. Which
alternative is more attractive if :-
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AAU, FoT, Department of Civil Engineering Instructor: Abraham Assefa
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a) i = 4% & b) i = 12%
Solution: -
a) i= 4%
20yrs
Alt.A
0.4 ×2×106 = 800,000 birr/hr
PWA = -800,000 (P/A, 4%, 20) = -800,000 × 13.59
= -10.87 × 106 Birr
] 10 birr
1× 6
Alt B.
PWB = - 5.5 ×106 – 260,000 (P/A, 4%, 20) + 1×106 (P/F, 4%, 20)
= -5.5 × 106 – 260,000 × 13.59 + 1×106 × 0.4564
= - 9.5 × 106 Birr
Æ Alt B is better than Alt A.
CSA 3yrs
CiA
IA
Alt 2. SB
CSB 4 yrs
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AAU, FoT, Department of Civil Engineering Instructor: Abraham Assefa
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CiB
In such cases the least common multiple of their service lives is considered as
follows:-
Alt 1.
SA
SA SA SA
IA
12
3 6 9
CSA CSA
Alt 2 CiA CiA
CiA CiA
SB SB
SB
IB
12
4 8
CSB CSB
CiB CiB CiB
E.g. For the two equipments shown below, the following cash flow is developed:-
Equipment A Equipment B
Initial cost 840,000 630,000
Salvage value 63,000 105,000
Service life 9 yrs 6 yrs
The operating cost of the equipment B is 168,000 birr per annum through out its life.
Equipment A has an operating cost of 140,000 for the first 5 years and 224,000 for the
remaining 4 yrs. Which equipment would you economically acceptable? Use i= 8%
Solution: -
Equipment A: -
63,000
63,000
104 9 14
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AAU, FoT, Department of Civil Engineering 18 Assefa
Instructor: Abraham
140,000 140,000
224,000 240,000
CEng 572 – Construction Management Lecture Note
105,000 105,000
105,000
6 12
Equipment B
168,000
630,000
630,000 630,000
Equipment A: -
- PWA = 840,000 + 140,000 (P/A, 8, 5) + 224,000 (P/A, 8, 4) (P/F, 8, 5) + (840,000 –
63,000) (P/F, 8, 9) + 140,000 (P/A, 8, 5) (P/F, 8, 9) + 224,000 (P/A, 8, 4) (P/F, 8,
14) – 63,000 (P/F, 8, 18)
PWA = -2.809 × 106 birr
Equipment B: -
- PWB = 630,000 + (630,000 – 105,000) ((P/F, 8, 6) + (P/F, 8, 12)) + 168,000 (P/A, 8, 18) –
105,000 (P/F, 8, 18)
PWB = -2.718 × 106 birr
Therefore Equipment B is better than Equipment A.
e) Annual /Cost or Income /Method: - Equivalent Cost Method
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AAU, FoT, Department of Civil Engineering Instructor: Abraham Assefa
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In this case all the cash flow is converted to an equal uniform series of cost or income.
Then for mutual exclusive alternatives, the one with higher annual income or lower
annual cost will be opted.
E.g. For the water supply example solved above, make an economic comparison by
using equivalent cost method.
Soln: - Alt. A 20
Alt B.
260,000
5.5 × 106
AC = 5.5 × 106 (A/P, 4%, 20) + 260,00 - 1 × 106 (A/F, 4%, 20)
= 5.5 × 106 × 0.07358 + 260,000 - 1 × 106 × 0.03358
= 631,000 birr/hrs
∴ Alternative B is better
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AAU, FoT, Department of Civil Engineering Instructor: Abraham Assefa
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3 402.10 [
i+i2 = 0.4021 (1 + i ) 3 − 1 ]
[
i(1+i) = 0.4021 (1 + i ) 3 − 1 ]
i = 10%
Thus based on IRR = 10% the project cash flow can be studied as follows:
0 - 1,000 0 0 -1,000
1 -1,000 -100.00 402.10 -697.90
2 -697.90 -69.79 402.10 -365.59
3 -365.59 -36.56 402.10 0.00
COMPUTATION OF IRR
Pw
Æ Simple investment i
Pw
Æ Non –simple • • • i
i. Direct solution
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AAU, FoT, Department of Civil Engineering Instructor: Abraham Assefa
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This applies when either there is only two flow transaction of cash flow series or when
the projects service life doesn’t exceed 2 yrs.
10,400 12,000
B)
1 2
-16,000
10,000 12,000
PW (i) = -16,000 + + =0
(1 + i )1 (1 + i ) 2
-1.6Æ - 160%
i ∴ i = 25%
0.25 Æ 25%
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AAU, FoT, Department of Civil Engineering Instructor: Abraham Assefa
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Æ Trial PW(i)
10% 841.84
30% - 213.70
25% 0
Selection Criterion:-
IRR (B-A) > MARR - select B
IRR (B-A) < MARR - select A
IRR (B-A) = MARR - select either
iv. When alternatives are above two
Considering two at a time, the selection can be easily carried out.
E.g. Yr A B B-A MARR = 40%
0 -1,000 -1,000 -2,000
1 900 600 900
2 500 500 900
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AAU, FoT, Department of Civil Engineering Instructor: Abraham Assefa
CEng 572 – Construction Management Lecture Note
E.g. For the cost reduction alternatives given below, select the best alternative based on
IRR method. (MARR = 10%)
n A1 A2 A3 A2 - A1 A3 - A2
0 0 -10,000 -15,000 -10,000 -5,000
1 -12,000 -9,000 -9,000 3,000 0
2 -12,000 -9,000 -8,000 3,000 1,000
3 -12,000 -9,000 -7,000 3,000 2,000
4 -12,000 -9,000 -6,000 3,000 3,000
5 -12,000 -9,000 -5,000 3,000 4,000
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AAU, FoT, Department of Civil Engineering Instructor: Abraham Assefa
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7.3 Deprecation
D) Sinking fund
The common methods are Straight line deprecation and Declining balance method.
E.g. If an excavator is purchased for 3.1 × 106 and has a useful life of 5 yrs & salvage
value is 860,000, determine the deprecation & the book value for each year by using
straight line method.
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AAU, FoT, Department of Civil Engineering Instructor: Abraham Assefa
CEng 572 – Construction Management Lecture Note
This method assumes that the asset is depreciating at a constant percentage for each
year. It allows accelerated deprecation and large depreciations are considered in the
initial stage.
⎡1.25 ↔ 2.0 ⎤
Let ∝ - the declining multiplier. ÆUsually ∝ = ⎢ ⎥⎦
⎣ 5
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AAU, FoT, Department of Civil Engineering Instructor: Abraham Assefa
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Æ S = P(1-∝)n
S
∝ = 1− n
P
E.g. For the above example compute the depreciation & book value for each year
S 860,000
Æ ∝ = 1− n = 1− 5 = 0.226
P P3.1 × 10 6
∴Dn = 0.226 BV0 (1-0.226)n-1 = 0.226 × 3.1 × 106 (1-0.226)n-1
Dn = 700.60 × 103 × 0.774n-1
BVn = BV0 (1- ∝)n = 3.1 × 106 × 0.774n
7.4 Inflation
Inflation is the loss of purchasing power of money through time. its effect is to increase
the price of things.
If: - B0 – cost of item at time 0 (now)
Bn - “ “ “ n
if – average inflation rate
Then Bn = B0 (1+if)n - assuming that its price goes up at the same rate as inflation.
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AAU, FoT, Department of Civil Engineering Instructor: Abraham Assefa
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Bn
if = n −1
B0
1
Thus, a birr to day (after n year’s time) will only buy of what it will now.
(1 + i f ) n
E.g. Compute the average and annual inflation rates for the cost of commodity in three
years time.
n cost
630
Bn =B0 (1+if)n Æ if = 5 − 1 = 0.08 = 8%
500
630 = 500 (1+if)5
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AAU, FoT, Department of Civil Engineering Instructor: Abraham Assefa
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⎛ 1 ⎞
Æ But these are in 1 year on birr’s, which are only worth ⎜ ⎟ of today’s birr’s.
⎜1+ i ⎟
⎝ f ⎠
P(1 + imon )
∴ In today’s birr’s you only have
(1 + i f )
P(1 + imon )
Æ P(1+ireal) =
(1 + if )
1+imon = (1+ireal) (1+if)
1 + imon
ireal = −1
1 + if
E.g. If P = 1,000 and imon = 3% & if = 13% what will be the real interest rate?
1 + 0.03
i real = − 1 = -0.088 = -8.80%
1 + 0.13
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AAU, FoT, Department of Civil Engineering Instructor: Abraham Assefa
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n Rental received
0 60,000
1 60,000
2 60,000
3 60,000
4 60,000
How much is the present worth of the rental income if, i mon = 10% and if = 5%?
3 60,000 51,830
4 60,000 49,362
Æ PW = 60,000 + 57,143 (P/F, 10, 1) + 54,422 (P/F, 10, 2) + 51,830 (P/F, 10, 3) +
49,362(P/F, 10, 4) = 229,581.00
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AAU, FoT, Department of Civil Engineering Instructor: Abraham Assefa
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An An
Æ =
(1 + ireal ) n
(1 + imon )n (1 + i f )n
1+i real = (1+i mon) (1+if)
i real = imon + i mon x if + if
i real = imon + imon x if + if
= 0.1 + 0.1 × 0.05 + 0.05 = 0.155 = 15.5
= 60,000 + 60,000
((1 + i ) − 1) n
(1 + i )n i
= 60,000 + 60,000 ×
((1 + 0.155) − 1)
4
(1 + 0.155)4 − 0.155
= 229,580.57
˜ 229.581.00 birr
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AAU, FoT, Department of Civil Engineering Instructor: Abraham Assefa