Construction Financial

Management

5: Investment and
Development
Appraisal

School of The Built Environment

Investment and
Development Appraisal

 Investment appraisal techniques

 Development appraisal techniques

Investment appraisal
techniques
 Which proposed scheme is the most economical or
profitable?

 Are any of the proposed schemes profitable enough?

Investment appraisal
techniques

 Economic comparisons
 Present worth.
 Equivalent annual cost.
 Profitability measures
 Payback period method.
 Rate of return method.
 Net present value (NPV).
 Internal rate of return (IRR).
Example
 Start of Scheme A Scheme B
 Year1 -£100,000 -£100,000
 Year2 +£40,000 + £4,000
 Year3 +£40,000 + £5,000
 Year4 +£20,000 + £10,000
 Year5 +£30,000 +£120,000

 Total +30,000 +39,000

Taking into account
interest
(e.g. 10%)
 Start of Scheme A Scheme B
 Year1 0 0
 Year2 +£4,000 +£400
 Year3 +£8,400 +£940
 Year4 +£11,240 +£2,034
 Year5 End End

 Total £23,640 £3,374
 Add to £30,000 £39,000
 £53,640 £42,374
Investment appraisals using
tables and formulae
 1- Compound amounts

(1  i)
 Factor = n

 If 1,000 is invested for some years, say 5, at an interest rate of 10%, the amount
that can be withdrawn at the end is:

1,000 x 1.6105 = 1610.50

Interest table for 10%

Year or period Compound Present Compound Sinking Present Capital

Amoun value amount fund worth recov
t of a of a of a deposi of a ery
single single unifor t unifor
sum sum m m
series series
1 1.100 0.909 1.000 1.000 0.909 1.100
2 1.210 0.826 2.100 0.476 1.736 0.576
3 1.331 0.751 3.310 0.302 2.487 0.402
4 1.464 0.683 4.641 0.215 3.170 0.315
5 1.611 0.621 6.105 0.164 3.791 0.264
6 1.772 0.564 7.716 0.130 4.355 0.230
7 1.949 0.513 9.487 0.105 4.868 0.205
8 2.144 0.467 11.436 0.087 5.335 0.187

9 2.358 0.424 13.579 0.074 5.759 0.174

10 2.594 0.386 15.937 0.063 6.145 0.163

Interest table for 15%

Year or period Compoun Present Compoun Sinking Present Capital

d Amount value of a d amount fund worth of recovery
of a single of a deposit a uniform
single sum uniform series
sum Series
1 1.150 0.870 1.000 1.000 0.870 1.150
2 1.323 0.756 2.150 0.465 1.626 0.615
3 1.521 0.658 3.473 0.288 2.283 0.438
4 1.749 0.572 4.993 0.200 2.855 0.350
5 2.011 0.497 6.742 0.148 3.352 0.298
6 2.313 0.432 8.754 0.114 3.784 0.264
7 2.660 0.376 11.067 0.090 4.160 0.240

8 3.059 0.327 13.727 0.073 4.487 0.223

9 3.518 0.284 16.786 0.060 4.772 0.210

10 4.046 0.247 20.304 0.049 5.019 0.199

Present worth
1
 Factor =
(1  i) n
 This is the inverse of the compound amount. If a sum of 1610.50
is required in 5 years, what amount has to be invested today to
generate this amount if interest is 10%?

 1.610.50 x 0.62092 = 1,000

 1,000 is called the present worth of 1,610.50 in year 5.

Compound amount of
a regular series
(1  i) n  1
 Factor =
i

 This factor gives the amount generated by investing a regular

sum each period for a specified number of periods at a given
rate.

 Thus investing 100 each year for six years at an annual rate of
15% will generate a total amount of 875.30;

 100 x 8.753 = 875.30.

Sinking fund deposit
i
 Factor =
(1  i ) n  1

 This factor calculates the amount needed to be invested each

period in order to generate a specified amount at some future
date.

 For example, if 500 was owed in 5 years time, the amount that
would have to be deposited each year is 81.90 provided 10%
can be obtained.

 500 x 0.16379 = 81.90

Present worth of a
regular series
(1  i ) n  1
 Factor =
i (1  i ) n
 The present worth of 100 each year for 5 years given an interest
rate of 15% is 335.21.

 100 x 3.3521 = 335.21

 That is 335.21 is the equivalent today of 100 each year for the
next five years; or 335.21 is the amount needed to be invested
today to pay 100 each year over the next 5 years.
Capital recovery

 Factor = i (1  i )
n

(1  i )  1
n

 This factor calculates the amount to be recovered each period

from an investment in order that the invested capital and a
specified return can be recovered. If 500 is invested the amount
that must be recovered each year for the next five years to
ensure a return of 10% is 131.90.

 500 x 0.26379 = 131.90

Present worth
comparisons
Example 12
 Consider Scheme 1 and 2 and the cash flows estimated at
today’s prices pertaining to buying and operating an item of
equipment.

Scheme 1 Scheme 2
Initial cost £5,000 £4,000
Running cost £ 500 pa £ 800 pa
Life 6 years 6 years

 If interest rates are 10% which of the two schemes is the most
economical?
Solution

Scheme 1
Present worth = £5,000 + £500 (4.3552)
= £7177.60
Scheme 2
Present worth = £4,000 + £800 (4.3552)
= £7484.16
Example 13
 Compare Scheme 1 from above and Scheme 3 below.

Scheme 3
Initial cost £3,000
Running cost £ 500 pa
Life 3 years
Solution
The present worth of Scheme 3
£3,000 + £500 (2.4868) = £4243.40

The present worth of scheme 3 and its replacement

£4,243.40 + £4,243.40 (0.75131) = £7,431.51

Example 14
Buying Hiring
Initial cost £8,000
Running cost £ 800 pa £2,100 pa
Life 7 years

PW of buying = £8,000 + £800 (4.8684) = £1 1,894.72

PW of hiring = £2,100 (4.8684) = £10,223.64
Equivalent annual cost
 Using Scheme 1 (example 12) the equivalent annual cost is:

 £500 + £5,000 (0. 2296) = £ 1,648

 Scheme 2 £800 + £4,000 (0.2296) = £1,718.40

 Scheme 3 £500 + £3,000 (0.4021 1) = £ 1,706.33
Example 14 cont’
 Equivalent annual cost of buying
£800 + £8,000 (0.2054) = £2,443.20

 Equivalent annual cost of hiring = £2,100

Payback period method
Project A Project B
Investment £15,000 £20,000
Cast inflows (£)
Year 1 4,000 8,000
Year 2 8,000 13,000
Year 3 3,000 5,000
Year 4 3,000 0
Year 5 3,000 0
Total cash inflows £21,000 £26,000
Payback period 3 years 2 years
 Rate of return method
from previous example:
Project A
Average profit: £21,000-£15,000 = £1,200
5 years
Return on the investment :
£1,200 x 100% = 8%
£15,000
Project B
Return on the investment :
£2,000 x 100% = 10%
£20,000
 Net present worth
(NPW)
Consider the cash flows of two proposed projects:

Project 1 Project 2
Cash flow Cash flow
Year (£) Year (£)
0 -4000 0 -4000
1 +2000 1 +1700
2 +2000 2 +1700
3 +2000 3 +1700

If the criterion rate is 15%:

NPW for Project 1 = +£566.40

NPW for Project 2 = -£1 18.56
 Internal rate of return
(IRR) or discount cash
flow yield (DCF yield)
First trial Second
trial
Projects’ PW factors PW factors
cash flow at 9% PW at 11% PW
Year £ £ £
0 -1000 1.00 -1000 1.00 -1000.00
1 +400 0.917 366.80 0.900 360.00
2 +400 0.841 336.40 0.811 324.40
3 +400 0.772 308.80 0.731 292.40

Net present worth +12.00 -23.20

Interpolating between 9% and 11 % gives the interest rate which results in a net
present worth of zero.

DCF yield = 9.68 %

 Calculating an
economic hire rate
An excavator, crawler mounted, 1.5m3 capacity, is purchased new for £46,000. Its
estimated life is 10 years, with a resale value of £4,000.

Capital cost £46,000

Resale value £4,000
Anticipated life 10 years
Insurance premium £200 per year
Road tax and licenses £100 per year
Maintenance 10% of capital cost
Consumables £400 per year
Overheads £2 per hour
Required rate of return on investment 15% per year
Budgeted operating 2000 hours per year
Transport charges Say £100
Solution
Capital recovery for 42,000 for 10 years is

42,000 x 0.199 = £8,358

For the £4,000, only interest needs to be recovered therefore,

4000 x 0.15 = £600

Fixed overheads = £2 x 2000 hours = £4000

Road tax and licenses = £100
Insurance = £200
Total ownership cost £13,258

Consumables = £400
Maintenance (10% of 46,000) = £4,600
Operating cost = £5,000

Total cost = £18,258

Hire charge 18,258/2000 £9.13, plus a fixed amount for

transport of 100 per contract
 Replacement age of
plant
The purchase price of a small electricity generating plant is £20,000. The operating
costs based on the annual average estimated hours of operation are £800 in the
first year, when manufacturers' warranties operate, and £ 1,200 in the second year,
rising by £300 each year thereafter. The resale value of the plant can be assumed
to be as predicted in the Table below. The cost of capital is 15%. Calculate the
optimum replacement age.

Year Predicted resale value

1 £18,000
2 £16,000
3 £15,000
4 £12,000
5 £8,000
6 £5,000
7 £2,000
 Solution
Option 2 years:

Present worth = -20,000 – 800 (0.869) – 1,200 (0.750) + 16,000 (0.750)

= - 9595

Equivalent annual cost = -9595 (0.615)

= -5900.9

Option 3 years:

Present worth = -20,000 – 800 (0.869) – 1,200 (0.750) – 1500 (0.657) + 15,000
(0.657)
= -12,725

Equivalent annual cost = -12,725 (0.437)

= -5,560.83 (which is less)
The residual method of
valuing construction
projects

The basic residual valuation method is:

Value of completed development (GDV)

Less Total expenditure cost
Equals Value of site or property in its present
condition (residual value)
Example 24 A simple
residual valuation
calculation

 You have been asked to value the development potential of a proposed

four-storey office building 3220m2 gross external area (2900m2 NIA)
with 55 car parking spaces. It is located in the centre of a busy city.

Building costs £2475000

(prepared by quantity surveyors from architect’s plans)
Finance 16%
Rent £150/m2
Yield 9%
Development period 12 months
Your valuation is:
Value of completed development
FRV £435,000
1/yield = YPperp @ 9% 11.11
Capital value (GDV) £4,833,333

Less Total expenditure costs

Building costs £2,475,000
Professional fees @ 10% £247,500
Voids and contingencies @ 5% £123,750
Advertising, marketing & sale fees @ £386,667
8%
Developers profit @ 15% £725,000
£3,957,917
Finance @ 16% £316,633
Residual value £558,783

Interest and fees on site acquisition

Interest @ 16 % for 12 months
Total amount available for land £558,783
acquisition
PV of £1 @ 16% for 1 year 0.8621
Amount for site acquisition (before interest) £481,727
Fees @ 4% of Amount for site acquisition £19,269
Site value £462,458
Development
valuations using
discounted cash flows
Summary of results
Sales £4,833,33
3
less advertising, marketing & sale £386,667
fees
Total income £4,446,66
6
Construction £2,475,00
0
Voids & contingencies £123,750
Professional fees £247,500
Total interest £212,801
Developer's profit £725,000
Total costs £3,784,05
1

Balances available for land £662,615

PV £1 @ 16% for 1 year 0.8621
total acquisition cost £571,240
Less purchase fees @ 0.04 £22,850
Site value £548,39
1