ECONOMIC ASSESSMENTS OR

INVESTMENT APPRAISAL TECHNIQUES

TCC 6103: CONSTRUCTION ECONOMICS
AND FINANCE

Dr. Muhumuza John Kakitahi

 ECONOMIC ASSESSMENTS OR
INVESTMENT APPRAISAL TECHNIQUES
These techniques seek to answer:
1. What is the most economic alternative?
2. Which alternative is pro table enough?

Examples of these techniques include:

1. Discounted Cash Flow (DCF) Yield
2. Present Worth and Future Worth
3. Equivalent Annual Costs
4. Bene t - Cost Ratio / Cost Bene t Analysis
5. Rate of Return (Types?)
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DISCOUNTED CASH FLOW

➤ Discounted Cash Flow (DCF) is a technique used to estimate the value of an investment
based on its expected future cash ows - the PW of future cash ows!!
➤ DCF analysis computes NPV takes as input; cash ows, discount rate and gives a price:
the opposite process takes; cash ows, price and infers a discount rate called the yield.
➤ DCF Yield is the interest/discount rate r which, if used to discount all cash ows CF,
would produce a net present worth of zero.
➤ The DCF Formula is:
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DCF Yield

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PRESENT WORTH
➤ Typically, the Present Worth (PW) technique is used for comparison of two or more
alternatives / schemes, each with di erent initial investment and running costs.
➤ Consider the following Schemes 1, 2 and 3 and the cash ows at today’s prices
related to buying and operating a piece of contractor equipment.

Scheme 1 Scheme 2 Scheme 3

Initial Investment USh 75,000,000 USh 50,000,000 USh 35,000,000

Annual Running Costs USh 6,000,000 USh 12,000,000 USh 8,000,000

Life (Years) 6 6 3

Note: The above are uniform-series cash flows!

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 PRESENT WORTH (CONTINUED)

➤ Note the di erence between Scheme 3 and both Schemes 1 and 2 - Life (Years).
➤ Also, PW = Initial Investment + NPV (Running Cost; interest rate i; duration n)
➤ If interest rate is 10%, PW of Schemes 1 and 2 are:
1. Scheme 1: PW = 75M + NPV (6M; 10%; 6years) = 75M + [6M x 1/0.22961]
[See Pg 149 Schaum’s Outlines for inverse of A/P (10%, 6years)] = 101.13M
2. Scheme 2: PW = 50M + NPV (12M; 10%; 6years)= 50M + [12M x 1/0.22961]
[See Pg 149 Schaum’s Outlines for inverse of A/P (10%, 6years)] = 102.26M

3. Scheme 3: PW = 35M + NPV (8M; 10%; 3years) = 35M + [8M x 1/0.40211]

[See Pg 149 Schaum’s Outlines for inverse of A/P (10%, 3years)] = 54.90M

** Note: Scheme 3 is for 3 years and will require replacement. What is the PW of Scheme 3 and its replacement? 96.15M?
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EQUIVALENT ANNUAL COSTS

➤ Typically, the Equivalent Annual Cost (EAC) comparisons are based on calculating the
equivalent capital cost each year of a project / scheme / alternative.
➤ Consider the earlier discussed Schemes 1, 2 and 3 related to contractor equipment.
➤ EAC = Annual Running Cost + NPV (Initial Cost; interest rate i; duration n)
1. Scheme 1: EAC = 6M + NPV (75M; 10%; 6years) = 6M + [75M x 0.22961]
[See Pg 149 Schaum’s Outlines for A/P (10%, 6years)] = 23.22M
2. Scheme 2: EAC = 12M + NPV (50M; 10%; 6years)= 12M + [50M x 0.22961]
[See Pg 149 Schaum’s Outlines for A/P (10%, 6years)] = 23.48M

3. Scheme 3: EAC = 8M + NPV (35M; 10%; 3years) = 8M + [35M x 0.40211]

[See Pg 149 Schaum’s Outlines for A/P (10%, 3years)] = 22.07M
** Note: Even if Scheme 3 gets a replacement, the EAC will still be 22.07M!

 BENEFIT - COST RATIO / COST BENEFIT ANALYSES

➤ Cost-Bene t Analyses (CBA) use discounting techniques to
compare and select projects - usually for public sector projects.
➤ CBAs capture societal bene ts as cash in ows. Examples of use
include; LCC, RIAs, Highway Engineering, etc.
➤ Bene t-Cost Ratio (BCR) is the value used in assessing viability of
a scheme / project in relation to its cost. It is de ned as: BCR =
[(B - D)/C]; B is ValueBene ts, D is ValueDisbene ts and C are CostsNet .
➤ Net Bene t Value, NBV = B - D - C.
➤ BCR > 1 and / or NBV > 0.
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 RATE OF RETURN
➤ Average Annual Rate of Return: Its weakness is not factoring the timings of the cash flows.

Using previous e.g, Average Annual ROR = ([15M+12M+10M+8M+8M]/5)/40M

= 0.265 or 26.5%
➤ Accounting Rate of Return: = Average Annual Pro t ([Net Pro t / Years])
Initial Investment
➤ Internal Rate of Return (IRR):

the discount rate that sets the NPV to zero.

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 PAYBACK PERIOD
➤ PayBack period (PBP) is the time required for an initial investment to be recovered,
without factoring the time value of money - how long does it take to repay original capital?
➤ Consider the example below: (Note that the PBP is somewhere between Year 3 and Year 4!)

YEAR CASH FLOW

By Linear Interpolation, PBP = 3 + (40M - 37M) [4 - 3]
0 US (40,000,000)
(45M - 37M)
1 US 15,000,000
= 3. 375 Years
2 US 12,000,000
3 US 10,000,000
Since PBP does not factor time value of money, its use is recommended for secondary
4 US 8,000,000
analysis when Net Present Value or Rate of Return are used as primary methods.
5 US 8,000,000
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 THE KEY DEFINITIONS …

➤ Net Future Value (NFV): net return at end of planning period above what could
have been gained by investing elsewhere at the MARR - the measure of pro tability.
➤ Net Present Value (NPV): discounted value of NFV to the present; a positive NPV
value indicating the present value of the net gain corresponding to the cash ows;
(OR the di erence between the present value of revenues/receipts and that of expenditures!)
➤ Internal Rate of Return (IRR): discount rate which sets the NPV of a series of cash
ows over a planning period to zero - return of an investment when the capital is in use.
➤ Minimum Attractive Rate of Return (MARR): opportunity cost determined by
compounding Cash Flows (CFs) over planning period OR discounting CFs to present.
➤ Bene t - Cost Ratio (BCR): discounted bene ts : discounted costs at same point in
time - a pro tability index based on discounted bene ts per unit of discounted costs.
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SUPPLEMENTARY READING!!

1. Modern Construction Management , Harris, F. and McCa er, R.

(Chapters 12 and 13)

2. https://www.pmstudy.com/trainingdocs2/v5/

projectcostmanagementformulae.pdf

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