PROFESSIONAL PRACTICE

ENGINEERING ECONOMICS AND PROJECT APPRAISAL

2022
KAREN LE JEUNE

MRICS 0830980 PrQS 2318 PMAQS 3049

BSc (QS) with distinction UCT MSc (Prop Stud) UCT
Senior Lecturer
Programme Convenor - BSc Constructions Studies, BSc (Hons) Construction Management, BSc (Hons) Quantity Surveying
Department of Construction Economics and Management
Faculty of Engineering and the Built Environment

t: +27 21 650 3443 (reception) 2451 (direct)

e: karen.lejeune@uct.ac.za
w: www.cons.uct.ac.za

Karen practised as a professional Quantity Surveyor until 2001, notably becoming a managing partner of Walters Simpson & Du Toit in 1998.
Having lectured part-time at UCT whilst working in private practice, she joined as a full-time staff member in 2002. Karen lectures mainly on the QS
Honours programme and is course convenor for Professional Practice, Measurement and Design Appraisal and Civil Engineering Measurement.
Her research interests include the use of digital technologies and tools in the Built Environment to meet the 4th Industrial Revolution challenges,
promotion of Sustainability in the Built Environment including social issues involving gender equalisation.

Karen also serves as a professional member of The Association of South African Quantity Surveyors, Chartered Surveyor registered with The Royal
Institution of Chartered Surveyors and Pr.QS registered with The South African Council for the Quantity Surveying Profession. Karen is also a
member of the Society of Architects Planners Engineers and Surveyors (APES) and Women’s Property Network (WPN), and an academic mentor
for the Association of Built Environment Students (ABES).
§ ENGINEERING ECONOMICS
§ PROJECT APPRAISAL
§ Introduction to principles of project appraisal from PrQS perspective
§ Tools and Methods to analyse profitability and risk of a project
§ Economic cycles
§ Supply & demand

§ Economic Cycles in Property

§ MSCI
§ Rode’s Report

§ Economic Cycles in Construction

§ MFA
§ BER Bldg Confidence Index
§ CPAP (Haylett) Indices

§ Economic Data
§ StatsSA
§ cidb
Building Cost report 4th quarter 2021
§ Quick pause to talk about estimating
§ Budget is R85million – what is the ”bricks and mortar” cost?
§ Using MFA/BER to calculate escalation
§ Using MFA/BER to calculate escalation
§ Principles of project appraisal
§ Profitability
§ Risk and uncertainty

§ Tools and Methods to analyse profitability and risk

§ Simple or Naïve Methods
§ Advanced Methods / Discounted Cash Flow method
§ Sophisticated / Risk Analysis Methods

Source: Kelly, B. (2013) Property Development Decision-

Making in Listed Property Companies with Specific Reference
to Investment Analysis Tools. Unpublished MSc Thesis, UCT
§ Profitability
§ Context: socio-economic, environmental, aesthetic, physical, legal, political,
marketing and financial
§ Risk
§ Measurement of the difference between the actual outcome and the predicted
outcome at the time of making decisions

§ Uncertainty
§ Unknown variables at play at the time of making decisions
§ Estimated measurement of uncertainty = “probability of occurrence” = risk
assessment, leads to risk management
§ Simple or Naïve Methods
§ Payback period
§ Return on Investment (ROI)

§ Advanced Methods / Discounted Cash Flow (DCF) method

§ Internal Rate of Return (IRR)
§ Net Present Value (NPV)
§ Profitability Index (PI)
§ Modified Internal Rate of Return (MIRR)

§ Sophisticated / Risk Analysis Methods

§ Life cycle cost analysis
§ Sensitivity analysis, scenario analysis, risk adjusted discount rates, simulation models
such as the Monte Carlo simulation, decision trees, real option analysis
§ Payback Period (Rule of Thumb)
§ Length of time it will take to get original capital back

§ Return on Investment or Accounting Rate of Return (ARR) or

§ Actual or project net income for a period / Total investment expenditure

§ First Year Yield / Initial return

§ Net operating income (1st yr) / Initial investment outlay

§ Direct / Income Capitalisation

§ Conversion of the net stabilised income flow into an estimate of value using market-
related capitalisation rate
§ Problems associated with Simple Methods
§ Does not take into consideration the time value of money
§ Not suitable as risk assessment measures
§ Short duration of income period doesn’t allow for economic cycles
§ Example
§ Property is Worth R8,000,000
§ 70% Bond for 20 years @ 8,5%
§ GLA 1500m2
§ Rent R115/m2 escalation @ 8% p.a.
§ O/C R45/m2 escalation @ 7% p.a. Gross income GI
§ Vacancy rate 25%
- Operating Costs - O/C
§ Tax Rate 28%
§ Property Values go up by 5% p.a. - Vacancy rate - Vac

= Net operating income = NOI

§ Example answer
Year 1
Gross income GI R 2 070 000 (1500m2 x R115/m2x12)
Operating Costs O/C R 810 000 (1500m2 x R45/m2x12)

Vacancy rate Vac R 517 500 (25%x1500m2xR115/m2x12)

Net operating income NOI R 742 500 (GI-O/C-Vac)

NOI R 742 500

Capital R 8 000 000

First year yield 9,28%

§ Net Present Value (NPV)
§ Discounts a set of projected cash flows back to a present value to allow for
comparison with present day investment value
§ Positive or negative NPV – Positive NPV is viable investment

§ Profitability Index (PI)

§ Benefit/Cost ratio (NPV divided by initial investment)
§ >1 = viable investment

§ Internal Rate of Return (IRR)

§ Rate of return at which the NPV of a project is zero
§ IRR> Hurdle rate = viable project

§ Modified Internal rate of Return (MIRR)

§ Actual rate at which cash flow reinvested (cost of capital rate)
§ Problems with DCF
§ Information is incomplete or limited at the time of using method (not factual)
§ Uncertainty of future cash flows not taken into consideration (same discount rate
used)
§ Easily manipulated by changing discount rates / capitalisation rates

§ Problems with IRR

§ Assumed that income from project is invested at IRR rate – if this rate > cost of
capital, over-inflation of return results
§ IRR over-sensitive to negative cash flows
§ Multiple IRRs can be generated
§ Not suitable as a comparative tool
§ Example A
Calculate the NPV, IRR and profitability index for the following 3 year scenario using
a discount rate of 13%:
Capital outlay = R200,000
Year 1 income = R125,000 escalating at 9.5% pa.
Year 1 operating costs = R45,000 escalating at 6% pa.
Is this a viable investment?
 Year 0 Year 1 Year 2 Year 3

Potential Sale
Gross income GI R125 000,00 R136 875,00 R149 878,13
Operating Costs O/C R45 000,00 R47 700,00 R50 562,00
Vacancy rate Vac R0,00 R0,00 R0,00

year
Net operating income NOI -R200 000,00 R80 000,00 R89 175,00 R99 316,13
PV = FV / (1 + r)n
PV 13% -R200 000,00 R70 796,46 R69 837,11 R68 831,06
NPV R9 464,62
IRR 15,67%
PI 1,05
§ Example B Gross income GI
§ Property is Worth R8,000,000 Operating Costs - O/C
§ 70% Bond for 20 years @ 8,5% Vacancy rate - Vac
Net operating income = NOI
§ GLA 1500m2
Debt Service - D/S x12
§ Rent R115/m2 escalation @ 8% p.a.
Before Tax Cash Flow = BTCF
§ O/C R45/m2 escalation @ 7% p.a.
§ Vacancy rate 25% Loan Interest Portion Int
§ Tax Rate 28% Taxable Income (NOI-Int
§ Property Values go up by 5% p.a. portion) Tax Inc
§ Holding period of property = 5 years Tax 28%

After Tax Cash Flow (BTCF-Tax) = ATCF

 Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Sale year
Gross income GI R 2 070 000 R 2 235 600 R 2 414 448 R 2 607 604 R 2 816 212
Operating Costs O/C R 810 000 R 866 700 R 927 369 R 992 285 R 1 061 745
Vacancy rate Vac R 517 500 R 558 900 R 603 612 R 651 901 R 704 053
Net operating income NOI R 742 500 R 810 000 R 883 467 R 963 418 R 1 050 414

Debt Service D/S x12 R 583 177 R 583 177 R 583 177 R 583 177 R 583 177 R (4 935 122)
Before Tax Cash Flow BTCF R 159 323 R 226 823 R 300 290 R 380 241 R 467 237

Loan Interest Portion Int R 471 724 R 461 873 R 451 151 R 439 481 R 426 779
Taxable Income (NOI-Int
portion) Tax Inc R 270 776 R 348 127 R 432 316 R 523 937 R 623 635
Tax 28% R 75 817 R 97 476 R 121 049 R 146 702 R 174 618

After Tax Cash Flow excluding

sale ATCF R (2 400 000) R 83 506 R 129 347 R 179 241 R 233 539 R 292 620 R 10 210 253
net income from
R 5 275 130 sale
After Tax Cash Flow ATCF R (2 400 000) R 83 506 R 129 347 R 179 241 R 233 539 R 5 567 750
IRR 22%

Discount rate 15% 1 2 3 4 5

PV of NOI R (2 400 000) R 72 614 R 97 805 R 117 854 R 133 526 R 2 768 156
NPV R 789 955
PI 1,32914804
§ Life cycle cost analysis (LCCA)
§ NPV of costs incurred over the life of a building element expressed in current day
costs
§ Allows for comparisons to be made between different materials, elements, entities
that perform the same function

§ Sensitivity analysis, scenario analysis, risk adjusted discount rates, simulation

models such as the Monte Carlo simulation, decision trees, real option analysis
§ Complex, difficult to explain to clients
§ Decision makers often use their own experience to make allowance for risk without
using formal (academic) methods
§ Typical historical test question
Your engineering company has recently secured a contract that will continue over a
period of four years. As operation’s manager, you are responsible for evaluating the
financial attributes of capital equipment. With respect to the above project you have
the option of purchasing and using one of two machines.
Machine A costs R20,000 and first year running expenses are R10,000. These costs are
estimated to escalate at 8% per annum. At the end of the contract the machine will
have no residual value and, therefore, no income from the resale can be offset against
expenditure.
Machine B costs R45,000 and first year running expenses are R6,000. These costs are
anticipated to escalate at 8% per annum. At the end of the contract you estimate that
you will be able to sell the machine for R20,000.
In the above problem, tax implications are ignored. If the applied discount (interest) rate
is 10%. Which machine do you recommend should be purchased ? Provide full details of
your calculations to determine the respective Net Present Values.
 Year 0 Year 1 Year 2 Year 3 Year 4
Machine A
Capital expenditure R 20 000,00
Running expenses R 10 000,00 R 10 800,00 R 11 664,00 R 12 597,12
Residual value R -
R 20 000,00 R 10 000,00 R 10 800,00 R 11 664,00 R 12 597,12
PV R 20 000,00 R 9 090,91 R 8 925,62 R 8 763,34 R 8 604,00
NPV R 55 383,87

Machine B
Capital expenditure R 45 000,00
Running expenses R 6 000,00 R 6 480,00 R 6 998,40 R 7 558,27

Residual value R (20 000,00)

R 45 000,00 R 6 000,00 R 6 480,00 R 6 998,40 R (12 441,73)

PV R 45 000,00 R 5 454,55 R 5 355,37 R 5 258,00 R (8 497,87)

NPV R 52 570,05
§ Estimate the total project cost
- Office block consisting of construction area 5,000m2
- Construction cost (AECOM) = R12,000/m2
- External works – allow R1,5million
- 12,5% preliminaries
- 5% contingencies
- 3% p.a. pre-tender escalation (9 months)
- 5% p.a. construction escalation (minimal delay between tender submission and site
hand over) (16 months)
- 16% professional fees
- 15% VAT
§ Is this a viable purchase?

https://www.broll.com/results/com
1520m2 gross office area
mercial/for-sale/cape-town/all/
25%circulation area
1140m2 rentable area
R147,00 /m2 GradeA rental
25%Operating Costs
12 parking bays @ R5400/month each
0%vacancy rate
Gross lettable area GLA 1700
Rent R90 per m2 per month
Rent escalation 8% per annum
Operating Costs OC R40 per m2 per month
Operating Cost escalation 7,5% per annum
Vacancy rate 25%

Property value R 5 000 000,00

Property value increase 5% per annum
Loan 80% bond
Loan duration 20 years
Loan rate ( r ) 9,00% per annum
Tax rate 28%
§ Compare timber windows vs aluminium windows
§ Aluminium windows = R164 436, no maintenance
§ Timber windows = R133 170, varnish annually 46.32m2 @ R170 (escalated at 5% pa)
§ Discount rate 8.5%

§ At which point in time would aluminium windows be more cost effective than timber
windows?