Construction Economics

INTRODUCTION

The relationship between engineering and economics is very close, and in fact
has been heightened in the present scenario, wherein engineers are expected to
not only create technical alternatives but also evaluate them for economic
efficiency.

With the growing maintenance cost, especially in the infrastructure sector, it has
been realized that not only the initial cost, but also the overall life-cycle cost of
a project should be taken into account while evaluating options.

In fact, in the case of construction projects, economics affects decision-making in

many ways – from the cost of materials and equipment to purchase, scrapping of
equipment, bonus and/or penalty clause, and so on. It is, therefore, extremely
important that engineers and construction managers have a working knowledge
of economic principles, terminology and methods.
ECONOMIC DECISION-MAKING

There are various situations – such as (a) comparison of designs or elimination of

over-design, (b) designing for economy of production/maintenance/transportation;
(c) economy of selection; (d) economy of perfection; (e) economy of relative size;
(f) economy of location; and (g) economy of standardization and simplification – in
which an engineer has to take a decision among the competing alternatives.

The three most common methods of evaluation in which the time value of money
is considered are:
1. Out-of-pocket commitment
2. Payback period
3. Average annual rate of return

Out-of-Pocket Commitment

The out-of-pocket commitment is the total expense required for an alternative.

Example 1: Suppose a pre-cast concrete factory has to produce 100,000 railway

sleepers per year. An economic choice is to be made between using steel formwork
and wooden formwork. The life of steel formwork is estimated to be one year,
while that of and wooden formwork is one month. The costs of preparing one set of
steel formwork and one set of wooden formwork are Tk. 400,000 and Tk. 50,000,
respectively. It is further estimated that the labor costs for fixing and removing the
steel formwork and wooden formwork are Tk. 10 and Tk. 9 per sleeper., respectively.
What will be the better alternative.

Solution:
The total expense for steel formwork option = Tk. 400,000 + Tk. 100,000 x 10
= Tk. 1,400,000

The total expense for wooden formwork option = Tk. 50,000 x 12 + Tk. 100,000 x 9
= Tk. 1,500,000

Since the out-of-pocket commitment for steel formwork option is lesser

than that for wooden formwork, the decision would be to choose the steel
formwork option.

Payback Period

The payback period for an investment may be taken as the number of years it
takes to repay the original invested capital. This method does not take into
account the cash flows occurring after the payback period.
Example 2: Choose a particular brand of excavator from two brands. Both the
brands are available for a down payment of Tk. 400,000 and have a service life of 4
years. Brand A is estimated to give a return of Tk. 50,000 for the first year, Tk.
150,000 for the second year, and Tk. 200,000 for the third and fourth years. Brand
B is expected to give a return of Tk. 150,000 for all the four years.

Solution:

The payback period for brand A = 3 years (50,000 + 150,000 + 200,000 = 400,000)

( , , )
The payback period for brand B = 2 years (2 x 150,000) + year
,
= 2.67 years

Hence, it is beneficial to buy brand B excavator as it has a lesser payback

period.

Average Annual Rate of Return (AARR)

In this method, the alternatives are evaluated on the basis of only the average rate
of return as expresses in terms of a percentage of the original investment
Example 3: Choose a particular brand of excavator from two brands of excavators
following AARR method using the information given in Pb. 2.

Solution:

The average annual return from brand A = (50,000 + 150,000 + 200,000 x 2)/4
= 150,000
AARR for brand A = (150,000/400,000) x 100 = 37.5%

The average annual return from brand B = (150,000 x 4)/4

= 150,000
AARR for brand B = (150,000/400,000) x 100 = 37.5%

Choose brand B because we are getting higher returns in the initial

years for brand B compared to brand A.
The 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. The time
value of money is a simple concept that accounts for variations in the value of a
sum of money over time.

The most important principle involved is that of ‘interest’, which could be looked
upon as the cost of using capital. The interest represents the earning power of
money, and is the premium paid to compensate a lender for the administrative cost
of making a loan, the risk of non-payment, and the loss of use of the loaned money.
A borrower pays interest charges for the opportunity to do something now that
otherwise would have to be delayed or would never be done. Interest could be
simple or compound.

Let use the following symbols for compound interest:

inom = the nominal rate of interest,
m= the number of periods in a year to be taken for compounding,
ieff = the effective rate of interest.

inom
Then, ieff = { (1 + )m – 1} x 100
𝒎 𝒙 𝟏𝟎𝟎
Example 4:

Fig. 1: Cash-flow diagram for Example 4.

Nominal and real interest rate

Nominal interest rate refers to the interest rate before taking

inflation into account. Nominal can also refer to the advertised
or stated interest rate on a loan, without taking into account any
fees or compounding of interest.

The real interest rate is so named, because unlike the nominal rate,
it factors inflation into the equation, to give investors a more
accurate measure of their buying power, after they redeem their
positions. If an annually compounding bond lists a 6% nominal yield
and the inflation rate is 4%, then the real rate of interest is actually
only 2%.

Effective Interest Rate

Investors and borrowers should also be aware of the effective
interest rate, which takes the concept of compounding into
account.
Perpetuities and annuities

Annuities are the regular payments of fixed principle for a precise period
of time. The time period followed is as per the terms and conditions in
the agreement which the parties have called a deal. Annuities are used in
banks, insurance, EMI (Equated Monthly Installment), Savings account, FD
(Fixed Deposit) accounts and RD (Recurring Deposit) accounts, monthly
home mortgage payments, and many more.

Perpetuity is referred to as an annuity or regular inflows of fixed principle

throughout the lifetime, infinite years without a fixed period of time. It is
also known as Perpetual Annuity. For example, a pension paid to retired
soldiers is perpetuity as they are paid a pension throughout their lifetime.

Security
Securities are fungible and tradable financial instruments used to raise
capital in public and private markets.

There are primarily three types of securities: equity—which provides ownership

rights to holders; debt—essentially loans repaid with periodic payments; and
hybrids—which combine aspects of debt and equity.
Capital Budgeting

Capital budgeting is a process that businesses use to evaluate potential major

projects or investments. Building a new plant or taking a large stake in an
outside venture are examples of initiatives that typically require capital
budgeting before they are approved or rejected by management.

As part of capital budgeting, a company might assess a prospective project's

lifetime cash inflows and outflows to determine whether the potential
returns it would generate meet a sufficient target benchmark. The capital
budgeting process is also known as investment appraisal.

Risk versus return

The term return refers to income from a security after a defined period either in the
form of interest, dividend, or market appreciation in security value. On the other
hand, risk refers to uncertainty over the future to get this return.
The greater the risk that an investment may lose money, the greater its potential for
providing a substantial return. By the same token, the smaller the risk an investment
poses, the smaller the potential return it will provide.
Shares are a classic example of a high risk, high return investment. If you invest in
shares, the value of your investment will change every minute of every day; sometimes
quite significantly. In addition, it's possible to lose your investment entirely if the
company you're invested in collapses.
CASH-FLOW DIAGRAMS
Any organization involved in a project receives and spends different amounts of
money at different points in time, and a cash-flow diagram is a visual representation
of this inflow and outflow of funds.

In a cash-flow diagram, time is drawn on the horizontal (x) axis in an appropriate

scale, whereas the y-axis represents the amount involved in the transaction, with the
receipts and disbursements being drawn on the positive and negative side,
respectively, of the y-axis.

Fig. 2: Typical cash-flow diagram

Example 5:
Example 6:
Solution: