DEVELOPMENT APPRAISAL

ESB 450
Prepared and presented by: Lawrence
Mutale
CEM: SBE - CBU
2015
 DEVELOPMENT APPRAISAL
• Construction projects are • Development needs are
undertaken for various evaluated using various
reasons. techniques
• Public sector: – Investment appraisal –
– political assess expected
profitability
– Social
– Cost Benefit Analysis (CBA)
– Community – compares the cost
• Private: against the gains
– use • Appraisal must be
– sale conducted at inception
– Lease stage
 DEVELOPMENT APPRAISAL
• Defined: Development • Development value.
Appraisal is defined as
the examination of the
financial implications of
undertaking a project.
– The difference between
cost of development
(land cost + construction
costs …++) and Market
price (selling price).
– Market value is highly
influenced by supply and
demand
 DEVELOPMENT APPRAISAL
Factors influencing development of construction
site.
– Type of envisaged development
– Site location, access, topography, size and shape
– Ground conditions (Geotechnical) and preparation
out challenges (made up levels, cut & fill)
– Available services
– Planning control (Kitwe City Council)
– Legal considerations
– Availability of assistance from Govt.
– Cost of site development and final value
 DEVELOPMENT APPRAISAL
General determinants of value.
• General determinants of value are supply and
demand.
• Demand arises from:
– Occupation
– Investment
– Speculation
– Development
 DEVELOPMENT APPRAISAL
Major factors affecting demand.
– State of the economy (boom or down turn)
– Structural changes in economy ( UNIP – Communism, MMD 1 -
Capitalism, PF - infrastructure)
– Cost of owning (rates- higher rates less borrowing, slow
business.
– Location (Prime area or not?)
– State of property (well maintained property, higher value)
– Government support (grants and aid)
– Surrounding infrastructure or facilities (good roads, services etc)
– Population
– Funding (Lending rates, interest rates)
 DEVELOPMENT APPRAISAL
INVESTMENT APPRAISAL.
• An aid to investment decision making.
• Applies throughout the project life cycle
Aim of investment appraisal: to realise the
maximum return on investment or financial
outlay.
Uses:
– decision to invest in new facility or not.
– Comparing alternative methods on achieving an objective.
– Comparing the benefits of re-capitalisation vs disposal.
– Helps to decide design quality and standards
– Helps to decide maintenance and service schedules.
 DEVELOPMENT APPRAISAL
STEPS TO FOLLOW WHEN MAKING AN INVESTMENT
APPRAISAL.
1. Define objectives (outcomes & how they to be
measured, general and specific objectives)
2. Identify options (various ways of doing it)
3. Measure cost and benefits (consider all necessary facts)
4. Discount cost and benefits (Present and future costs,
compare apples with apples i.e Future values)
5. Consider uncertainties (Risks and contingencies)
6. Assess other factors (political, social economical etc)
7. Combine techniques with professional
judgement/experience
 DEVELOPMENT APPRAISAL
Investment Appraisal
Conventional Techniques Discount Techniques
• Comparative method • attempt to evaluate the
• Contractor’s method effect that time has
• Residual Method over the worth of
income and
• Profits or accounts expenditure
method
• tries to evaluate
• Investment method income, expenditure,
• Reinstatement method etc. over the life time of
• Hedonic price modelling the project
 DEVELOPMENT APPRAISAL
Discount Appraisal Techniques
• Usually considered to be more accurate than
conventional methods due to their
consideration of time value for money.
• two main discounting methods are the net
present value (NPV) and the internal rate of
return (IRR)
 DEVELOPMENT APPRAISAL
Discount Appraisal Techniques
Net present value (NPV)
1. It shows on a yearly basis
– the cash out flows for an organisation as a result of creating and
maintaining the investment
– the cash in flows into the organisation from the investment

2. Calculating the ultimate disposal value of the investment.

3. Discounting the cash flow over a life of an investment at a selected

rate of interest, to a common comparative date (eg base date).
This allows for comparing different costs incurred at different
times on a project , at a single point in time.
 DEVELOPMENT APPRAISAL
Discount Appraisal Techniques
Net present value (NPV)
• Golden rule always select a rate (discount rate) that reflects the real
return currently being achieved on investments.
• discount rate can be considered almost as the rate of return
required by the investor which includes costs, risks and lost
opportunities.

• Present value (PV) =1/(1+i)n

• where (i) = rate of interest expected or discount rate
• and (n) = the number of years.

• PV shows the value of the amount at an interest rate of i in the year

n
 DEVELOPMENT APPRAISAL
Discount Appraisal Techniques
Net present value (NPV)
E.g in year one, at an interest rate of 6%,
PV =1/(1+i)n
=1/(1+0.06)1
OR 100/(100+06)1
= 100/(106)1
= 0.9434

Therefore, given an initial investment amount of ZMW 10,000.00 at a rate of 6%,

The PV after year one will be
PV = (1/(1+i)n) x 10,000
PV = (0.9434) x 10,000
PV = 9434.00
 DEVELOPMENT APPRAISAL
Discount Appraisal Techniques
Net present value (NPV).
Consider two projects A and B with capital investments of
ZMW 10.00m (Project A) and ZMW 5.00m (Project B) and
expected annual benefits to be ZMW2.50m and ZMW1.5m
per year respectively.
Given that the expected benefits for both projects will
accrue for a period of 4 years and that the discount rate
for both projects is 3.5%,

Calculate the NPV for projects A and B over the 4

year period.
 DEVELOPMENT APPRAISAL
Discount Appraisal Techniques
PV =1/(1+i)n
PV for year 1 = 0.9662
PV for year 2 = 0.9335
PV for year 3 = 0.9019
PV for year 4 = 0.8714
Project A
Initial capital 10.00m -10.00
Benefits
Year 1 = 2.5 PV = 0.9662 x 2.5 2.42
Year 2 = 2.5 PV = 0.9335 x 2.5 2.33
Year 3 = 2.5 PV = 0.9019 x 2.5 2.25
Year 4 = 2.5 PV = 0.8714 x 2.5 2.18
9.18
NPV = -10.00 + 9.18 = -0.82 The investment will be a loss (Not economically viable)
 DEVELOPMENT APPRAISAL
Discount Appraisal Techniques
PV =1/(1+i)n
PV for year 1 = 0.9662
PV for year 2 = 0.9335
PV for year 3 = 0.9019
PV for year 4 = 0.8714
Project B
Initial capital 5.00m -5.00
Benefits
Year 1 = 1.5 PV = 0.9662 x 1.5 1.45
Year 2 = 1.5 PV = 0.9335 x 1.5 1.40
Year 3 = 1.5 PV = 0.9019 x 1.5 1.35
Year 4 = 1.5 PV = 0.8714 x 1.5 1.31
5.51
NPV = -5.00 +5.51= 0.51 = The investment will be a ………………..(viable?)
 DEVELOPMENT APPRAISAL
Discount Appraisal Techniques
Internal Rate of Return (IRR)
• It is the interest rate at which the NPVs of all the cash flows (both positive and
negative) from
a project or investment equal zero.

1. used to evaluate the attractiveness of an investment.

2. If the IRR of a new project is greater than company’s required rate of return, that
project is worth investing in.
3. If IRR < required rate of return, then the project in not worth investing in.
Calculation of the appropriate IRR for the organisation is usually done through trial
and error, until a rate with a yield very close to Zero is found.C
Can also be calculated using software

Other uses of IRR:

Calculation of return on investment (Yield)
 DEVELOPMENT APPRAISAL
Discount Appraisal Techniques
Internal Rate of Return (IRR)

Advantages:
• Allows for ranking of projects based on overall rate of return as opposed to their NPV.
– Therefore investment with highest IRR is chosen
• Allows for ease of comparison.

Disadvantages:
• Works only for investments that have an initial cash outflow (the purchase of the investment) followed by one or
more cash inflows. It works well where initial cashflows are positive followed by positive return towards the end.
• does not take into account the actual size of the investment or the return (just focuses on rate)
• Not suitable for investment that generate interim cash flows.
• does not consider cost of capital and can’t compare projects with different durations.

IRR is best-suited for analyzing venture capital and private equity investments, which typically
Entail multiple cash investments over the life of the business, and a single cash outflow at the end
Via Sale.
 DEVELOPMENT APPRAISAL
Discount Appraisal Techniques
Internal Rate of Return (IRR)
Formula:
0 = P0 + P1/(1+IRR) + P2/(1+IRR)2 + P3/(1+IRR)3 + . . .
+Pn/(1+IRR)n or
0 = P0 +Pn/(1+IRR)n
where P0, P1, . . . Pn equals the cash flows in
periods,
IRR = project's internal rate of return.
 DEVELOPMENT APPRAISAL
Example.
Assume Company ABC must decide whether to purchase a
piece of factory equipment for ZMW300,000. The equipment
would only last three years, but it is expected to generate
ZMW150,000 of additional annual profit during those years.
Company ABC also thinks it can sell the equipment for
scrap afterward for about ZMW10,000. Using IRR, Company
ABC can determine whether the equipment purchase is a
better use of its cash than its other investment options,
which should return about 10%.
IRR =
0 = -ZMW300,000 + (ZMW150,000)/(1+.2431) + (ZMW150,000)/(1+.2431) 2 +
(ZMW150,000)/(1+.2431)3 + ZMW10,000/(1+.2431)4
 DEVELOPMENT APPRAISAL
Example.
The investment's IRR is 24.31%, which is the rate
that makes the PV of the investment's cash
flows equal to zero. From a purely financial
standpoint, Company ABC should purchase the
equipment since this generates a 24.31% return
for the Company --much higher than the 10%
return available from other investments.

Note that the 24.31% is arrived at trough trial and error

 DEVELOPMENT APPRAISAL
Feasibility report.
Feasibility reports are generally aimed at
answering one major question.
That is;
• will the capital invested in the project make
the required yield or profit?
 DEVELOPMENT APPRAISAL
Feasibility report.
Factors that may negatively affect a well laid
development plan.

• Economic conditions, including interest rates

and employment levels,
• Government interventions i.e. planning and rezoning, release of land for
new developments.
• Demography and market need changes
• Competition and new entrants in the markets.
• Increase in cost of resources e.g. material
• Shortage of labour and scarcity of resources
• Inelastic nature of the market. Increase in one fact may not translate into
immediate increase in another variable. The change may take some time.
 DEVELOPMENT APPRAISAL
Contents of a Feasibility Report.
• Section Title
• Project particulars. Title of the project, name of client and professional,
advisers and date.
• Table of contents with page numbers.
• List of exclusions (qualifications or notes) e.g. the report does not take
into consideration the following: Professional fees, legal fees, taxes, etc.
• Executive summary. Brief of the most important findings
• Main report:
– Basis of the report. Assumptions made on the project constraints and
performance, expected yield development and disposal time scales.
– Developer’s budget
• Recommendations
• Appendices
 TEST
ESB/Q 450
DATE 22/08/2014
TIME: 40 MINUTES
PLEASE NOTE THAT THIS TEST MAY BE CONSIDERED IN YOUR C.A. CALCULATION

Discount Appraisal Techniques

QUESTION 1 (20 Marks)

You have been asked to advise the client on the best project to invest in, based on of your knowledge Investment appraisal. Your client is considering
investing in one of the two shopping malls. Shopping Mall A is based in Ndola while Shopping Mall B is base in Kitwe. All the two projects are to be
discounted
at the same interest rate (4%) and over the same period, of 5 Years.

Given the following Data’

Project A. Project B.
Initial capital ZMW 8000million Initial capital ZMW 6000million
Period 5 years Period 5 years
Interest 4% Interest 4%
Cash inflow. Cash inflow
Year 1 = 1800m Year 1 = 1600m
Year 2 = 1800m Year 2 = 1600m
Year 3 = 1800m Year 3 = 1600m
Year 4 = 1800m Year 4 = 1600m
Year 5 = 1800m Year 5 = 1600m

Calculate the NPVs for the two projects. Based on your calculation, advise your Client on which project to invest in. Substantiate your advice .

End of Test