FEASIBILITY ANALYSIS FOR CONSTRUCTION PROJECTS
1 Feasibility of Construction
ProjectsEconomic Approach
Construction investments represent major commitments
of resources and have serious consequences on the profitability and financial
stability of an organization which proposes to develop a construction project.
The feasibility of a project refers to whether the
project can be done without violating certain accepted rules, principles or
constraints.
The constraints can range from logical consistency or
physical possibility to arbitrary criteria based on the goals and objectives of
some involved party.
When referring to constraints at least three main
approaches to feasibility can be identified, namely:
· Technical
feasibility  dealing
with structural requirements, buildability or construction technology related
constraints. These aspects are likely to become dominant mostly in case of
large or avant garde projects.
· Legal
feasibility  referring
to codes and zoning regulations or other legal constraints that can prevent a
project from going on.
· Economic and
Financial Feasibility  referring
to constraints that are measures of economic performance of the project
delivery process (ex: cost, revenue, rate of return, etc).
It
is important to distinguish between the economic evaluation of alternative schemes
which are meant to satisfy the same main goal and the alternative financing
plans for the project.
· The former refers to the evaluation of cash flow representing
the benefits and costs associated with the acquisition and operation of the
facility. More specific, this approach refers to design, construction,
operation and maintenance of the facility.
· The latter refers to the evaluation of the cashflow representing
the incomes and expeditures as a result of adopting a specific financing plan
for funding the project.
The essential difference between traditional economic
feasibility assessment and those of modern approach to feasibility is the
latter's recognition of the effect of the time value of money. This modern
approach to economic feasibility (investment appraisal technique) regards to
the project life cycle. It begins with the initial conception of the project
and ends with its disposal. The attention that now is being paid to life cycle
cost analysis (or modern approach to economic feasibility) was generated by the
energy crisis in the 1970'.
Life Cycle
Costing
Life Cycle Costing is the use of the discounted
cashflow (taking into account the effect of time versus money) to allow
alternative designs to be evaluated at an earlier stage tacking into account
not only the initial capital cost, but also the future running costs and
income.
A systematic approach to economic feasibility (Life
Cycle Costing Analysis) of investments consists in the following major steps:
(i) Generate a set of alternative projects for investment
consideration;
(ii) Establish the planning horizon for economic analysis
(usually the horizon refers to the project useful life);
(iii) Estimate the cashflow profile for each alternative
project;
(iv) Establish the criterion for accepting or rejecting a
proposal on the basis of the objective of the investment;
(v) Perform risk (sensitivity) analysis;
(vi) Accept or reject a proposal on the basis of the
established criteria;
The advantages of life Cycle Costing analysis consists
in:
(i) Assessing the total cost and resources required in the
project;
(ii) Identifying the required funding in relationship to
any constraint;
(iii)
Conducting
trade off studies between alternatives;
(iv)
Estimating
the revenue levels required to produce a required rate of return.
For example the total cost of a project over the
project life cycle will include the following components (Eq.1) and (Fig.1)
where:
C_{T} = Total cost of the project over the project useful
life.
C_{I} = Initial project cost referring to:
· cost of feasibility studies
· cost of design
· land cost
· permits
· construction costs
· professional fees
· furniture/ equipment
· construction financing cost.
C_{U} = Cost in use, due to:
· operation
· maintenance
· taxes
· repair and replacement
C_{D} = Disposal cost: sale or demolition cost.
These costs (both initial and future costs) must be
weighed against the benefits of the constructed facility. Normally , the
benefits are expected to occur lately in the future. This is why discounted
analyses are needed for.
2. The time value of money; Discounting
Discounting is a method of appraising capital (investment)
projects by comparing their income in the future and their present and future
costs with the current equivalents. The current equivalents take account of the
fact that future receipts are less valuable than current, in that interest can
be earned on current receipts. On the other hand, future payments are less
onerous than current payments, as interest can be earned on money retained for
future payments. Accordingly, future receipts and payments are discounted to
their present values by applying discount factors, taking account of interest
that could be earned for the relevant number of years to the date of payment or
receipt.
Interest is the charge made for borrowing money. The rate of
interest is the charge made, expressed as a percentage of the total sum loaned,
for a stated period of time (usually one year or one month). Interest can be
simple or compound.
In simple
interest, the charge is calculated on the sum loaned only. (Eq.2)
where:
I_{S} = the simple interest ; (lei)
P = the principal sum ; (lei)
r = the rate of interest ; (%
/year) or (% /month) etc.
T = the time period ; (year)
;(month) etc.
In compound
interest, the charge is calculated on the sum loaned plus any interest that
has accrued in previous periods (Eq.3).
where:
n = the number of periods for which interest is separately calculated.
Discount
Factors
The basic discounting procedures are presented bellow:
(i) Future value: The future value (F) of a present single amount of
money (P) invested for n periods at a rate ”r” is given by Equation 4.
Example 10:1. If a sum of money, say P = 1000 lei, is invested in an account for n = 5 years at an interest rate of r = 10%, the amount that can be withdrawn at the end
accumulates as follows:
F_{1} = P+ P´i = P(1+r) = 1000(1+0.1) = 1100 lei: at the end of the first period (year)
F_{2} = F_{1}+F_{1}´i = P(1+r)^{2} = 1000(1+0.1)^{2} = 1210 lei : at end of the second period (year)
.
.
.
F_{5} = P(1+r)^{5} = 1000(1+0.1)^{5} = 1000´1.6105 = 165 lei; the end of the fifty period (year)
(ii) Present
value: The present value (P) of a sum
(F) to be received “n” periods from the present date (year zero), considering
an interest rate “r”, is given by Equation
5.
This is the inverse of the future value
Example 2. If a sum of money, say 165 lei is required in five
years time, what amount has to be invested today to generate this amount if
interest rate is 10%. The solution is:
_{}
The terms (1+r)^{n} or 1/(1+r)^{n} are called discount factors which
usually are given by tables.
The discounting procedure provides a convenient way to
compare two different sums of money occurring at different times.
(iii)
Future value of an annuity
If a uniform amount A is invested at the
end of each period for “n” periods, at a rate of interest r per period, then
the total equivalent amount “FV_{a} “ at the end of the “n” periods
will be as follows: (note that the last payment/ receipt does not earn any
interest).
By multiplying both sides of the equation by (1+r) and subtracting the result from the original
equation, the result will be:
FV_{a}´ r = A(1+r)^{n} 1

(7)

which can finally be rearranged to designate the
future value of the annuity (Eq.8)
The term _{} is sometimes known as the uniform series compound amount factor .
The relationship can be rearranged to yield:
Here, the term _{} is known as the uniform series sinking fund factor, because it determines the
uniform endofperiod investment “A” that must be made in order to provide an
amount ”FV” at the end of 'n' periods.
(iv)
Present value of an annuity (PV_{a})
Now, we are interested in the present
value “PV_{a}”of a series of equal payments of amount ”A”, considering
a discount rate “r” per each period.
To find this value, simply discount the future value
of the annuity (Eq.8) as a lump sum,
as given by Eq. The resulting
equation is:
The discount factor now is known as the uniform series present value factor.
Equation 10 gives the equivalent uniform periodic series
(annuity) required to replace a present value of PV.
By inverting Eq.
10, we can obtain the equivalent uniform series of end of period values
“A” from a present value “PV” (Eq.11).
In this case, the discount factor is called the uniform series capital recovery factor.
3. Economic Performance Measures
The problem of assessing the worthwhileness of a
project from an economic point of view is equivalent to that of selecting
appropriate measures of economic performance and than estimating its value for
the project under scrutinity from a standpoint of a decision maker .
A measure of performance can be defined as a variable
that can be measured, that tells the designer / constructor / economic analyst
of any object or solution for a problem how well a solution is doing, how well
the object or solution serves his purpose.
A measure of economic performance for a building for
example, is a variable that measures how well the building meets the economic
objectives and concerns of the client. Similar assessment can be considered
related to execution of the building contract.
There are several economic performance measures that
are commonly used by decision makers, whoever they might be, such as cost,
profit, rate of return, payback  period, internal rate of return etc.
The interrelationship between money and time for a
project lasting more than 1 year (usually) is presented using related
cashflows and applying the discounting procedures.
A cash flow
is the transfer of money out of (cash out º negative cash flow) or into (cash in º positive cash flow) the project in question at a
known or forecast point in time.
Knowledge of the amount and time of cash flows
representing a project permit the use of modern investment techniques
(discounted procedure).
(i) Cost(C)
Cost is an expenditure, usually of money, incurred in
achieving a goal (ex: building a factory, construct a bridge, etc.). Cost may
be viewed as initial cost, running annual cost, life cycle cost etc. For an
investor constructing a factory , for example, the initial cost of the project
(or the maximum capital lockup) is the maximum demand for capital from the
start of the project until the project starts its operations(brings incomes).
Present
value of Cost .
Often in engineering economic studies, the typical use
of present worth analyze is to compare two ore more schemes, each with
different initial investment and different running costs. The present worth is
found by discounting the cost flows of the schemes using a predetermined rate
of interest (Minimum attractive rate of interest). The minimum most attractive
rate of interest is usually equal to the current rate of interest for borrowed
capital (cost of capital rate) plus an additional rate for such factors as
risk, uncertainty etc. (Eq.12)
where:
PV =present value of the project's costs
C_{n} = Cost occurring in interval “n”
T = total period of time (comprising “n” periods)
r = rate of interest considered (discount rate)
(ii) Income
For investment purposes, income is any sum a person or
organization receives as a return on investments (revenue).
The discounted income for a project scheme will be: (Eq.13)
where:
P.IN. = present value of the project's incomes.
Consider the project generates incomes after one year.
Year zero is for investment.
(iii)
Net Present Value (N.P.V.)
A net present value (N.P.V) can be seen to be a
statement in present day terms of the value of an investment to an investor.
N.P.V. is calculated by summing the project (investment) revenues and costs
over its full life and subtracting the later from the former (Eq.14).
where:
C_{fn} = The incremental cash flow in period “n”. Receipts
are designated as positive and
payments as negative cash flows.
C_{0} = The initial investment;
r = Usually is the most attractive rate or return.
If the calculation yields a positive NPV, then the
project should be profitable. NPV is a measure of a gain from a project.
Calculation of NPV as a profitability measure for a
project often involves subjective judgments (future cash flow and interest
rates), therefore the decision making process should consider other
profitability measures as well (payback period, benefitcost ratio etc.).
N.P.V. can be seen as the net profit of an investment
.
(iv)
Payback Period (P_{b})
This involves how long is taken for a project(usually
years) to repay its original invested capital. The shorter the payback period,
the greater is the likelihood that the project will be profitable. The weakness
of this method is that it does not take account of the cashflows that occur
after the payback period.
(v) Average Rate
of Return (ARR)
This is the annual amount of income from an investment
expressed as a percentage of the original investment. (Eq.15)
where:
B = The benefit/profit generated by investment. This will be taken as the
sum of the cash flows minus the initial investment.
In this respect, if discounted, B = N.P.V.
This rate is very important in assessing the relative
merits of different investments. It indicates what share of the money invested
'returns' to the investor each year.
Obviously, the greater the ARR, the more profitably
the project/variant of investment will
be.
The weakness of this method is that it usually does
not discount benefits and therefore does not discriminate between the timing of
the cash flows. For this purpose, the benefit cost ratio is considered.
(vi)
BenefitCost Ratio (B/C)
The benefit cost ratio is the ratio of the discounted
benefits to the discounted cost at the same point in time. To be profitable, a
project should have its B/C ratio greater than one (Eq.16).
However, a project with the maximum B/C ratio among a
group of mutual exclusive proposals, generally does not necessarily lead to the
maximum net benefit. Therefore, this approach is not recommended by itself for
use in selecting the best proposal but in conjunction with other profitability
measures .
(vii)
Internal Rate of Return (IRR)
The Internal Rate of Return is that discount rate that
will produce zero Net Present Value for a project (Eq.17)
The IRR can be seen as the maximum interest rate that
could be paid on borrowed capital assuming that all the outlay to fund the
project is acquired as an overdraft. The IRR is sometime called Discounted
Cashflow Yield.
If the IRR exceeds the market rate of interest , then
the project is profitable (This means that the project NPV will be positive).
INFLATION
Inflation is the persistent rise in the level of
prices and wages throughout an economy.
So far it has been assumed that the forecasts of
future costs and revenues have been at today's prices. However, for insight analysis
the effect of inflation may be considered. The simplest way for doing this is
to adjust the interest rate used to discount the future cash flows. The cash
flows remains estimated at today's princes (year zero) but the discount rate
will take account both of the interest rate and inflation rate (Eq.18).
where:
d = The 'real' discounting rate (decimal figure)
r = The interest rate (decimal figure)
i = The inflation rate (decimal figure)
Then, the discounting factor for present values will
be 1/(1+d)^{n}.
4. Application of Economic Performance
Measures
The following examples will illustrate a few
application ways of the Economic Performance Measures for construction.
Example3
A contractor proposes to buy a new item of a certain
plant. For this purpose he considered two possible schemes , each with a
different initial investment and different running costs, as follows:
Initial plant cost

Scheme 1

Scheme 2


5, 000 u.v.

4, 000 u.v.

Running cost

600 u.v./year

800 u.v./year

Useful life considered

6 years

6 years

If the interest rate is r = 10%, which is the less costing scheme/the optimum
solution.
Solution
If no discounting is considered, obviously the less
costing scheme should be scheme 1 with a total cost over the useful life of
8,600 u.v. instead of 8,800 u.v. as for scheme 2.
However, so far the cost of capital was not
considered. Applying the discounting procedure and calculating the present
values of the two schemes will generate a more realistic result. The
calculation is based on Eq.5 for
determining the present value of future amounts of money. (Table 1)
Table 1. Calculation of Present Value (r =10%)
Year (n)

Discounting
factor

Scheme 1

Scheme 2


f =1/(1+r)^{n}

Value (C_{n})

Present
value by year (C_{n}xf)

Value (C_{n})

Present
value by
year (C_{n}xf)

0

1.000

5000

5, 000.00

4000

4, 000.00

1

0.9091

600

545.46

800

727.28

2

0.8264

600

495.84

800

661.12

3

0.7513

600

450.78

800

601.04

4

0.6830

600

409.80

800

546.40

5

0.6209

600

372.54

800

496.72

6

0.5648

600

338.70

800

451.60

P.V.


8600

7, 613.12

8800

7, 484.16

Thus, since scheme 2 has in fact the smaller present
value (of cost) it is said that scheme 2 is
more economic.
What is being compared in fact is the 1000 u.v. extra
initial investment of scheme 1 with the 200 u.v. extra running cost in scheme
2. (Is 1000 u.v. now more or less than 200 u.v. each year for the next 6 years;
the interest rate being 10%?).
From previous calculation 1000 u.v. now is 128.96 u.v.
more than 200 u.v. each year for six years.
Note .The same conclusion would result if the particular
formula for discounting annuities had been used .
The present value of a regular seria (annuity) of
payments/ receipts is given by Eq.19.
where:
PV_{a}= The present value of an annuity
A= The uniform amount of money payments (receipts) continuing for a
duration of n periods. (payments/ receipts occur at the end of period)
Thus the present value discount factor for both
schemes (when r= 10% and n= 6 years) is 4.3552 (from tables).
Having said this, the calculation is very simple:
P.V._{1}= 5000+600x4.3552= 7, 613.12
P.V._{2}= 4000+800x4.3552= 7, 484.16 Þoptimum.
Example 4
Find the Internal Rate of Return for the project below
(Table 2)
Table 2.
Project Cash Flow
Stage of investment

Year

Project's cash flow
(x10^{4 }lei)

Investment

0

1300

Return

1

500


2

500


3

500

Solution
The calculation of IRR is given in Table 3 by applying the discounting
procedure (Remember that IRR is that particular interest rate that makes the
project NPV equal to zero).
Table 3
Calculation of IRR
Year

Project Cashflow

First Trial

Second Trial



Present Value Factors at 7%

Present Value

Present Value Factors at 8%

Present Value

0

1300

1.0000

1300.00

1.0000

1300.00

1

500

0.9346

467.30

0.9259

462.95

2

500

0.8734

436.70

0.8573

428.65

3

500

0.8163

408.15

0.7938

396.90

Net Present Values:

NPV_{1}

12.15

NPV_{2}

11.50

Then, interpolating between 7% and 8%, gives the IRR:
_{}
The graph bellow (Fig.2)
illustrates the same result.









Fig. 2 N.P.V. versus
interest rate


Thus, if the cost of capital is greater then 7.52%,
the project does not yield enough to be profitable.
Example 5
An investor is considering three project schemes in
order to decide on which of them to invest his money. The three schemes, whose
cashflows are outlined in Table 4, are
to be apprised according to the modern economic performance measures. If you
were the investor's consultant, which scheme would you propose? The interest
rate is 5%.
Table 4.
Cashflows (10^{5 }lei)
Year

Project schemes


A

B

C

0

1000

500

1000

1

400

300

200

2

300

300

300

3

100

100

500

4

100

50

700

Solution
(i) Payback
If decision makers specify a required payback period,
and if an investment has a payback period equal to, or shorter than this period
, the investment is accepted. If the payback period is longer than that
specified, the project is rejecter. If no period is specified, the shorter the
payback period, the better .
If we assume that cash flows are received at the end
of each year, the payback for the three schemes is shown in Table 5.
Table 5.
Payback calculation
Project

Initial outlay()

Cumulative cashflow (+)

Payback Period.



Years:

1

2

3

4


A

1000


400

700

800

900

Never

B

500


300

600

700

750

2 Years

C

1000


200

500

1000

1700

3 Years

Table 5
reveals the following:
· Project A will never manage to payback the initial
investment. (It will have a negative N.P.V.).Consequently it should be
rejected.
· Project B will have a payback period of 2 years.
· Project C will have a payback period of 3 years.
According to this performance measure, project C is
the one to be accepted.
However , this criteria used by itself is not
completely relevant, since the future receipts are neglected (ex: Project C
will have a 700 u.v. gain after its payback period since project B will have
only 150 u.v.). Also, the timing of the cashflows were neglected. This is why
this economic performance measure should be used in conjunction with other
performance measures.
(ii) Net Present
Value
From this stage, project A has been rejected.
The calculation of N.P.V. for the remained projects is
given in Table 6
Table 6. Net
Present Value Calculation
Year

Discount factor for r=5%

Cash flows (Today’s values)

Present Value



B

C

B

C

0

1.000

500

1000

500

1000

1

0.952

300

200

286

190

2

0.907

300

300

272

272

3

0.864

100

500

86

432

4

0.823

50

700

41

576

Net Present Value (NPV):

185

470

Operation of the NPV rule indicates that project B and
C should be accepted (they both have NPV>0). Further, from these two
possible options, project C appears more profitable.
(iii) Average Rate
of Return
Being a relative measure, the Average Rate of Return
calculation may be conducted using the initial cashflows. The calculation for
projects B and C is shown in Table 7.
TABLE 7.
Average Rate Of Return Calculation (Non discount approach)
Project

Total cash inflow
(I)

Initial Cost (C_{0})

Nondiscounted Benefit
(B=IC_{0})

Project Life
(T)

Average Rate of Return _{}

B

300 + 300 + 100 + 50 =
750

500

250

4

12.5

C

200 + 300 + 500 + 700 =
1700

1000

700

4

17.5

Both rates are greater than the market rate of return
used for discounting (r= 5%). Therefore both projects can be considered as being acceptable.
Where the design maker specifies a greater rate of
interest (say 'the most attractive rate of return  MARR') to
motivate himself for investment into a particular field, the average rate of
return of a project should be greater than this MARR. (For example if MARR = 15%, then project B will be rejected by the decision
maker). However, from the ARR stand print, project C again appears of being the
most profitable.
(iv) Internal
Rate of Return
Following the methodology given by Eq.17 and Example 4 the Internal Rates of Return for projects B and C have
resulted as follows:
IRR_{B }» 25%
IRR_{C }» 20%
This means that project B can afford a cost of capital
up to 25%, whereas project C can be funded considering a maximum level of the
cost of capital of 20%. Hence, in respect with this performance criteria,
project B appears more advantageous.
Anyway, for borrowing rates around the market interest
rate, project C has resulted to be the optimum choice. However, further discussions
may appear related to the hierarchy score the decision maker is giving to each
performance measures. The cumulative net cash flow for project C is outlined in
Fig.3.
Example 6
Determine the adjusted discount
rate (d) if the interest
rate (r) is 10% and the inflation rate (i) is 6%.
Solution
The adjusted discount rate is given by Eq.(18) as follows:
_{}
Example 7
A contractor is considering to either purchase and run
a new item of plant or to hire it.
The cost of the new plant is 55 mil. lei and the
forecasted salvage value is 10 mil. lei. The operation of the new plant will
cost 5 mil. lei per annum. The hiring cost of the plant is 15 mil lei per
annum.
For both schemes, the period considered is 5 years,
and the discount rate is r= 10%.
Which of the two alternatives is more economical?
Solution
The input data for the problem can be arranged as
follows:
Input data

Alternatives


Buying

Hiring

Initial Cost

50 mil. lei



Running Cost

5 mil. lei p.a.

15 mil. lei p.a.

Salvage value

10 mil.lei p.a.



Duration

5 years

Discount rate

10%

Knowing that the discount factor for an annuity for 5
years and r= 10% is 3.791 (Table B4) and that the discount factor
for an amount occurring in year 5 is 0.621 (Table B2) the equivalent costs (present value) of the two
alternatives is given bellow. The corresponding cash flows are also presented.
Buying
Hiring
Therefore, hiring is more economical.