Assessment of Civil Engineering

Projects
Construction Management
Department of Civil Engineering
Lesson 8

Economic Assessment of Engineering

Projects
Time Value of Money
⚫ Money is a medium for exchanging goods
⚫ Money has a time value because it can earn more money over
time (earning power).
⚫ Money has a time value because its purchasing power
changes over time (inflation).
⚫ Time value of money is measured in terms of interest rate.
⚫ Interest is the cost of money—a cost to the borrower and an
earning to the lender

Increase in time
Methods of Calculating Interest

⚫ Simple interest: charging an interest rate only

to an initial sum (principal amount) – even
though you do not withdraw it.
⚫ Compound interest: charging an interest rate to
an initial sum and to any previously
accumulated interest that has not been
withdrawn.
Simple Interest

⚫ P = Principal amount
⚫ I = Interest
⚫ i = Interest rate
⚫ n = Number of interest periods
Example:
P = K1,000
i = 8%
n = 3 years

I = Pin
F = P+I = P(1+in)
Compound Interest

⚫ Year zero :P+0 = P (1+i)0

⚫ End of 1st period: P+Pi = P(1+i)1
⚫ End of 2nd period: P(1+i)1 + iP(1+i)1 = P(1+i)2
⚫ End of 3rd period: P(1+i)2 + iP(1+i)2 = P(1+i)3
⚫ End of 4th period: P(1+i)3 + iP(1+i)3 = P(1+i)4
⚫ -- -- -- -- -- -- -- -- -- -- --
⚫ -- -- -- -- -- -- -- -- -- -- --
⚫ -- -- -- -- -- -- -- -- -- -- --
⚫ At the end of n periods: P(1+i)n-1 + iP(1+i)n-1 = P(1+i)n
⚫ F = P(1+i)n is the fundamental law in engineering economy
Economic Equivalence

⚫ The compound interest formula F = P(1+i)n

expresses the equivalence between some
present amount P and future amount F for
given i and n.
⚫ Equivalent cash flows are equivalent at any
common point in time.
Economic Equivalence

⚫ If you deposit P Kwachas

today for n periods at i, F
you will have F Kwachas F = P(1+i)n
at the end of period n.
⚫ F Kwachas at the end of 0
period n is equal to a n
single sum P Kwachas
P = F(1+i) -n
now, if your earning power
is measured in terms of P
interest rate i.
Types of Cash Flows

(a) Single cash flow

(b) Equal (uniform) payment

series

(c) Linear gradient series

(d) Geometric gradient series

(e) Irregular payment series

Uniform Periodic Annual Payments

⚫ Projects frequently generate recurring

income or cost streams on an annual basis

x x x x x x x x

0 1 2 3 4 5 6 (n-1) n

x = annuity
Discounting a Series
of Payments

. m
1  1 1 1 
P = X = X + + ... + m
j=1 (1 + i) j
 (1 + i) (1 + i)2
(1 + i) 
−1
(1 + i) = a
P = X a + a + a + ... + a 
2 3 m

Pa = X a + a + a + ... + a 
2 3 4 m+1

m+1
P = X(1 − a) = x(a − a )
 Discounting a Series of
Payments con’t

 a − am+1   1 − am 
P = X  = Xa  
 1− a   1− a 
  1 m 
 1−   
(1 + i) − 1
m
 1    1+ i  
= X  =X
 1 + i 
 1− 1  i(1 + i)m

 1 + i 
 
 (1 + i)m−1   1 − (1 + i)− m 
 P = X m 
= X 
 i(1 + i)   i 
Capital Recovery Factor

 i 
1 − (1 + i)−m   captial recovery factor
 
 i 
X= −m 
P
1 − (1 + i) 
Future Equivalents of Annuities

(1 + i)m − 1
P = S(1 + i)−m =X
i(1 + i)m
(1 + i)m − 1
S=X
i
 i 
X = S 
 (1 + i) m
− 1
Summary

⚫ Money has a time value because of its earning

power and inflation rate.
⚫ Economic equivalence exists between
individual cash flows and/or patterns of cash
flows that have the same value. Even though
the amounts and timing of the cash flows may
differ, the appropriate interest rate makes them
equal.
⚫ The purpose of developing various interest
formulas was to facilitate the economic
equivalence computation.
Net Present Value

⚫ 2. Net present value (NPV) takes the amount invested today and
the value of revenue or savings achievable in the future to
calculate the value of the project at today's prices. Future returns
are discounted to reflect the effect of inflation or the cost of capital
required to fund the project. There is no standard discount rate
applied to every type of project; the rate used depends on the
particular investment costs and demands of the project.
⚫ When:
– NPV > 0 accept the project
– NPV = 0 Indifferent to the project
– NPV < 0 reject the project
– If only costs are considered take the less costly
– If only benefits are considered take the most positive
Example 1
⚫ Blantyre City Assembly is considering to build a bridge and has received
two proposals given below. Which one should it adopt?
Details Project 1 Project 2
Initial capital (K) 5,000 4,000
Running cost per annum (K) 500 800
Life span (years) 5 5
Interest rate per annum (%) 10 10
 Cash Flow As Costs

Year Project 1 Project 2

0 -5000) -4000
1 -500 -800
2 -500 -800
3 -500 -800
4 -500 -800
5 -500 -800
Example 2
⚫ Blantyre City Assembly is considering to build a bridge and has received
two proposals given below. Which one should it adopt?
Details Project 1 Project 2
Initial capital (K) 20,000 15,000
Maintenance cost per annum (K) 1,000 2,000
Life span (years) 3 4
Interest rate per annum (%) 10 10
Cash Flow As Costs
Year Project 1 Project 2

0 20,000 15,000 Since the life spans are

1 1,000 2,000 different a replacement is
2 1,000 2,000 required to compare the
3 1,000 20,000 2,000 projects on the same
4 1,000 2,000 15,000 basis 12 years is chosen
5 1,000 2,000
as a common least
6 1,000 20,000 2,000
7 1,000 2,000
multiple.
8 1,000 2,000 15,000 The projects involve
9 1,000 20,000 2,000 costs only and therefore
10 1,000 2,000 the project which is less
11 1,000 2,000 costly will be adopted.
12 1,000 2,000
 Cash Flow As Costs
Yr Project 1 Project 2

0 20,000 15,000

1 1,000 2,000
2 1,000 2,000
3 1,000 20,000 2,000
4 1,000 2,000 15,000
5 1,000 2,000
6 1,000 20,000 2,000
7 1,000 2,000
8 1,000 2,000 15,000

9 1,000 20,000 2,000

10 1,000 2,000
11 1,000 2,000
12 1,000 2,000
 n
1/(1+i)
Year NPF Cashflow NPW NPF Cashflow NPW
0 1.0000 -20,000 -20000.00 1.0000 -15,000 -15,000.00
1 0.9091 -1,000 -909.09 0.9091 -2,000 -1,818.18
2 0.8264 -1,000 826.45 0.8264 -2,000 -1,652.89
3 0.7513 -21000 -15,777.61 0.7513 -2,000 -1,502.63
4 0.6830 -1,000 -683.01 0.6830 -17,000 -11,611.23
5 0.6209 -1,000 -620.92 0.6209 -2,000 -1,241.84
6 0.5645 21,000 -11,853.95 0.5645 -2,000 -1,128.95
7 0.5132 -1,000 -513.16 0.5132 -2,000 -1,026.32
8 0.4665 -1,000 -466.51 0.4665 -17,000 -7930.63
9 0.4241 -21,000 -8,906.05 0.4241 -2,000 -848.20
10 0.3855 -1,000 -385.54 0.3855 -2,000 -771.09
11 0.3505 -1,000 -350.49 0.3505 -2,000 -700.99
12 0.3186 -1,000 -318.63 0.3186 -2,000 --637.26
-61611.42 -45870.20
Internal Rate of Return

⚫ Internal rate of return demonstrates the return on a

project or investment as a percentage figure. Like net
present value, IRR discounts future cash flows.
However, rather than applying a standard discount rate
to the project, the discount rate is calculated as the
figure required to make the net present value zero.
Using this methodology allows comparison of the
rates of return expected across a range of different
projects and against the rate of return achievable from
other investments.
Calculation of IRR
IRR vs. NPV
⚫ Oftentimes, IRR and NPV give the same
decision/ranking among projects.
⚫ IRR only looks at rate of gain – not size of gain
⚫ IRR does not require you to assume (or compute) a
discount rate.
⚫ IRR ignores capacity to reinvest
⚫ IRR may not be unique
NPV

Discount Rate
Examples

⚫ Which project should be accepted if they have

4 year life span at 10% p.a. with the details
given in the table.
⚫
Steel Bridge Concrete
Bridge

Capital 40,000,000 30,000,000

Maintenance 8,000,000
per year
Examples

⚫ Which project should be accepted with the

details given in the table.
⚫ Steel Bridge Concrete
K Bridge K
Capital 40,000,000 30,000,000
Maintenance 8,000,000 9,000,000
per year
Life span 2yrs 3yrs
Interest rate 10% 10%
p.a.