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1.040/1.

401

Project Management
Spring 2007

Project Financing & Evaluation

Dr. SangHyun Lee


lsh@mit.edu
Department of Civil and Environmental Engineering
Massachusetts Institute of Technology

Preliminaries

STELLAR access: to be announced


AS1 Survey due by tonight 12 pm
TP1 and AS2 are out

AS 2: Student
Presentation

10 minute presentation followed by 5 minute


discussion
1 or 2 presentations from Feb. 20 to Mar. 19
Topics

Your past project experience (strongly recommended if you


have any)

Size of project is not important!


Project main figures
Main managerial aspects
Project management practices
Problems, strengths, weaknesses, risks
Your learning

Emerging construction technologies (e.g., 4D CAD, Virtual


Reality, Sensing, )

Preliminaries

STELLAR access: to be announced


AS1 Survey due by tonight 12 pm
TP1 and AS2 are out
Pictures will be taken before you leave
Who we are
Dont memorize course content.
Understand it.

Outline

Session Objective & Context

Project Financing

Financial Evaluation

Owner
Project
Contractor
Additional Issues

Time value of money


Present value
Rates
Interest Formulas
NPV
IRR & payback period

Missing factors

Session Objective

The role of project financing

Mechanisms for project financing

Measures of project profitability

Project Management Phase

FEASIBILITY

DESIGN
PLANNING

DEVELOPMENT

Financing &
Evaluation
Risk

CLOSEOUT

OPERATIONS

Context: Feasibility
Phases

Project Concept
Land Purchase & Sale Review
Evaluation (scope, size, etc.)
Constraint survey

Site constraints
Cost models
Site infrastructural issues
Permit requirements

Summary Report
Decision to proceed
Regulatory process (obtain permits, etc)
Design Phase

Lecture 2 - References
More details on:

Hendrickson PM for Construction online textbook

Chapter 7

Outline

Session Objective & Context

Project Financing

Financial Evaluation

Owner
Project
Contractor
Additional Issues

Time value of money


Present value
Rates
Interest Formulas
NPV
IRR & payback period

Missing factors

Financing Gross
Cashflows
years
OWNER
investment
operation incomes
owner cashflow
owner cum cashflow

10

($10,000,000) ($20,000,000)
$2,000,000
$4,000,000
$6,000,000
$6,000,000
$0 ($10,000,000) ($20,000,000) $2,000,000
$4,000,000
$6,000,000
$6,000,000
$0 ($10,000,000) ($30,000,000) ($28,000,000) ($24,000,000) ($18,000,000) ($12,000,000)

CONTRACTOR
costs
($4,000,000) ($7,000,000) ($14,000,000)
revenues
$0 $10,000,000 $20,000,000
contractor cashflow
($4,000,000) $3,000,000
$6,000,000
contractor cum cashflow
($4,000,000) ($1,000,000) $5,000,000

$0
$0
$0
$5,000,000

Owner investment = contractor revenue

$0
$0
$0
$5,000,000

$0
$0
$0
$5,000,000

$0
$0
$0
$5,000,000

$6,000,000
$6,000,000
($6,000,000)

$6,000,000
$6,000,000
$0

$6,000,000
$6,000,000
$6,000,000

$0
$0
$0
$5,000,000

$0
$0
$0
$5,000,000

$0
$0
$0
$5,000,000

Financing Gross
Cashflows

Design/Preliminary Construction
years
OWNER
investment
operation incomes
owner cashflow
owner cum cashflow

10

($10,000,000) ($20,000,000)
$2,000,000
$4,000,000
$6,000,000
$6,000,000
$0 ($10,000,000) ($20,000,000) $2,000,000
$4,000,000
$6,000,000
$6,000,000
$0 ($10,000,000) ($30,000,000) ($28,000,000) ($24,000,000) ($18,000,000) ($12,000,000)

CONTRACTOR
costs
($4,000,000) ($7,000,000) ($14,000,000)
revenues
$0 $10,000,000 $20,000,000
contractor cashflow
($4,000,000) $3,000,000
$6,000,000
contractor cum cashflow
($4,000,000) ($1,000,000) $5,000,000

$0
$0
$0
$5,000,000

Owner investment = contractor revenue

$0
$0
$0
$5,000,000

$0
$0
$0
$5,000,000

$0
$0
$0
$5,000,000

$6,000,000
$6,000,000
($6,000,000)

$6,000,000
$6,000,000
$0

$6,000,000
$6,000,000
$6,000,000

$0
$0
$0
$5,000,000

$0
$0
$0
$5,000,000

$0
$0
$0
$5,000,000

Financing Gross
Cashflows

Design/Preliminary Construction
years
OWNER
investment
operation incomes
owner cashflow
owner cum cashflow

10

($10,000,000) ($20,000,000)
$2,000,000
$4,000,000
$6,000,000
$6,000,000
$0 ($10,000,000) ($20,000,000) $2,000,000
$4,000,000
$6,000,000
$6,000,000
$0 ($10,000,000) ($30,000,000) ($28,000,000) ($24,000,000) ($18,000,000) ($12,000,000)

CONTRACTOR
costs
($4,000,000) ($7,000,000) ($14,000,000)
revenues
$0 $10,000,000 $20,000,000
contractor cashflow
($4,000,000) $3,000,000
$6,000,000
contractor cum cashflow
($4,000,000) ($1,000,000) $5,000,000

$0
$0
$0
$5,000,000

$0
$0
$0
$5,000,000

$0
$0
$0
$5,000,000

$0
$0
$0
$5,000,000

$6,000,000
$6,000,000
($6,000,000)

$6,000,000
$6,000,000
$0

$6,000,000
$6,000,000
$6,000,000

$0
$0
$0
$5,000,000

$0
$0
$0
$5,000,000

$0
$0
$0
$5,000,000

Owner investment = contractor revenue

Early expenditure
Takes time to get reve

Project Financing

Aims to bridge this gap in the most


beneficial way!

Critical Role of
Financing

Makes projects possible


Has major impact on

Riskiness of construction
Claims
Prices offered by contractors (e.g., high bid price for
late payment)

Difficulty of Financing is a major driver


towards alternate delivery methods (e.g.,
Build-Operate-Transfer)

How Does Owner Finance a


Project?

Public

Private

Project financing

Outline

Session Objective & Context

Project Financing

Financial Evaluation

Owner
Project
Contractor
Additional Issues

Time value of money


Present value
Rates
Interest Formulas
NPV
IRR & payback period

Missing factors

Public Financing

Sources of funds

Social benefits important justification

Benefits to region, quality of life, unemployment relief, etc.

Important consideration: exemption from taxes


Public owners face restrictions (e.g. bonding caps)

General purpose or special-purpose bonds


Tax revenues
Capital grants subsidies
International subsidized loans

Major motivation for public/private partnerships

MARR (Minimum Attractive Rate of Return) much


lower (e.g. 8-10%), often standardized

Private Financing

Major mechanisms

Equity

Invest corporate equity and retained earnings


Offering equity shares

Must entice investors with sufficiently high rate of return


May be too limited to support the full investment
May be strategically wrong (e.g., source of money, ownership)

Debt

Stock Issuance (e.g. in capital markets)

Borrow money
Bonds

Because higher costs and risks, require higher


returns
MARR varies per firm, often high (e.g. 20%)

Private Owners w/Collateral


Facility Distinct Financing
Periods

Short-term construction loan

Bridge Debt

Long-term mortgage

Senior Debt

Risky (and hence expensive!)


Borrowed so owner can pay for construction (cost)

Typically facility is collateral


Pays for operations and Construction financing debts
Typically much lower interest

Loans often negotiated as a package

construction
w/o tangible

operation
w/ tangible

time

Outline

Session Objective & Context

Project Financing

Financial Evaluation

Owner
Project
Contractor
Additional Issues

Time value of money


Present value
Rates
Interest Formulas
NPV
IRR & payback period

Missing factors

Project Financing

Investment is paid back from the project profit rather than


the general assets or creditworthiness of the project
owners
For larger projects due to fixed cost to establish

Investment in project through special purpose corporations

Often joint venture between several parties

Need capacity for independent operation


Benefits

Small projects not much benefit

Off balance sheet (liabilities do not belong to parent)


Limits risk
External investors: reduced agency cost (direct investment in
project)

Drawback

Tensions among stakeholders

Outline

Session Objective & Context

Project Financing

Financial Evaluation

Owner
Project
Contractor
Additional Issues

Time value of money


Present value
Rates
Interest Formulas
NPV
IRR & payback period

Missing factors

Contractor Financing I

Payment schedule

Break out payments into components

Often some compromise between contractor and


owner
Architect certifies progress
Agreed-upon payments

Advance payment
Periodic/monthly progress payment (itemized breakdown
structure)
Milestone payments

retention on payments (usually, about 10%)

Often must cover deficit during construction


Can be many months before payment received

S-curve Work
Man-hours

months

S-curve Cost
8

100
90

80
6
5

$K

60

50
40

30
2
20
1

10

0
1

6 7

9 10 11 12 13 14 15 16 17 18 19 20 21 22
Working days

Cumulative costs $K

70

Daily cost
Cum. costs

Expense & Payment

Contractor Financing II

Owner keeps an eye out for

Front-end loaded bids (discounting)


Unbalanced bids

Contractor Financing II

Owner keeps an eye out for

Contractors frequently borrow from

Front-end loaded bids (discounting)


Unbalanced bids
Banks (Need to demonstrate low risk)

Interaction with owners

Some owners may assist in funding

Help secure lower-priced loan for contractor

Sometimes assist owners in funding!

Big construction company, small municipality


BOT

Contractor Financing III

Agreed upon in contract

Often structure proposed by owner

Should be checked by owner (fair-cost


estimate)

Often based on Masterformat Cost


Breakdown Structure (Owner standard CBS)

Certified by third party


(Architect/engineer)

Outline

Session Objective & Context

Project Financing

Financial Evaluation

Owner
Project
Contractor
Additional Issues
Time value of money
Present value
Rates
Interest Formulas
NPV
IRR & payback period

Missing factors

Latent Credit

Many people forced to serve as lenders to


owner due to delays in payments

Designers
Contractors
Consultants
CM
Suppliers

Implications

Good in the short-term


Major concern on long run effects

Role of Taxes

Tax deductions for

Depreciation - Link

the process of recognizing the using up of an


asset through wear and obsolescence and of
subtracting capital expenses from the
revenues that the asset generates over time
in computing taxable income

Others

Outline

Session Objective & Context

Project Financing

Financial Evaluation

Owner
Project
Contractor
Additional Issues

Time value of money


Present value
Rates
Interest Formulas
NPV
IRR & payback period

Missing factors

Develop or Not Develop

Is any individual project worthwhile?

Given a list of feasible projects, which one


is the best?

How does each project rank compared to


the others on the list?

Project Evaluation
Example:

Project A

Project B

Construction=3
years

Construction=6
years

Cost = $1M/year

Cost=$1M/year

Sale Value=$4M

Sale Value=$8.5M

Total Cost?

Total Cost?

Profit?

Profit?

Quantitative Method

Profitability

Create value for the company

Profit
TOTAL
EQUIVAL. $

REVENUES

5,500,000.
00

COSTS

4,600,000.
00

Project management

400,000.00

Engineering

800,000.00

Material & transport

2,200,000.00

Construction/commissioni
ng

1,300,000.00

Contingencies

GROSS
MARGIN
Time
factor?

200,000.00

900,000.0

Quantitative Method

Profitability

Create value for the company

Opportunity Cost

Time Value of Money

A dollar today is worth more than a dollar tomorrow

Investment relative to best-case scenario

E.g. Project A - 8% profit, Project B - 10% profit

Money Is Not
Everything

Social Benefits

Hospital

School

Highway built into a remote village

Intangible Benefits (E.g, operating and


competitive necessity)

New warehouse

New cafeteria

Outline

Session Objective & Context

Project Financing

Financial Evaluation

Owner
Project
Contractor
Additional issues

Time value of money


Present value
Rates
Interest Formulas
NPV
IRR & payback period

Missing factors

Basic Compounding

Suppose we invest $x in a bank offering interest rate


i
If interest is compounded annually, asset will be
worth

0
$x

$x(1+i)
$x(1+i)2
$x(1+i)3
$x(1+i)n

after 1 year
after 2 years
after 3 years .
after n years

1 $x(1+i)

2 $x(1+i)2

n $x(1+i)n

Time Value of Money

If we assume

That money can always be invested in the bank


(or some other reliable source) now to gain a
return with interest later
That as rational actors, we never make an
investment which we know to offer less money
than we could get in the bank

Then

Money in the present can be thought as of


equal worth to a larger amount of money in the
future
Money in the future can be thought of as having
an equal worth to a lesser present value of
money

Equivalence of Present
Values

Given a source of reliable


investments, we are indifferent
between any cash flows with the same
present value they have equal
worth

This indifferences arises because we


can convert one to the other with no

Preliminaries

STELLAR access:
http://stellar.mit.edu/S/course/1/sp07/1.040/
Next Tuesday Recitation: Skyscraper Part I
Please set up an appointment to discuss
your AS2 if you choose emerging
technologies (MF preferred)
Office: 1-174
TA (50%) for our class

Send your resume (or brief your experience) by


this Sunday

Outline

Session Objective & Context

Project Financing

Financial Evaluation

Owner
Project
Contractor
Additional issues

Time value of money


Present value
Rates
Interest Formulas
NPV
IRR & payback period

Missing factors

Time Value of Money:


Revisit

If we assume

That money can always be invested in the bank


(or some other reliable source) now to gain a
return with interest later
That as rational actors, we never make an
investment which we know to offer less money
than we could get in the bank

Then

Money in the present can be thought as of


equal worth to a larger amount of money in the
future
Money in the future can be thought of as having
an equal worth to a lesser present value of
money

Present Value (Revenue)

How is it that some future revenue r at time t has


a present value?
Answer: Given that we are sure that we will be
gaining revenue r at time t, we can take and
spend an immediate loan from the bank

We choose size of this loan l so that at time t, the total


size of the loan (including accrued interest) is r

The loan l is the present value of r

l = PV(r)

Future to Present
Revenue
If I know this is coming
x
t

I can borrow this from the bank now


PV(x)

t
0

PV(x)

Ill pay this back to the bank


later
-x
The net result is that I can convert a sure x
t
into a (smaller) PV(x) now!

Present Value (Cost)

How is it that some future cost c at time t has a


present value?
Answer: Given that we are sure that we will bear
cost c at time t, we immediately deposit a sum of
money x into the bank yielding a known return

We choose size of deposit x so that at time t, the total size of


the investment (including accrued interest) is c
We can then pay off c at time t by retrieving this money
from the bank

The size of the deposit (immediate cost) x is the


present value of c.

Future to Present Cost


t

-x
If I know this cost is coming

I retrieve this back from the bank la


I can deposit this in the bank now
PV(x)

x
t

t
PV(x)

The net result is that I can convert a sure cost x at


into a (smaller) cost of PV(x) now!

Summary

Because we can flexibly switch from one such


value to another without cost, we can view these
values as equivalent
0

PV

FV
t

Summary

Because we can flexibly switch from one such


value to another without cost, we can view these
values as equivalent
0

PV

v= v(1+i)t

FV
t

Given a reliable source offering annual return i


(i.e., interest) we can shift without additional
costs between cash v at time 0 and v(1+i)t at
time t

Outline

Session Objective & Context

Project Financing

Financial Evaluation

Owner
Project
Contractor
Additional issues

Time value of money


Present value
Rates
Interest Formulas
NPV
IRR & payback period

Missing factors

Rates

Difference between PV (v) and FV ( =v(1+i)t ) depends on i and t.

Rates

Difference between PV (v) and FV ( =v(1+i)t ) depends on


i and t.

Interest Rate

Contractual arrangement between a borrower and a lender

Discount Rate (real change in value to a person or group)

Worth of Money + Risk

Discount Rate > Interest Rate

Minimum Attractive Rate of Return (MARR)

Minimum discount rate accepted by the market corresponding to


the risks of a project (i.e., minimum standard of desirability)

Choice of Discount Rate


r = rf + ri + rr
Where:
r
rf
ri
rr

is the discount rate


the risk free interest rate. Normally government bond
Rate of inflation. It is measured by either by consumer price
index or GDP deflator.
Risk factor consisting of market risk, industry risk, firm
specific risk and project risk
Market Risk
rr
Industry Risk
=
Firm specific Risk
Project Risk

GDP = Gross Domestic Product

Outline

Session Objective & Context

Project Financing

Financial Evaluation

Owner
Project
Contractor
Additional issues

Time value of money


Present value
Rates
Interest Formulas
NPV
IRR & payback period

Missing factors

Interest Formulas

i = Effective interest rate per interest period


(discount rate or MARR)

n = Number of compounding periods

PV = Present Value

FV = Future Value

A = Annuity (i.e., a series of payments of set size) at


end-of-period

Interest Formulas:
Payment

Single Payment Compound Amount Factor (F=PFactor)

Factor that will make your present value future value in single
payment

(F/P, i, n) = (1 + i )n

n
F

Interest Formulas:
Payment

Single Payment Present Value Factor (P=FFactor)

Factor that will make your future value present value in


single payment

(P/F, i, n) = 1/ (1 + i )n = 1/ (F/P, i, n)
0

n-1

P
F

Interest Formulas:
Payment
- Example

If you wish to have $100,000 at the end


of five years in an account that pays 12
percent annually, how much would you
need to deposit now?

Interest Formulas:
Payment
- Example

If you wish to have $100,000 at the end


of five years in an account that pays 12
percent annually, how much would you
need to deposit now?
0

P=?

F=$100,000

(P/F, 0.12, 5) or (F/P, 0.12,


5)?

Interest Formulas:
Payment
- Example

If you wish to have $100,000 at the end


of five years in an account that pays 12
percent annually, how much would you
need to deposit now?

P = F(P/F, 0.12, 5)

P = 100,000 (P/F, 0.12,


5)

P = 100,000 0.5674 =
$56,740

Interest Formulas: Series

Uniform Series Compound Amount Factor (F=AFactor)


(F=AFactor

Factor that will make your annuity value future value in series
payment

(F/A, i, n) =[(1+i)n - 1]/ i


F
0

Annuity
period occurs at the end of the interest

Interest Formulas: Series

Uniform Series Compound Amount Factor (F=AFactor)


(F=AFactor

Factor that will make your annuity value future value in series
payment

(F/A, i, n) =[(1+i)n - 1]/ i


F=A
F
0

Interest Formulas: Series

Uniform Series Compound Amount Factor (F=AFactor)


(F=AFactor

Factor that will make your annuity value future value in series
payment

(F/A, i, n) =[(1+i)n - 1]/ i


F = A+A(1+i)
F
0

Interest Formulas: Series

Uniform Series Compound Amount Factor (F=AFactor)


(F=AFactor

Factor that will make your annuity value future value in series
payment

(F/A, i, n) =[(1+i)n - 1]/ i

F = A + A(1+i) + + A(1
+ i )n-1

Interest Formulas: Series

Uniform Series Sinking Fund Factor (A=FFactor)

Factor that will make your future value annuity value in series
payment

(A/F, i, n) = i / [ (1 + i )n 1] = 1 / (F/A, i, n)

A
F

Interest Formulas: Series

Uniform Series Present Value Factor (P=AFactor)

Factor that will make your annuity value present value in


series payment

(P/A, i, n) = [ (1 + i )n -1 ] / [ i (1 + i )n ]
P
0

Interest Formulas: Series

Uniform Series Present Value Factor (P=AFactor)

Factor that will make your annuity value present value in


series payment

(P/A, i, n) = [ (1 + i )n -1 ] / [ i (1 + i )n ]
P = A/ (1 + i )
0

Interest Formulas: Series

Uniform Series Present Value Factor (P=AFactor)

Factor that will make your annuity value present value in


series payment

(P/A, i, n) = [ (1 + i )n -1 ] / [ i (1 + i )n ]

P = A/(1 + i ) + A/(1 + i )2
0

Interest Formulas: Series

Uniform Series Present Value Factor (P=AFactor)

Factor that will make your annuity value present value in


series payment

(P/A, i, n) = [ (1 + i )n -1 ] / [ i (1 + i )n ]

P = A/(1 + i ) + A/(1 + i )2 + + A/(1 + i )n


0

Verify it!

Interest Formulas: Series

Uniform Series Capital Recovery Factor


(A=PFactor)

Factor that will make your present value annuity value in


series payment

(A/P, i, n) = [i (1 + i )n / [(1 + i )n 1] = 1 / (P/A, i, n)


0
P

Verify it!

Interest Formulas: Series


- Example

A ranch is offered for sale in Mexico with a 15


year mortgage rate at 40% compounded annually,
and 20% down payment. Annual payments are to
be made. The first cost of the ranch is 5 million
pesos. What yearly payment is required?

Interest Formulas: Series


- Example

A ranch is offered for sale in Mexico with a 15


year mortgage rate at 40% compounded annually,
and 20% down payment. Annual payments are to
be made. The first cost of the ranch is 5 million
pesos. What yearly payment is required?

Down Payment = 5,000,000 * 0.2 =


1,000,000

P = 5,000,000 1,000,000 = 4,000,000

A = P * (which factor?)

Interest Formulas: Series


- Example

A ranch is offered for sale in Mexico with a 15


year mortgage rate at 40% compounded annually,
and 20% down payment. Annual payments are to
be made. The first cost of the ranch is 5 million
pesos. What yearly payment is required?

Down Payment = 5,000,000 * 0.2 =


1,000,000

P = 5,000,000 1,000,000 = 4,000,000

A = P * (which factor?) = P * (A/P, 0.4, 15)

A = 4,000,000 * 0.40259 = 1,610,400


pesos/year

Equipment Example

$ 20,000 equipment expected to last 5


years

$ 4,000 salvage value

Minimum attractive rate of return 15%

What are the?

A - Annual Equivalent

P - Present Equivalent

Equipment Example

Equipment Example

A = -20,000 * (A/P, 0.15, 5) + 4,000 * (A/F, 0.15, 5)


= -20,000 * (0.2983) + 4,000 * (0.1483)
= -5,373

P = -20,000 + 4,000 * (P/F, 0.15, 5)


= -20,000 + 4,000 * (0.4972)
= -18,011

Outline

Session Objective & Context

Project Financing

Financial Evaluation

Owner
Project
Contractor
Additional issues

Time value of money


Present value
Rate
Interest Formulas
NPV
IRR & payback period

Missing factors

Net Present Value

Suppose we had a collection (or stream, flow)


of costs and revenues in the future

The net present value (NPV) is the sum of the


present values for all of these costs and
revenues

Treat revenues as positive and costs as negative

Calculation of Net
Present Value
Total Revenue (R)
(+)

Tax (-)

Discount Rate (r)

Various Costs (C)


(-)

Calculate Gross
Return
Calculate Net
Return
PV of Net Return

Initial Invest (-I)


NPV of the Project

Net Present Value


Decision Rule
NPV

>
=
<

Accept the project


Indifferent to the project
Reject the project

Accept a project which has 0 or


positive NPV
Alternatively,
Use NPV to choose the best among a
set of (mutually exclusive) alternative
projects

Mutually exclusive projects: the acceptance of a

Project Evaluation
Example Revisit: Which
one is better?

Project A

Project B

Construction=3
years

Construction=6
years

Cost = $1M/year

Cost = $1M/year

Sale Value = $4M

Sale Value = $8.5M

Total Cost?

Total Cost?

Profit?

Profit?

Drawing out the


examples

Project A
0

$4M
1

$1M

$1M

$1M

Project B
0

$8.5M
6

$1M

$1M

$1M

Assume 10% discount rate


Link

$1M

$1M $1M

Or Using Interest
Formulas

Project A

-$1M * (P/A, 0.1, 3) + $4M * (P/F, 0.1, 3)

Project B

-$1M * (P/A, 0.1, 6) + $8.5M * (P/F, 0.1,


6)

Assume 10% discount rate

Four Independent
Projects

The cash flow profiles of four independent projects


are shown below. Using a MARR of 20%, determine
the acceptability of each of the projects on the
basis of the net present value criterion for
accepting independent projects.

Solution
[NPV1]20%
= -77 + (235)(P/F, 0.2, 5) = -77 + 94.4
= 17.4

NPV1 Cash Flow

Year 0

$235 M

-$77 M

[NPV2]20%
= -75.3 + (28)(P/A, 0.2, 5) = -75.3 + 83.7
= 8.4

$28 M each year

NPV2 Cash
Flow

Year 0

-$75.3 M

Solution
[NPV3]20%
= -39.9 + (28)(P/A, 20%, 4) - (80)(P/F, 20%, 5)
= -39.9 + 72.5 - 32.2
$28 M each year
= 0.4
NPV3 Cash Flow

Year 0

-$39.9 M

-$80 M

[NPV4]20%
= 18 + (10)(P/F, 20%, 1) - (40)(P/F, 20%, 2)
- (60)(P/F, 20%, 3) + (30)(P/F, 20%, 4)
+ (50)(P/F, 20%, 5)
= 18 + 8.3 - 27.8 - 34.7 + 14.5 + 20.1 = -1.6
NPV4 Cash Flow

$50 M

$30 M

$18 M $10 M

Year 0

2
-$40 M

-$60 M

Source: Hendrickson and Au, 1989/2003

Solution

[NPV1]
[NPV2]
[NPV3]
[NPV4]

=
=
=
=

17.4
8.4
0.4
-1.6

Source: Hendrickson and Au, 1989/2003

Discount Rate in NPV

NPV (and PV) is relative to a discount rate

In the absence of risk or inflation, this is just the interest


rate of the reliable source (opportunity cost)

Correct selection of the discount rate is fundamental. If too


high, projects that could be profitable can be rejected. If
too low, the firm will accept projects that are too risky
without proper compensation.

Its choice can easily change the ranking of projects.

Example

Selection of Discount Rate:


Example

2 pieces of equipment: one needs a human operator (initial cost


$10,000, annual $4,200 for labor); the second is fully automated (initial
cost $18,000, annual #3,000 for power). n=10years.

Is the additional $8,000 in the initial investment of the second


equipment worthy the $1,200 annual savings? (discount rate: 5 or
10%)

Link

Selection of Discount Rate:


Example

2 pieces of equipment: one needs a human operator (initial cost $10,000,


annual $4,200 for labor); the second is fully automated (initial cost $18,000,
annual #3,000 for power). n=10years.

Is the additional $8,000 in the initial investment of the second equipment


worthy the $1,200 annual savings? (discount rate: 5 or 10%)

There is a critical value of i that changes the equipment choice


(approximately 8.15%)

Example: The US Federal Highway Administration promulgated a regulation


in the early 1970s that the discount rate for all federally funded highways
would be zero. This was widely interpreted as a victory for the cement
industry over asphalt industry. Roads made of concrete cost significantly
more than those of made of asphalt while requiring less maintenance and
less replacement [Shtub et al., 1994] - Link

Outline

Session Objective & Context

Project Financing

Financial Evaluation

Owner
Project
Contractor
Additional issues

Time value of money


Present value
Rate
Interest Formulas
NPV
IRR & payback period

Missing factors

Internal Rate of Return


(IRR)

Defined as the rate of return that makes the NPV


of the project equal to zero

To see whether the projects rate of return is


equal to or higher than the rate of the firm to
expect to get from the project

IRR Calculation Example

NPV = -20,000 + 5,600 (P/A, i, 5) + 4,000 (P/F, i, 5)

Link

Relationship between NPV


& IRR

IRR

IRR Investment Rule


r-

>
=

r*

<

Accept
Indifferent
Reject

- r = IRR,
* r = MARR

Accept a project with IRR larger than MARR


Alternatively,

Maximize IRR across mutually exclusive


projects.

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

Link

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
Use both NPV (size) and IRR together (rate)
However, Trust the NPV: It is the only criterion that
ensures wealth maximization. It measures how much
richer one will become by undertaking the investment
opportunity.

Payback Period

Payback period (Time to return)

Minimal length of time over which benefits


repay costs
Typically only used as secondary assessment

Payback Period

Payback period (Time to return)

Minimal length of time over which benefits repay costs


Typically only used as secondary assessment
Important for selection when the risk is extremely high
Drawbacks

Ignores what happens after payback period


Does not take into account discounting

Comparing Projects

Financing has major impact on project


selection

Suppose that one had to choose between 2


investment projects

How can one compare them?

Comparing Projects

Financing has major impact on project


selection

Suppose that one had to choose between 2


investment projects

How can one compare them?

Use NPV

Verify IRR

Check payback period

Other Methods

Benefit-Cost ratio (benefits/costs)

Discounting still generally applied


Accept if >1 (benefits > costs)
Common for public projects
Does not consider the absolute size of the
benefits

Cost-effectiveness

Looking at non-economic factors


Discounting still often applied for non-economic

$/Life saved
$/Life quality

Inflation & Deflation

Inflation means that the prices of goods and


services increase over time either imperceptibly
or in leaps and bounds. Inflation effects need to
be included in investment because cost and
benefits are measured in money and paid in
current dollars, francs or pesos. An inflationary
trend makes future dollars have less purchasing
power than present dollars.

Deflation means the opposite of inflation. Prices


of goods & services decrease as time passes.

Inflation & Deflation


i ' i j ij
If i, A(y=0) will be A*(1+i) after
one year. Then, if j, A will be
A*(1+i)*(1+j).

discount rate excluding


i inflation

i' discount rate including


inflation
j
annual inflation rate

Inflation & Deflation


discount rate excluding
i inflation

i ' i j ij
If i, A(y=0) will be A*(1+i) after
one year. Then, if j, A will be
A*(1+i)*(1+j).

When the inflation jrate


approximated by:

i' i j

i' discount rate including


inflation
j

annual inflation rate


is small, these relations can be
or

i i' j

NPV A0 At / (1 i ) t
t 1

NPV A0 At' / (1 i ' ) t


t 1

At cash flow in year t expressed in terms of constant


(base year) dollars
A't cash flow in year t expressed in terms of inflated

Inflation Example

A company plans to invest $55,000 initially in a piece


of equipment which is expected to produce a uniform
annual constant dollars net revenue before tax of
$15,000 over the next five years. The equipment has
a salvage value of $5,000 in constant dollars at the
end of 5 years and the depreciation allowance is
computed on the basis of the straight line
depreciation method (i.e., $10,000 during next five
years). The marginal income tax rate for this
company is 34%. The inflation expectation is 5% per
year, and the after-tax MARR specified by the
company is 8% excluding inflation. Determine
whether the investment is worthwhile.
Link

Solution

Depreciation costs are not inflated to current dollars in conformity with the
practice recommended by the U.S. Internal Revenue Service.

With 5% inflation, the investment is no longer worthwhile because


the value of the depreciation tax reduction is not increased to
match the inflation rate.
Verify that the use of MARR including inflation gives the same
result (credit by next Monday send me one-page excel sheet)
Whether taking into account inflation or not, NPV could be

Impact of Inflation: Boston


Central Artery
Year
t
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004

Price
Index
1982 $
100
104
111
118
122
123
130
134
140
144
146
154
165
165
165
175
172
176
181
183
189
195
202

Price
Index
2002 $
53
55
59
62
65
65
69
71
74
76
77
82
88
88
87
93
91
94
96
97
100
103
107

Project
Expenses
($ K)

33,000
82,000
131,000
164,000
214,000
197,000
246,000
574,000
854,000
852,000
764,000
1,206,000
1,470,000
1,523,000
1,329,000
1,246,000
1,272,000
1,115,000
779,000

Project
Expenses
(1982 $ k)

27,000
67,000
101,000
122,000
153,000
137,000
169,000
372,000
517,000
515,000
464,000
687,000
853,000
863,000
735,000
682,000
674,000
572,000
386,000

Project
Expenses
(2002 $ K)

51,000
126,000
190,000
230,000
289,000
258,000
318,000
703,000
975,000
973,000
877,000
1,297,000
1,609,000
1,629,000
1,387,000
1,288,000
1,272,000
1,079,000
729,000

Source: Hendrickson and Au, 1989/2003

Outline

Session Objective & Context

Project Financing

Financial Evaluation

Owner
Project
Contractor
Additional issues

Time value of money


Present value
Rates
Interest Formulas
NPV
IRR & payback period

Missing factors

What are we Assuming


Here?

That only quantifiable monetary


benefits matter

Certainty about future cash flows

Main uncertainties:

Financial concerns

Currency fluctuations (international projects)


Inflation/deflation
Taxes variations

Project risks

Project Management Phase

FEASIBILITY

DESIGN
PLANNING

DEVELOPMENT

Financing &
Evaluation
Risk

CLOSEOUT

OPERATIONS

Risk Management

Case Study

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