COTM 5104: CONSTRUCTION MANAGEMENTChapter 3Project Financial Appraisal

School of Civil and Environmental Engineering

AAU, AAiT, Construction Management, Lecture Notes,March 2014, Getaneh G.

Contents Project Financial Appraisal

1. General2. Time Value of Money3. Financial Appraisal Methods4. Depreciation

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1. General1.1 Basic Definitions1.1.1 AssetAssets represents how much a company owns at a given time of reporting usually, it is within the budget year.Assets are divided into:Current assets: include cash at hand other assets which can easily be converted into cash in less than a year (e.g. cash at hand, accounts receivable). Fixed assets: permanent properties which cant be easily converted into cash within a year (e.g. land, equipment, buildings). Other assets: include other investments and good will.*

1. General1.1 Basic Definitions1.1.2 LiabilitiesLiabilities represents what the company owes like loans, debts etc. Liabilities are divided into: Current liabilities: debts to be settled in a short period of time. Other liabilities: includes long term loans, performance bonds, wages, etc. 1.1.3 Stakeholders EquityStakeholders equity (capital) represents the capital provided by owners of the company.*

1. General1.2 Basic Finance Notes1.2.1 Balance SheetThe balance sheet is a statement which shows the financial position of a company at the end of a certain reporting period, which is the fiscal year. It mainly shows the assets, liabilities and stockholders equity, based on the accounting equations:Assets = Liabilities + Owners equity1.2.2 Profit Profit is an earning of a given period concerned whether or not they have been received minus the expenses of the same period whether or not they have been paid.

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1. General1.2 Basic Finance Notes1.2.3 Income StatementThis is a form of financial statement that shows whether the company has made or lost money during that reporting period. Income statements can be prepared monthly, quarterly, etc. However, usual accounting periods extend to one year, which is the fiscal year.In the income statement one shows or itemizes:Revenues and net sales;Production costs and gross margin;Gross profit and net profit; andEarning per share.

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1. General1.2 Basic Finance Notes1.2.4 Cash Flow StatementThe income statement shows how much the company has lost or gained, but does not indicate financing and investment activities during the period. Cash flow statement show how the company generated the cash and how it has spent or utilized it.1.2.5 Retained EarningsThis is money which is retained from the net profit to be used for expansion purposes or saved as security for risks. The remaining balance, which is net profit minus retained earnings, will be given as dividend to owners.

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2. Time Value of Money2.1 Basic Concepts and Terminologies2.1.1 Basic ConceptsThe concept of the time value of money is as old as money itself money costs money.Because money has both earning power and purchasing power over timeMoney 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 i.e. a cost to the borrower and an earning to the lender.

Example : to buy refrigerator= $100 , if u invest it at annual interest rate =6% and if Inflation rate =8% , inf. rate =4%. Analyze it .*

2. Time Value of Money2.1 Basic Concepts and Terminologies2.1.2 TerminologiesP (Principal): Initial amount of money invested or borrowed.i (Interest rate): expressed as a percentage per period of time.n (Interest period): determines how frequently interest is calculated. N (Number of interest periods): duration of transaction.An (a plan for receipts or disbursements): a particular cash flow pattern.F (Future Amount): cumulative effects of the interest.*

2. Time Value of Money2.2 Cash Flow DiagramsThe graphic presentation of the costs and benefits over the time is called the cash flow diagram. It is a presentation of what costs have to be incurred and what benefits are received at all points in time.The following conventions are used in the construction of the cash flow diagram:The horizontal axis represents time;The vertical axis represents costs and benefits;Costs are shown by downward arrows; andBenefits are shown by upward arrows.All the benefits and/or costs incurred during a period are assumed to have been incurred at the end of that period. Since the period is normally a year, this is called the ''end of the year" rule.*

2. Time Value of Money2.2 Cash Flow Diagramscash flows with in a given period of time .

The two computational schemes for calculating this earned interest yield either simple interest or compound interest.*Cash Flow

2. Time Value of Money2.3 Methods of Calculating Interest2.3.1 Simple InterestSimple interest is the practice of charging an interest rate only to an initial sum (principal amount).Fn = P+ (iP) N = P(1+i N)Example: calculate the future value of ETB 1,500 at the end of three years with an interest rate of 9%.Table 1: Simple Interest Calculation.*

End of YearBeginning Balance (P)Interest (I = 9%)Ending Balance (F)01, 50011, 5001351, 63521, 6351351, 77031, 7701351, 905

2. Time Value of Money2.3 Methods of Calculating Interest2.3.2 Compound InterestCompound interest is the practice of charging an interest rate to an initial sum and to any previously accumulated interest that has not been withdrawn.the entire amount (principal and interest) will be compounded. the factor (1 + i)N is known as the compound-amount factor. P(l + i)(l + i) = P(l + i)2.

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End of YearBeginning Balance (P)Interest (I = 9%)Ending Balance (F)01, 50011, 5001351, 63521, 635147.151, 782.1531, 782.15160.401, 942.55

2. Time Value of Money2.3 Methods of Calculating Interest2.3.2 Compound InterestCompounding Process of compound interest is shown below.F = $1,500(1+0.09)3 = $1,942.54*

2. Time Value of Money2.3 Methods of Calculating Interest2.3.2 Compound InterestCompound interest compounding Process equation derivation.*

2. Time Value of Money2.3 Methods of Calculating Interest2.3.3 Equivalence CalculationEquivalence calculations are usually made to compare alternatives. Equivalence:-Interest formulas allow us to place different cash flows received at different times in the same time frame and to compare them.

There are certain rules that one should follow to make these calculations. They need to have a common time basis;Equivalence is dependent on interest rate; and.

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2. Time Value of Money2.4 Interest Formula in Different Cash Flow Categories2.4.1 Single Cash Flows 2.4.1.1 Future (Compound) SumF = P(1+i)n (1+i)n Single Payment Compound (Growth) Amount Factor = P(F/P, i, n)Example: If you had $2,000 now and invested it at 10%, how much would it be worth in 8 years?

*$2,000F = ?80i = 10%

2. Time Value of Money2.4 Interest Formula in Different Cash Flow Categories2.4.1 Single Cash Flows 2.4.1.1 Future (Compound) SumGiven: P = $2,000I = 10%N = 8 YearsReqd :-FSolution: F = $2,000(1+0.10)8F = $2,000 (P/F, 10%, 8)F = $4,287.18Using compound-interest tables: page 510,The interest tables can be used to locate the compound-amount factor for i = 10% and N = 8. F = P(F/P, i, N). F= P(F/P, 10%, 8)

*F0NP

Contd #1. Suppose you buy a share of stock for $10 and sell it for $20; If your investment takes five years, what would be the rate of return on your investment? Given: P = $10, F = $20, and N = 5. Find: i.Method 1: Go through a trial-and-error process in which you insert different values of i = 14.87%. Method 2: You can solve the problem by using the interest tables F = P(1+i)n ,20= 10(1+i)5Now look across the N = 5 row under the (F/P, i, 5) column until you can locate the value of 2.This value is approximated in the 15% interest table at (F/P, 15%, 5) = 2.0114.

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Contd #2. You have just purchased 100 shares of General Electric stock at $30 per share. You will sell the stock when its market price doubles. If you expect the stock price to increase 12% per year, how long do you expect to wait before selling the stock ?#2. Given: P = $3,000, F = $6,000, and i = 12% per year. Find: N (years). Tables ?calculator ? N=6

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2. Time Value of Money2.4 Interest Formula in Different Cash Flow Categories2.4.1 Single Cash Flows 2.4.1.2 Present Worth (Discount) SumP = F(1+i)-n (1+i)-n Single payment Present Worth (Discount) Factor = F(P/F, i, n)Given: F = $1,000i = 12%N = 5 YearsReqd: PSolution: P = $1,000(1+0.12)-5P = $1,000 (F/P, 12%, 5)P = $567.40

*FN0P

2. Time Value of Money2.4 Interest Formula in Different Cash Flow Categories2.4.2 Multiple Payments2.4.2.1 Uneven Payment SeriesExample: how much do you need to deposit today (P) to withdraw $25,000 at n =1, $3,000 at n = 2, and $5,000 at n =4, if your account earns 10% annual interest?

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2. Time Value of Money2.4 Interest Formula in Different Cash Flow Categories2.4.2 Multiple Payments2.4.2.1 Uneven Payment Series

*01 2 3 4$25,000$3,000$5,000P01 2 3 4$25,000P101 2 3 4$3,000P21 2 3 4$5,000P4++0

2. Time Value of Money2.4 Interest Formula in Different Cash Flow Categories2.4.2 Multiple Payments2.4.2.2 Uniform (Equal) Payment Series

*012NFP0N012NAAA

2. Time Value of Money2.4 Interest Formula in Different Cash Flow Categories2.4.2 Multiple Payments2.4.2.2 Uniform (Equal) Payment SeriesA. Compound Amount Factor (Future Value/Annuity)

*012N012NAAAFA(1+i)N-1A(1+i)N-2

2. Time Value of Money2.4 Interest Formula in Different Cash Flow Categories2.4.2 Multiple Payments2.4.2.2 Uniform (Equal) Payment SeriesA. Compound Amount Factor (Future Value/Annuity)Example: Given: A = $5,000, N = 5 years, and i = 6%Reqd: FSolution: F = $5,000(F/A,6%,5) = $28,185.46

*0 1 2 3NFA

2. Time Value of Money2.4 Interest Formula in Different Cash Flow Categories2.4.2 Multiple Payments2.4.2.2 Uniform (Equal) Payment SeriesA. Compound Amount Factor (Future Value/Annuity)

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F =?

0 1 2 3 4 5

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

i = 6%

2. Time Value of Money2.4 Interest Formula in Different Cash Flow Categories2.4.2 Multiple Payments2.4.2.2 Uniform (Equal) Payment SeriesB. Sinking Fund FactorExample: College Savings PlanGiven: F = $100,000, N = 8 years, and i = 7%Reqd: ASolution: A = $100,000(A/F,7%,8) = $9,746.78

*0 1 2 3NFA

2. Time Value of Money2.4 Interest Formula in Different Cash Flow Categories2.4.2 Multiple Payments2.4.2.2 Uniform (Equal) Payment SeriesC. Capital Recovery FactorExample: Paying Off Education LoanGiven: P = $21,061.82, N = 5 years, and i = 6%Reqd: ASolution: A = $21,061.82(A/P,6%,5) = $5,000

* 1 2 3NPA = ?

2. Time Value of Money2.4 Interest Formula in Different Cash Flow Categories2.4.2 Multiple Payments2.4.2.2 Uniform (Equal) Payment SeriesD. Present Worth FactorExample: Powerball LotteryGiven: A = $7.92M, N = 25 years, and i = 8%Reqd: PSolution: P = $7.92M(P/A,8%,25) = $84.54M

* 1 2 3NP = ?A

2. Time Value of Money2.4 Interest Formula in Different Cash Flow Categories2.4.2 Multiple Payments2.4.2.2 Uniform (Equal) Payment SeriesE. Present Worth of PerpetuitiesPerpetuity: A stream of cash flows that continues forever.

* 1 2 3NP = ?A

Contd 2.4.2.3 Gradient Series1. Linear Gradient Series . 2. Geometric Gradient Series

Linear Gradient SeriesSometimes cash flows will vary linearly, that is, they increase or decrease by a set amount, G, the gradient amount. This type of series is known as a strict gradient series.Note that each payment is An = (n - 1)G. the series begins with a zero cash flow at the end of period zero. If G > 0. the series is referred to as an increasing gradient series. If G < 0, it is referred to as a decreasing gradient series.as a composite series, or a set of two cash flows. Two types of linear gradient series as composites of a uni- form series of N payments of A, and a gradient series of increments of a constant amount G.

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2. Time Value of Money2.4 Interest Formula in Different Cash Flow Categories2.4.2 Multiple Payments2.4.2.3 Gradient SeriesA. Linear Gradient Series

*P

2. Time Value of Money2.4 Interest Formula in Different Cash Flow Categories2.4.2 Multiple Payments2.4.2.3 Gradient SeriesA. Linear Gradient Series Example: Present value calculation for a gradient seriesHow much do you have to deposit now in a savings account that earns a 12% annual interest, if you want to withdraw the annual series as shown in the figure?

*$1,000$1,250$1,500$1,750$2,0001 2 3 4 50P =?

2. Time Value of Money2.4 Interest Formula in Different Cash Flow Categories2.4.2 Multiple Payments2.4.2.3 Gradient SeriesB. Gradient Series as a Composite Series

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Contd Geometric Gradient Series Another kind of gradient series is formed when the series in a cash flow is deter- mined not by some fixed amount like $250, but by some fixed rate expressed as a percentage.involve cash flows that increase or decrease over time by a constant percentage (geometric), a process that is called compound growth. Price changes caused by inflation are a good example of such a geometric series. An = A1(1 + g)^(n-1)The g can take either a positive or a negative sign, depending on the type of cash flow. If g > 0. the series will increase: if g < 0, the series will decrease. *

2. Time Value of Money2.4 Interest Formula in Different Cash Flow Categories2.4.2 Multiple Payments2.4.2.3 Gradient Series C. Geometric Gradient Series

Given: Al = $50.000, g = 5%. i = 7%, and N = 25 years, Find: P ?

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2. Time Value of Money2.4 Interest Formula in Different Cash Flow Categories2.4.2 Multiple Payments2.4.2.3 Gradient Series Geometric Gradient Series Present Worth Factor,

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Contd Suppose that your retirement benefits during your first year of retirement are $50.000. However, your cost of living is expected to increase at an annual rate of 5%, due to inflation. Suppose you expect to receive cost-of-living adjustment in your retirement pension., If your savings account earns 7% interest a year, how much should you set aside before hand(now )in order to get this payments both the cost of living adjustment and the constant money of your penstion for the over 25 years?Given: Al = $50.000, g = 5%. i = 7%, and N = 25 years,. Find: P.?

P=$940,696

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2. Time Value of Money2.5 Standard Factors for Economic Analysis

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3. Financial Appraisal Methods. proper planning is now vital. It serves as a guideline, which is flexible enough to accommodate the changes and be used for checking planned against the actual executed work.

The amount of detailing in planning is likely to be the function of the size of the firm, the complexity of the project and the expertise of the management.

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3. Financial Appraisal Methods3.1 Investment AlternativesThere are two categories of investment alternatives while dealing with multiple alternatives.Independent Investment: This means that a decision on one investment does not affect the other.Mutually Exclusive Investment: In this case acceptance of one automatically eliminates the others.In this section only mutually exclusive alternatives are considered for subsequent discussions.

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3. Financial Appraisal Methods3.2 Financial (Investment) Appraisal MethodsThe common methods used for financial appraisal of projects are:Straight cost Method;Pay back Method; Rate of return Method; Benefit - Cost Ratio;Present worth or Net Present Value Method;Future Value Method;Annual Equivalent Cost Method; andInternal Rate of Return Method.

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3. Financial Appraisal Methods2.1 Straight Cost MethodCompares the initial investment/immediate costs only. E.g. Loader A ETB 4,500,000 Loader B ETB 5,000,000 Loader A2.2 Payback MethodA simple crude method for getting a quick evaluation of the alternatives is to calculate how long it takes to recover the initial investment. The time in any unit that it takes to recover the initial investment is called the payback period.It is obvious that the payback period neglects the time value of money and is only accurate when the interest rate is zero. Even with this shortcoming, many analysts consider this method to be a useful quick way of comparison.

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3. Financial Appraisal Methods2.2 Payback MethodThis method uses the number of years it takes to pay back the initial investments from profits of the investment. In computing the pay back period one can either consider time value of money or disregard it.When one considers time value of money, it is called discounted payback method, otherwise it is conventional.

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3. Financial Appraisal Methods2.2 Payback MethodExample: For a dozer purchased at a cost of ETB 3.5 million, determine the pay back period if the hourly rental rate is 900birr/hr and the cost for fuel, operator and maintains is 150birr/hr with 5 years of economic life.Solution:Yearly profit = (900-150) 8312 = ETB 1,872,000Year Cash Flow 0-3,500,0001 1,872,0002 1,872,000Pay Back Period = 2yrs3 1,872,0004 1.872,00051,872,000

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3. Financial Appraisal Methods2.3 Rate of Return MethodThis method uses percentage of the average annual return to the initial investment as:-

Rate of return =

Example: If the dozer given in the pay back problem can have a life span of four years, determine the rate of return.Solution:

Rate of return= =53.5%*

3. Financial Appraisal Methods2.4 Benefit Cost RatioAnother method of assessing the viability of a system or comparing several systems is to calculate the net present value of the costs and the benefits and obtain the benefit-cost ratio (B/C). If this ratio is greater than one, then the project is profitable.B/C > 1 Accept;B/C = 1 Indifferent; andB/C < 1 Reject.

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3. Financial Appraisal Methods2.5 Present Worth (Net Present Value) MethodIn this case all disbursements and receipts are brought to their net present worth and the comparison of their present worth is made. In the present value method, the present time (time zero or start of year 1) equivalent value of all the costs and benefits incurred during the life of the system or the project is calculated using a specific interest rate.In this method all cash inflows and outflows of a given project (having a given project life) are brought to time 0. If the difference between the inflows minus the outflows is positive then the project is acceptable. If it is to compare among various projects, the one having more positive value is economically the best alternative.

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3. Financial Appraisal Methods2.5 Present Worth (Net Present Value) MethodIn order to evaluate projects one need to use discounted cash flow techniques (DCF). One of these is the method of net present worth (NPW) or net present value (NPV).

PW costs = Ci + CSn(P/A, i ,n) PW incomes = In (P/A, i, n) + S (P/F, i, n)NPW(NPV) = PW incomes - PW costs *SCiCSnIn

3. Financial Appraisal Methods2.5 Present Worth (Net Present Value) MethodExample 1 A construction company wants to introduce a new system of billing/preparing invoices for payment certificates for the next 5yrs after which the company will consider other new options shown below. Two alternatives with identical capacities and job are available.Model A: It is semi-automatic that costs ETB 112,500 which lasts 3yrs with annual operation and maintenance cost of 45,000 having a salvage value of 18,000. Model B: It is a complete automatic that costs ETB 135,000 which lasts 4yrs with annual operation and maintenance cost of 36,000 having a salvage value of 13,500. if a yearly revenue of ETB 54,000 is obtained for both models.Which model is acceptable if the interest rate is 15%?

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3. Financial Appraisal Methods2.6 Future Worth (Net Future Value) MethodA corollary to the present value and net present worth is the future value and the net future worth (NFW).In this method all cash inflows and outflows of a given project (having a given project life) are brought to time n. If the difference between the inflows minus the outflows is positive then the project is acceptable. If it is to compare among various projects, the one having more positive value is economically the best alternative.

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3. Financial Appraisal Methods2.7 Annual Equivalent Worth MethodIn this case all the cash flow is converted to an equal uniform series of cost or income. Then for mutual exclusive alternatives, the one with higher annual income or lower annual cost will be opted. This helps to determine an investments worth in terms of equal annual basis.The main benefits of this method are:Report format;Need for unit cost/benefit analysis; andEase of analysis for mutually exclusive projects with unequal project lives, as long as identical repetition is to be made.Example 3: Compute the AE of Example 1*

Contd Contd *

3. Financial Appraisal Methods2.8 Internal Rate of Return (IRR) MethodThe internal rate of return, IRR is that interest rate at which future cash flows when discounted will equate to the initial investment i.e. their present value will be zero.If IRR is Internal Rate of Return and MARR is the Minimum Attractive Rate of Return (Market Interest Rate), then if :IRR > MARR Accept;IRR = MARR Indifferent; and IRR < MARR Reject. *

4. Depreciation2.8 Internal Rate of Return (IRR) MethodIRR is the interest which makes the summation of present worth value to be zero.

This expression only works for cash flows with 3yrs of life. Cash flow projecting beyond three years involve complex polynomial functions.

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3. Financial Appraisal Methods2.8 Internal Rate of Return (IRR) MethodComputation of IRRPlot the PW cash flow against interest (horizontal axis).

A. Simple Investment

B. Non-simple Investment*

3. Financial Appraisal Methods2.8 Internal Rate of Return (IRR) MethodComputation of IRR2.8.1 Direct Solution MethodThis applies when either there is only two flow transaction of cash flow series or when the projects service life doesnt exceed 2 yrs.Example: consider the following cash flow and compute the IRR for both options.

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nA B 0-8,000-16,0001010,4002012,000312,000

3. Financial Appraisal Methods2.8 Internal Rate of Return (IRR) MethodComputation of IRR2.8.1 Direct Solution MethodSolution:Project A: PW (i) = -8000 + 12,000 (P/F, i, 4) = 0 - 8000 +12000/(1+i)4 = 0 (1+i)4 = i= 10.6681%Project B: PW (i) = -16,000 + 10000/ (1+i)1 + 12000/ (1+i)2 = 0 -16,000 (1+i)2 + 10,000 (1+i) + 12,000 = 016i2 21.62 6.4 = 0i = -1.6 = -160%; not feasiblei = 0.25 = 25%; therefore, i =25%

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3. Financial Appraisal Methods2.8 Internal Rate of Return (IRR) MethodComputation of IRR2.8.2 Trial and Error Approach In this method, assume a certain value for i and compute PW(i) = 0. PW(i) PWi > 0-increase i PWi < 0- decrease iThe computation process proceeds until PW(i) = 0.*

3. Financial Appraisal Methods2.8 Internal Rate of Return (IRR) MethodComputation of IRR2.8.3 Incremental Analysis: two alternativesIRR method cant give a clue on the best alternative when used for investment analysis. Thus it is recommended to use the incremental analysis. It is done in such a way that by projecting a cash flow which is the difference of cash flows of the alternatives presented for comparative analysis.*

3. Financial Appraisal Methods2.8 Internal Rate of Return (IRR) MethodComputation of IRR2.8.3 Incremental AnalysisExample: Select a better option if MARR = 10%.YrAB B-A 0 -3,000 -12,000 -9,0001 1,350 4,200 2,8002 1,800 6,225 4,4253 1,500 6,330 4,830IRR 25% 17.43% 15% Alternative B is selected Selection Criterion:-IRR (B-A) > MARR - select BIRR (B-A) < MARR - select AIRR (B-A) = MARR - select either*

3. Financial Appraisal Methods2.8 Internal Rate of Return (IRR) MethodComputation of IRR2.8.3 Incremental Analysis: alternatives more than twoConsidering two at a time, the selection can be easily carried out. YrA BC B-A C-B0 -1,000 -1,000 -2,000 0-1,0001 900 600 900 -300 3002 500 500 900 0 4003 100 500 900 400 4004 50 100 900 50 800IRR 21% 26.3%First Comparison:- Alternative B is better, reject ASecond Comparison:- Alternative C is better; therefore Alternative C is acceptable.*

3. Financial Appraisal Methods2.9 Source of FinanceCollateral base of the domestic construction industry is very weak. There are two broad choices for financing construction projects where as a combination of the two is also possible:Equity Financing;Debt Financing; andHybrid of equity and debt.*

3. Financial Appraisal Methods2.9 Source of Finance2.9.1 Equity FinancingShare company:- retained earnings. Private company:- re-investment of profits.Issuance of Stocks:- Eg. Ayat Real Estate a couple of years ago.2.9.2 Debt FinancingIt can be grouped in to three main categories:Short term (up to one year);Medium term ( 1-5 years); andLong term (>5 years).*

3. Financial Appraisal Methods2.9 Source of Finance2.9.2 Debt FinancingA. Short Term FinancingIt requires more working capital (operating cost).The current asset need to be much greater than current liability to come up with a positive working capital.When negative working capital encountered; the following measures usually taken:Delay wage payments and salaries;Delay credit payment; andSelling some fixed assets.AAU, AAiT, Construction Management, Lecture Notes,March 2014, Getaneh G. *

AAU, AAiT, Construction Management, Lecture Notes,March 2014, Getaneh G.

3. Financial Appraisal Methods2.9 Source of Finance2.9.2 Debt FinancingA. Short Term FinancingShort term financing schemes:Bank overdraft;Trade credit; andFactoring.i. Bank OverdraftIt has high interest rate.If not paid, the company will be liquidated and declare bankruptcy where the client will be sued.AAU, AAiT, Construction Management, Lecture Notes,March 2014, Getaneh G. *

AAU, AAiT, Construction Management, Lecture Notes,March 2014, Getaneh G.

3. Financial Appraisal Methods2.9 Source of Finance2.9.2 Debt FinancingA. Short Term Financingii. Trade CreditAcquire supply of materials on a credit basis.Depends on the credibility of the company.It has no interest.iii. FactoringDelegating another company to fix the credit and collect the revenues of the company; and finally share the profit as per the agreement.AAU, AAiT, Construction Management, Lecture Notes,March 2014, Getaneh G. *

AAU, AAiT, Construction Management, Lecture Notes,March 2014, Getaneh G.

3. Financial Appraisal Methods2.9 Source of Finance2.9.2 Debt FinancingB. Medium Term FinancingBank loans.Sale and lease back.C. Long Term FinancingBank loans (International Bank loans).Bond Financing.Joint Venture Financing: due to size of the project and its associated risk where:Risk shared;Good opportunity to knowledge;Capital and material combined; and Reduces competition.AAU, AAiT, Construction Management, Lecture Notes,March 2014, Getaneh G. *

AAU, AAiT, Construction Management, Lecture Notes,March 2014, Getaneh G.

4. Depreciation4.1 Definition and Requirements4.1.1 Depreciation: DefinitionThe number of years over which a machine is depreciated is called its depreciable life. Depreciation is a business expense the government allows to offset the loss in value of business assets.Depreciation deductions reduce the taxable income of businesses and thus reduce the amount of tax paid.Accountants define depreciation as follows: the systematic allocation of the cost of an asset over its useful, or depreciable life.The latter definition is used for determining taxable income hence, income taxes.

AAU, AAiT, Construction Management, Lecture Notes,March 2014, Getaneh G. *

AAU, AAiT, Construction Management, Lecture Notes,March 2014, Getaneh G.

4. Depreciation4.1 Definition and Requirements4.1.2 Depreciation RequirementsIn general business assets can only be depreciated if they meet the following basic requirements:The property must have a useful life that can be determined, and this life must be longer than one year.The property must be an asset that decays, gets used up, wears out, becomes obsolete, or loses value to the owner due to natural causes.

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4. Depreciation4.2 Depreciation CausesDue to use and obsolescence every equipment loses its value. This loss is accounted for by depreciating the equipment every year. Depreciation is a decrease in value of an asset each year.Depreciation: whenever any machine or equipment performs useful work its wear and tear is bound to occur. This can be minimized up to some extent by proper care and maintenance but cant be totally prevented.Obsolescence: is the depreciation of existing machinery or asset due to new and better invention, design of equipment of processes etc. *

4. Depreciation4.3 Classification of Depreciation*

4. Depreciation4.4 Depreciation Calculation Fundamentals and Methods4.4.1 Depreciation Calculation FundamentalsThe following are the methods for calculating depreciation.BVt = cost basis (d1 + d2 + + dt)This equation is used to compute the book value of an asset at the end of any time t.Book value can be viewed as the remaining unallocated cost of an asset:

Book value = Cost Depreciation charges made to date

Note: If the item has a salvage value then the final book value will be the salvage value.

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4. Depreciation4.4 Depreciation Calculation Fundamentals and Methods4.4.2 Depreciation Calculation MethodsThe following are the methods for calculating depreciation.Straight line Methods, Declining Balance Method (esp. DDB),The Sum Of the Years Digits (SOYD) Method, Sinking fund Method, Annuity Charging method, The Insurance policy method,The Revaluation or Regular Valuation method, and Machine Hour Basis method.

AAU, AAiT, Construction Management, Lecture Notes,March 2014, Getaneh G. *

AAU, AAiT, Construction Management, Lecture Notes,March 2014, Getaneh G.

4. Depreciation4.5 Calculation of Depreciation4.5.1 Straight Line MethodThis method assumes that the loss of value of machine is directly proportional to its age. It means one should deduct the scrap value from the original value and divide the remaining value by the number of years of useful life.D = (C-S)/NWhere: D = Depreciation amount per year. C = Initial cost of a machine. S = Scrap/Salvage value. N = Number of years of life of machine.

AAU, AAiT, Construction Management, Lecture Notes,March 2014, Getaneh G. *

AAU, AAiT, Construction Management, Lecture Notes,March 2014, Getaneh G.

4. Depreciation4.5 Calculation of Depreciation4.5.2 [Double] Declining Balance MethodFor straight line depreciation with N years, the rate of decrease each year is 1/N. Declining balance depreciation uses a rate of either 150% or 200% of the straight-line rate. Since 200% is twice the straight-line rate, it is called double declining balance (DDB). The DDB equation for any year isDDB depreciation dt = (2/N) ( Book value)Book value = Initial cost total charges to date,So,DDB deprec. dt = (2/N) (Initial cost total charges to date)

AAU, AAiT, Construction Management, Lecture Notes,March 2014, Getaneh G. *

AAU, AAiT, Construction Management, Lecture Notes,March 2014, Getaneh G.

4. Depreciation4.5 Calculation of Depreciation4.5.2 [Double] Declining Balance MethodIt can be shown for DDB, that the depreciation schedule in year t is given by:DDB depreciation in year t = (2B/N)(1 2/N)t-1For 150% declining balance depreciation, the depreciation in year t is given by:

DB depreciation in year t =(1.5 B/N)(1 1.5/N)t-1.Where: B = Book ValueN = Number of years of life of machine.It is common usually to use DDB in many depreciation computations.

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4. Depreciation4.5 Calculation of Depreciation4.5.3 Sum of Years Digits (SOYD) MethodSOYD depreciation causes larger decreases in book value in earlier years than in later years.dt= [(N+1-t)/SOYD](B-S) = [2(N+1-t)/(N(N+1))](B-S)Where: 2(N+1-t)/N(N+1) = multiplierB = Book Value S = Scrap/Salvage value. N = Number of years of life of machine.The product of the multiplier and B-S for the year is the depreciation charge for the year. Note the multipliers add to 1. i.e. (N+1-t)/SOYD = 2(N+1-t)/N(N+1) = 1

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4. Depreciation4.5 Calculation of DepreciationExample: DepreciationAn excavator costs Birr 5, 000,000.00 with a scrap value of Birr 200,000 after its useful life of 5 years in the taxpayers hand. Calculate the depreciation value in the useful life of this machine using:Straight line method,SOYD method, andDDB method.Show your result in the entire useful life of the excavator. Compare and comment on both results by the help of a graph.*

THANK YOU!

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