Cost Control, Monitoring and Accounting

1 The Cost Control Problem
During the execution of a project, procedures for project control and record keeping become indispensable tools to managers and other participants in the construction process. These tools serve the dual purpose of recording the financial transactions that occur as well as giving managers an indication of the progress and problems associated with a project. The problems of project control are aptly summed up in an old definition of a project as "any collection of vaguely related activities that are ninety percent complete, over budget and late." [1] The task of project control systems is to give a fair indication of the existence and the extent of such problems.
In this chapter, we consider the problems associated with resource utilization, accounting, monitoring and control during a project. In this discussion, we emphasize the project management uses of accounting information. Interpretation of project accounts is generally not straightforward until a project is completed, and then it is too late to influence project management. Even after completion of a project, the accounting results may be confusing. Hence, managers need to know how to interpret accounting information for the purpose of project management. In the process of considering management problems, however, we shall discuss some of the common accounting systems and conventions, although our purpose is not to provide a comprehensive survey of accounting
procedures.
The limited objective of project control deserves emphasis. Project control procedures are primarily intended to identify deviations from the project plan rather than to suggest possible areas for cost savings. This characteristic reflects the advanced stage at which project control becomes important. The time at which major cost savings can be achieved is during planning and design for the project. During the actual construction, changes are likely to delay the project and lead to inordinate cost increases. As a result, the focus of project control is on fulfilling the original design plans or indicating deviations from these plans, rather than on searching for significant improvements and cost savings. It is only when a rescue operation is required that major changes will normally occur in the construction plan.
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Finally, the issues associated with integration of information will require some discussion. Project management activities and functional concerns are intimately linked, yet the techniques used in many instances do not facilitate comprehensive or integrated consideration of project activities. For example, schedule information and cost accounts are usually kept separately. As a result, project managers themselves must synthesize a comprehensive view from the different reports on the project plus their own field observations. In particular, managers are often forced to infer the cost impacts of schedule changes, rather than being provided with aids for this process. Communication or integration of various types of information can serve a number of useful purposes, although it does require special attention in the establishment of project control procedures.
2 The Project Budget
For cost control on a project, the construction plan and the associated cash flow estimates can provide the baseline reference for subsequent project monitoring and control. For schedules, progress on individual activities and the achievement of milestone completions can be compared with the project schedule to monitor the progress of activities. Contract and job specifications provide the criteria by which to assess and assure the required quality of construction. The final or detailed cost estimate provides a baseline for the assessment of financial performance during the project. To the extent that costs are within the detailed cost estimate, then the project is thought to be under financial control. Overruns in particular cost categories signal the possibility of problems and give an indication of exactly what problems are being encountered. Expense oriented construction planning and control focuses upon the categories included in the final cost estimation. This focus is particular relevant for projects with few activities and considerable repetition such as grading and paving roadways.
For control and monitoring purposes, the original detailed cost estimate is typically converted to a project budget, and the project budget is used subsequently as a guide for management. Specific items in the detailed cost estimate become job cost elements. Expenses incurred during the course of a project are recorded in specific job cost accounts to be compared with the original cost estimates in each category. Thus, individual job cost accounts generally represent the basic unit for cost control. Alternatively, job cost accounts may be disaggregated or divided into work elements which are related both to particular scheduled activities and to particular cost accounts. Work element divisions will be described in Section 8.
In addition to cost amounts, information on material quantities and labor inputs within each job account is also typically retained in the project budget. With this information, actual materials usage and labor employed can be compared to the expected requirements. As a result, cost overruns or savings on particular items can be identified as due to changes in unit prices, labor productivity or in the amount of material consumed.
The number of cost accounts associated with a particular project can vary considerably. For constructors, on the order of four hundred separate cost accounts
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might be used on a small project. [2] These accounts record all the transactions associated with a project. Thus, separate accounts might exist for different types of materials, equipment use, payroll, project office, etc. Both physical and non-physical resources are represented, including overhead items such as computer use or interest charges. Table 12-1 summarizes a typical set of cost accounts that might be used in building construction. [3]
TABLE 12-1 Illustrative Set of Project Cost Accounts
201
Clearing and Preparing Site
202
202.1 202.2 202.3
202.31 202.32 202.33
Substructure
Excavation and Shoring Piling Concrete Masonry
Mixing and Placing Formwork Reinforcing
203
Outside Utilities (water, gas, sewer, etc.)
204
204.1 204.2 204.3 204.4 204.5 204.6
204.61 204.62 204.63 204.64 204.65 204.66 204.67 204.68 204.69
204.7
204.71 204.72 204.73 204.74 204.72
Superstructure
Masonry Construction Structural Steel Wood Framing, Partitions, etc. Exterior Finishes (brickwork, terra cotta, cut stone, etc.) Roofing, Drains, Gutters, Flashing, etc. Interior Finish and Trim
Finish Flooring, Stairs, Doors, Trim Glass, Windows, Glazing Marble, Tile, Terrazzo Lathing and Plastering Soundproofing and Insulation Finish Hardware Painting and Decorating Waterproofing Sprinklers and Fire Protection
Service Work
Electrical Work Heating and Ventilating Plumbing and Sewage Air Conditioning Fire Alarm, Telephone, Security, Miscellaneous
205
Paving, Curbs, Walks
206
Installed Equipment (elevators, revolving doors, mailchutes, etc.)
207
Fencing
Note that this set of accounts is organized hierarchically, with seven major divisions (accounts 201 to 207) and numerous sub-divisions under each division. This hierarchical structure facilitates aggregation of costs into pre-defined categories; for example, costs associated with the superstructure (account 204) would be the sum of
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the underlying subdivisions (ie. 204.1, 204.2, etc.) or finer levels of detail (204.61, 204.62, etc.). The sub-division accounts in Table 12-1 could be further divided into personnel, material and other resource costs for the purpose of financial accounting, as described in Section 4.
In developing or implementing a system of cost accounts, an appropriate numbering or coding system is essential to facilitate communication of information and proper aggregation of cost information. Particular cost accounts are used to indicate the expenditures associated with specific projects and to indicate the expenditures on particular items throughout an organization. These are examples of different perspectives on the same information, in which the same information may be summarized in different ways for specific purposes. Thus, more than one aggregation of the cost information and more than one application program can use a particular cost account. Separate identifiers of the type of cost account and the specific project must be provided for project cost accounts or for financial transactions. As a result, a standard set of cost codes such as the MASTERFORMAT codes described in Chapter 9 may be adopted to identify cost accounts along with project identifiers and extensions to indicate organization or job specific needs. Similarly the use of databases or, at a minimum, inter-communicating applications programs facilitate access to cost information, as described in Chapter 14.
Converting a final cost estimate into a project budget compatible with an organization's cost accounts is not always a straightforward task. As described in Chapter 5, cost estimates are generally disaggregated into appropriate functional or resource based project categories. For example, labor and material quantities might be included for each of several physical components of a project. For cost accounting purposes, labor and material quantities are aggregated by type no matter for which physical component they are employed. For example, particular types of workers or materials might be used on numerous different physical components of a facility. Moreover, the categories of cost accounts established within an organization may bear little resemblance to the quantities included in a final cost estimate. This is particularly true when final cost estimates are prepared in accordance with an external reporting requirement rather than in view of the existing cost accounts within an organization.
One particular problem in forming a project budget in terms of cost accounts is the treatment of contingency amounts. These allowances are included in project cost estimates to accommodate unforeseen events and the resulting costs. However, in advance of project completion, the source of contingency expenses is not known. Realistically, a budget accounting item for contingency allowance should be established whenever a contingency amount was included in the final cost estimate.
A second problem in forming a project budget is the treatment of inflation. Typically, final cost estimates are formed in terms of real dollars and an item reflecting inflation costs is added on as a percentage or lump sum. This inflation allowance would then be allocated to individual cost items in relation to the actual expected inflation over the period for which costs will be incurred.
Example 12-1: Project Budget for a Design Office
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An example of a small project budget is shown in Table 12-2. This budget might be used by a design firm for a specific design project. While this budget might represent all the work for this firm on the project, numerous other organizations would be involved with their own budgets. In Table 12-2, a summary budget is shown as well as a detailed listing of costs for individuals in the Engineering Division.
TABLE 12-2 Example of a Small Project Budget for a Design Firm
Personnel Architectural Division Engineering Environmental Division Total Other Direct Expenses Travel Supplies Communication Computer Services Total Overhead Contingency and Profit Total
Budget Summary
$ 67,251.00 45,372.00 28,235.00 $140,858.00 2,400.00 1,500.00 600.00 1,200.00 $ 5,700.00 $ 175,869.60 $ 95,700.00 $ 418,127.60
Senior Engineer
Associate Engineer
Engineer Technician
Total
Engineering Personnel Detail
$ 11,562.00 21,365.00 12,654.00
$ 45,372.00
For the purpose of consistency with cost accounts and managerial control, labor costs are aggregated into three groups: the engineering, architectural and environmental divisions. The detailed budget shown in Table 12-2 applies only to the engineering division labor; other detailed budgets amounts for categories such as supplies and the other work divisions would also be prepared. Note that the salary costs associated with individuals are aggregated to obtain the total labor costs in the engineering group for the project. To perform this aggregation, some means of identifying individuals within organizational groups is required. Accompanying a budget of this nature, some estimate of the actual man-hours of labor required by project task would also be prepared. Finally, this budget might be used for internal purposes alone. In submitting financial bills and reports to the client, overhead and contingency amounts might be combined with the direct labor costs to establish an aggregate billing rate per hour. In
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this case, the overhead, contingency and profit would represent allocated costs based on the direct labor costs.
Example 12-2: Project Budget for a Constructor
Table 12-3 illustrates a summary budget for a constructor. This budget is developed from a project to construct a wharf. As with the example design office budget above, costs are divided into direct and indirect expenses. Within direct costs, expenses are divided into material, subcontract, temporary work and machinery costs. This budget indicates aggregate amounts for the various categories. Cost details associated with particular cost accounts would supplement and support the aggregate budget shown in Table 12-3. A profit and a contingency amount might be added to the basic budget of $1,715,147 shown in Table 12-3 for completeness.
TABLE 12-3 An Example of a Project Budget for a Wharf Project (Amounts in Thousands of Dollars)
Material Cost
Subcontract Work
Temporary Work
Machinery Cost
Total
Cost
Steel Piling Tie-rod Anchor-Wall Backfill Coping Dredging Fender Other Sub-total
$292,172 88,233 130,281 242,230 42,880 0 48,996 5,000 $849,800
$129,17829,25460,87327,91922,307111,65010,344 32,250$423,775
$16,38900013,17100 0$29,560
$0 0 0 0 0 0 1,750 0 $1,750
$437,739117,487191,154300,14978,358111,65061,090 37,250$1,304,885
Summary Total of direct cost Indirect Cost Common Temporary Work Common Machinery Transportation Office Operating Costs Total of Indirect Cost Total Project Cost
$1,304,88519,32080,93415,550294,458 410,262.$1,715,147
3 Forecasting for Activity Cost Control
For the purpose of project management and control, it is not sufficient to consider only the past record of costs and revenues incurred in a project. Good managers should focus upon future revenues, future costs and technical problems. For this purpose, traditional financial accounting schemes are not adequate to reflect the dynamic nature of a project. Accounts typically focus on recording routine costs and past expenditures associated with activities. [4] Generally, past expenditures represent
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sunk costs that cannot be altered in the future and may or may not be relevant in the future. For example, after the completion of some activity, it may be discovered that some quality flaw renders the work useless. Unfortunately, the resources expended on the flawed construction will generally be sunk and cannot be recovered for re-construction (although it may be possible to change the burden of who pays for these resources by financial withholding or charges; owners will typically attempt to have constructors or designers pay for changes due to quality flaws). Since financial accounts are historical in nature, some means of forecasting or projecting the future course of a project is essential for management control. In this section, some methods for cost control and simple forecasts are described.
An example of forecasting used to assess the project status is shown in Table 12-4. In this example, costs are reported in five categories, representing the sum of all the various cost accounts associated with each category:
• Budgeted Cost
The budgeted cost is derived from the detailed cost estimate prepared at the start of the project. Examples of project budgets were presented in Section 2. The factors of cost would be referenced by cost account and by a prose description.
• Estimated total cost
The estimated or forecast total cost in each category is the current best estimate of costs based on progress and any changes since the budget was formed. Estimated total costs are the sum of cost to date, commitments and exposure. Methods for estimating total costs are described below.
• Cost Committed and Cost Exposure!!
Estimated cost to completion in each category in divided into firm commitments and estimated additional cost or exposure. Commitments may represent material orders or subcontracts for which firm dollar amounts have been committed.
• Cost to Date
The actual cost incurred to date is recorded in column 6 and can be derived from the financial record keeping accounts.
• Over or (Under)
A final column in Table 12-4 indicates the amount over or under the budget for each category. This column is an indicator of the extent of variance from the project budget; items with unusually large overruns would represent a particular managerial concern. Note that variance is used in the terminology of project control to indicate a difference between budgeted and actual expenditures. The term is defined and used quite differently in statistics or mathematical analysis. In Table 12-4, labor costs are running higher than expected, whereas subcontracts are less than expected.
The current status of the project is a forecast budget overrun of $5,950. with 23 percent of the budgeted project costs incurred to date.
TABLE 12-4 Illustration of a Job Status Report
Factor
Budgeted Cost
Estimated Total Cost
Cost Committed
Cost Exposure
Cost To Date
Over or (Under)
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Labor Material Subcontracts Equipment Other Total
$99,406 88,499 198,458 37,543 72,693 496,509
$102,34288,499196,32337,543 81,432506,139
$49,59642,50683,35223,623 49,356248,433
---45,99397,832--- ---143,825
$52,746 --- 15,139 13,920 32,076 113,881
$2,9360(2,135)0 8,7395,950
For project control, managers would focus particular attention on items indicating substantial deviation from budgeted amounts. In particular, the cost overruns in the labor and in the "other expense category would be worthy of attention by a project manager in Table 12-4. A next step would be to look in greater detail at the various components of these categories. Overruns in cost might be due to lower than expected productivity, higher than expected wage rates, higher than expected material costs, or other factors. Even further, low productivity might be caused by inadequate training, lack of required resources such as equipment or tools, or inordinate amounts of re-work to correct quality problems. Review of a job status report is only the first step in project control.
The job status report illustrated in Table 12-4 employs explicit estimates of ultimate cost in each category of expense. These estimates are used to identify the actual progress and status of a expense category. Estimates might be made from simple linear extrapolations of the productivity or cost of the work to date on each project item. Algebraically, a linear estimation formula is generally one of two forms. Using a linear extrapolation of costs, the forecast total cost, Cf , is:
( 1)
where Ct is the cost incurred to time t and pt is the proportion of the activity completed at time t. For example, an activity which is 50 percent complete with a cost of $40,000 would be estimated to have a total cost of $40,000/0.5 = $80,000. More elaborate methods of forecasting costs would disaggregate costs into different categories, with the total cost the sum of the forecast costs in each category.
Alternatively, the use of measured unit cost amounts can be used for forecasting total cost. The basic formula for forecasting cost from unit costs is:
( 2)
where Cf is the forecast total cost, W is the total units of work, and ct is the average cost per unit of work experienced up to time t. If the average unit cost is $50 per unit of work on a particular activity and 1,600 units of work exist, then the expected cost is (1,600)(50) = $80,000 for completion.
The unit cost in Equation ( 2) may be replaced with the hourly productivity and the unit cost per hour (or other appropriate time period), resulting in the equation:
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( 3)
where the cost per work unit (ct) is replaced by the time per unit, ht, divided by the cost per unit of time, ut.
More elaborate forecasting systems might recognize peculiar problems associated with work on particular items and modify these simple proportional cost estimates. For example, if productivity is improving as workers and managers become more familiar with the project activities, the estimate of total costs for an item might be revised downward. In this case, the estimating equation would become:
( 4)
where forecast total cost, Cf, is the sum of cost incurred to date, Ct, and the cost resulting from the remaining work (W - Wt) multiplied by the expected cost per unit time period for the remainder of the activity, ct.
As a numerical example, suppose that the average unit cost has been $50 per unit of work, but the most recent figure during a project is $45 per unit of work. If the project manager was assured that the improved productivity could be maintained for the remainder of the project (consisting of 800 units of work out of a total of 1600 units of work), the cost estimate would be (50)(800) + (45)(800) = $76,000 for completion of the activity. Note that this forecast uses the actual average productivity achieved on the first 800 units and uses a forecast of productivity for the remaining work. Historical changes in productivity might also be used to represent this type of non-linear changes in work productivity on particular activities over time.
In addition to changes in productivities, other components of the estimating formula can be adjusted or more detailed estimates substituted. For example, the change in unit prices due to new labor contracts or material supplier's prices might be reflected in estimating future expenditures. In essence, the same problems encountered in preparing the detailed cost estimate are faced in the process of preparing exposure estimates, although the number and extent of uncertainties in the project environment decline as work progresses. The only exception to this rule is the danger of quality problems in completed work which would require re-construction.
Each of the estimating methods described above require current information on the state of work accomplishment for particular activities. There are several possible methods to develop such estimates, including [5]:
• Units of Work Completed
For easily measured quantities the actual proportion of completed work amounts can be measured. For example, the linear feet of piping installed can be compared to the required amount of piping to estimate the percentage of piping work completed.
• Incremental Milestones
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Particular activities can be sub-divided or "decomposed" into a series of milestones, and the milestones can be used to indicate the percentage of work complete based on historical averages. For example, the work effort involved with installation of standard piping might be divided into four milestones:
o Spool in place: 20% of work and 20% of cumulative work.
o Ends welded: 40% of work and 60% of cumulative work.
o Hangars and Trim Complete: 30% of work and 90% of cumulative work.
o Hydrotested and Complete: 10% of work and 100% of cumulative work.
Thus, a pipe section for which the ends have been welded would be reported as 60% complete.
• Opinion Subjective judgments of the percentage complete can be prepared by inspectors, supervisors or project managers themselves. Clearly, this estimated technique can be biased by optimism, pessimism or inaccurate observations. Knowledgeable estimators and adequate field observations are required to obtain sufficient accuracy with this method.
• Cost Ratio
The cost incurred to date can also be used to estimate the work progress. For example, if an activity was budgeted to cost $20,000 and the cost incurred at a particular date was $10,000, then the estimated percentage complete under the cost ratio method would be 10,000/20,000 = 0.5 or fifty percent. This method provides no independent information on the actual percentage complete or any possible errors in the activity budget: the cost forecast will always be the budgeted amount. Consequently, managers must use the estimated costs to complete an activity derived from the cost ratio method with extreme caution.
Systematic application of these different estimating methods to the various project activities enables calculation of the percentage complete or the productivity estimates used in preparing job status reports.
In some cases, automated data acquisition for work accomplishments might be instituted. For example, transponders might be moved to the new work limits after each day's activity and the new locations automatically computed and compared with project plans. These measurements of actual progress should be stored in a central database and then processed for updating the project schedule. The use of database management systems in this fashion is described in Chapter 14.
Example 12-3: Estimated Total Cost to Complete an Activity
Suppose that we wish to estimate the total cost to complete piping construction activities on a project. The piping construction involves 1,000 linear feet of piping which has been divided into 50 sections for management convenience. At this time, 400 linear feet of piping has been installed at a cost of $40,000 and 500 man-hours of labor. The original budget estimate was $90,000 with a productivity of one foot per
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man-hour, a unit cost of $60 per man hour and a total material cost of $ 30,000. Firm commitments of material delivery for the $30,000 estimated cost have been received.
The first task is to estimate the proportion of work completed. Two estimates are readily available. First, 400 linear feet of pipe is in place out of a total of 1000 linear feet, so the proportion of work completed is 400/1000 = 0.4 or 40%. This is the "units of work completed" estimation method. Second, the cost ratio method would estimate the work complete as the cost-to-date divided by the cost estimate or $40,000/$ 90,000 = 0.44 or 44%. Third, the "incremental milestones" method would be applied by examining each pipe section and estimating a percentage complete and then aggregating to determine the total percentage complete. For example, suppose the following quantities of piping fell into four categories of completeness:
complete (100%) hangars and trim complete (90%) ends welded (60%) spool in place (20%)
380 ft 20 ft 5 ft 0 ft
Then using the incremental milestones shown above, the estimate of completed work would be 380 + (20)(0.9) + (5)(0.6) + 0 = 401 ft and the proportion complete would be 401 ft/1,000 ft = 0.401 or 40% after rounding.
Once an estimate of work completed is available, then the estimated cost to complete the activity can be calculated. First, a simple linear extrapolation of cost results in an estimate of $40,000/0.4 = $100,000. for the piping construction using the 40% estimate of work completed. This estimate projects a cost overrun of 100,000 - 90,000 = $10,000.
Second, a linear extrapolation of productivity results in an estimate of (1000 ft.)(500 hrs/400 ft.)($60/hr) + 30,000 = $105,000. for completion of the piping construction. This estimate suggests a variance of 105,000 - 90,000 = $15,000 above the activity estimate. In making this estimate, labor and material costs entered separately, whereas the two were implicitly combined in the simple linear cost forecast above. The source of the variance can also be identified in this calculation: compared to the original estimate, the labor productivity is 1.25 hours per foot or 25% higher than the original estimate.
Example 12-4: Estimated Total Cost for Completion
The forecasting procedures described above assumed linear extrapolations of future costs, based either on the complete experience on the activity or the recent experience. For activities with good historical records, it can be the case that a typically non-linear profile of cost expenditures and completion proportions can be estimated.
Figure 12-1 illustrates one possible non-linear relationships derived from experience in some particular activity. The progress on a new job can be compared to this historical record. For example, point A in Figure 12-1 suggests a higher expenditure than is normal for the completion proportion. This point represents 40% of work completed with an expenditure of 60% of the budget. Since the historical record suggests only 50% of the budget should be expended at time of 40% completion, a 60 - 50 = 10% overrun in cost is expected even if work efficiency can be increased to
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historical averages. If comparable cost overruns continue to accumulate, then the cost-to-complete will be even higher.
Figure 12-1 Illustration of Proportion Completion versus Expenditure for an Activity
4 Financial Accounting Systems and Cost Accounts
The cost accounts described in the previous sections provide only one of the various components in a financial accounting system. Before further discussing the use of cost accounts in project control, the relationship of project and financial accounting deserves mention. Accounting information is generally used for three distinct purposes:
• Internal reporting to project managers for day-to-day planning, monitoring and control.
• Internal reporting to managers for aiding strategic planning.
• External reporting to owners, government, regulators and other outside parties.
External reports are constrained to particular forms and procedures by contractual reporting requirements or by generally accepted accounting practices. Preparation of such external reports is referred to as financial accounting. In contrast, cost or managerial accounting is intended to aid internal managers in their responsibilities of planning, monitoring and control.
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Project costs are always included in the system of financial accounts associated with an organization. At the heart of this system, all expense transactions are recorded in a general ledger. The general ledger of accounts forms the basis for management reports on particular projects as well as the financial accounts for an entire organization. Other components of a financial accounting system include:
• The accounts payable journal is intended to provide records of bills received from vendors, material suppliers, subcontractors and other outside parties. Invoices of charges are recorded in this system as are checks issued in payment. Charges to individual cost accounts are relayed or posted to the General Ledger.
• Accounts receivable journals provide the opposite function to that of accounts payable. In this journal, billings to clients are recorded as well as receipts. Revenues received are relayed to the general ledger.
• Job cost ledgers summarize the charges associated with particular projects, arranged in the various cost accounts used for the project budget.
• Inventory records are maintained to identify the amount of materials available at any time.
In traditional bookkeeping systems, day to day transactions are first recorded in journals. With double-entry bookkeeping, each transaction is recorded as both a debit and a credit to particular accounts in the ledger. For example, payment of a supplier's bill represents a debit or increase to a project cost account and a credit or reduction to the company's cash account. Periodically, the transaction information is summarized and transferred to ledger accounts. This process is called posting, and may be done instantaneously or daily in computerized systems.
In reviewing accounting information, the concepts of flows and stocks should be kept in mind. Daily transactions typically reflect flows of dollar amounts entering or leaving the organization. Similarly, use or receipt of particular materials represent flows from or to inventory. An account balance represents the stock or cumulative amount of funds resulting from these daily flows. Information on both flows and stocks are needed to give an accurate view of an organization's state. In addition, forecasts of future changes are needed for effective management.
Information from the general ledger is assembled for the organization's financial reports, including balance sheets and income statements for each period. These reports are the basic products of the financial accounting process and are often used to assess the performance of an organization. Table12-5 shows a typical income statement for a small construction firm, indicating a net profit of $ 330,000 after taxes. This statement summarizes the flows of transactions within a year. Table 12-6 shows the comparable balance sheet, indicated a net increase in retained earnings equal to the net profit. The balance sheet reflects the effects of income flows during the year on the overall worth of the organization.
TABLE 12-5 Illustration of an Accounting Statement of Income
Income Statement
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for the year ended December 31, 19xx
Gross project revenues Direct project costs on contracts Depreciation of equipment Estimating Administrative and other expenses Subtotal of cost and expenses Operating Income Interest Expense, net Income before taxes Income tax Net income after tax Cash dividends Retained earnings, current year Retention at beginning of year Retained earnings at end of year
$7,200,000 5,500,000 200,000 150,000 650,000 6,500,000 700,000 150,000 550,000 220,000 330,000 100,000 230,000 650,000 $880,000
TABLE 12-6 Illustration of an Accounting Balance Sheet
Balance Sheet December 31, 19xx
Assets
Amount
Cash Payments Receivable Work in progress, not claimed Work in progress, retention Equipment at cost less accumulated depreciation Total assets
$150,000 750,000 700,000 200,000 1,400,000 $3,200,000
Liabilities and Equity
Liabilities Accounts payable Other items payable (taxes, wages, etc.) Long term debts Subtotal Shareholders' funds 40,000 shares of common stock (Including paid-in capital) Retained Earnings Subtotal Total Liabilities and Equity
$950,000 50,000 500,000 1,500,000 820,000 880,000 1,700,000 $3,200,000
In the context of private construction firms, particular problems arise in the treatment of uncompleted contracts in financial reports. Under the "completed-contract" method, income is only reported for completed projects. Work on projects underway
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is only reported on the balance sheet, representing an asset if contract billings exceed costs or a liability if costs exceed billings. When a project is completed, the total net profit (or loss) is reported in the final period as income. Under the "percentage-of-completion" method, actual costs are reported on the income statement plus a proportion of all project revenues (or billings) equal to the proportion of work completed during the period. The proportion of work completed is computed as the ratio of costs incurred to date and the total estimated cost of the project. Thus, if twenty percent of a project was completed in a particular period at a direct cost of $180,000 and on a project with expected revenues of $1,000,000, then the contract revenues earned would be calculated as $1,000,000(0.2) = $200,000. This figure represents a profit and contribution to overhead of $200,000 - $180,000 = $20,000 for the period. Note that billings and actual receipts might be in excess or less than the calculated revenues of $200,000. On the balance sheet of an organization using the percentage-of-completion method, an asset is usually reported to reflect billings and the estimated or calculated earnings in excess of actual billings.
As another example of the difference in the "percentage-of-completion" and the "completed-contract" methods, consider a three year project to construct a plant with the following cash flow for a contractor:
Year
Contract Expenses
Payments Received
1 2 3 Total
$700,000180,000 320,000$1,200,000
$900,000 250,000 150,000 $1,300,000
The supervising architect determines that 60% of the facility is complete in year 1 and 75% in year 2. Under the "percentage-of-completion" method, the net income in year 1 is $780,000 (60% of $1,300,000) less the $700,000 in expenses or $80,000. Under the "completed-contract" method, the entire profit of $100,000 would be reported in year 3.
The "percentage-of-completion" method of reporting period earnings has the advantage of representing the actual estimated earnings in each period. As a result, the income stream and resulting profits are less susceptible to precipitate swings on the completion of a project as can occur with the "completed contract method" of calculating income. However, the "percentage-of-completion" has the disadvantage of relying upon estimates which can be manipulated to obscure the actual position of a company or which are difficult to reproduce by outside observers. There are also subtleties such as the deferral of all calculated income from a project until a minimum threshold of the project is completed.
As a result, interpretation of the income statement and balance sheet of a private organization is not always straightforward. Finally, there are tax disadvantages from using the "percentage-of-completion" method since corporate taxes on expected profits may become due during the project rather than being deferred until the project completion. As an example of tax implications of the two reporting methods, a study of forty-seven construction firms conducted by the General Accounting Office found
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that $280 million in taxes were deferred from 1980 to 1984 through use of the "completed-contract" method. [6]
It should be apparent that the "percentage-of-completion" accounting provides only a rough estimate of the actual profit or status of a project. Also, the "completed contract" method of accounting is entirely retrospective and provides no guidance for management. This is only one example of the types of allocations that are introduced to correspond to generally accepted accounting practices, yet may not further the cause of good project management.
Another common example is the use of equipment depreciation schedules to allocate equipment purchase costs. Allocations of costs or revenues to particular periods within a project may cause severe changes in particular indicators, but have no real meaning for good management or profit over the entire course of a project. As Johnson and Kaplan argue: [7]
Today's management accounting information, driven by the procedures and cycle of the organization's financial reporting system, is too late, too aggregated and too distorted to be relevant for managers' planning and control decisions....
Management accounting reports are of little help to operating managers as they attempt to reduce costs and improve productivity. Frequently, the reports decrease productivity because they require operating managers to spend time attempting to understand and explain reported variances that have little to do with the economic and technological reality of their operations...
The management accounting system also fails to provide accurate product costs. Cost are distributed to products by simplistic and arbitrary measures, usually direct labor based, that do not represent the demands made by each product on the firm's resources.
As a result, complementary procedures to those used in traditional financial accounting are required to accomplish effective project control, as described in the preceding and following sections. While financial statements provide consistent and essential information on the condition of an entire organization, they need considerable interpretation and supplementation to be useful for project management.
Example 12-5: Calculating net profit
As an example of the calculation of net profit, suppose that a company began six jobs in a year, completing three jobs and having three jobs still underway at the end of the year. Details of the six jobs are shown in Table 12-7. What would be the company's net profit under, first, the "percentage-of-completion" and, second, the "completed contract method" accounting conventions?
TABLE 12-7 Example of Financial Records of Projects
Net Profit on Completed Contracts (Amounts in thousands of dollars)
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Job 1 Job 2 Job 3 Total Net Profit on Completed Jobs
$1,436 356 - 738 $1,054
Status of Jobs Underway
Job 4
Job 5
Job 6
Original Contract Price Contract Changes (Change Orders, etc.) Total Cost to Date Payments Received or Due to Date Estimated Cost to Complete
$4,2004003,6003,520500
$3,800 600 1,710 1,830 2,300
$5,630 - 300 620 340 5,000
As shown in Table 12-7, a net profit of $1,054,000 was earned on the three completed jobs. Under the "completed contract" method, this total would be total profit. Under the percentage-of completion method, the year's expected profit on the projects underway would be added to this amount. For job 4, the expected profits are calculated as follows:
Current contract price
= Original contract price + Contract Changes = 4,200 + 400 + 4,600
Credit or debit to date
= Total costs to date - Payments received or due to date = 3,600 - 3,520 = - 80
Contract value of uncompleted work
= Current contract price - Payments received or due = 4,600 - 3,520 = 1,080
Credit or debit to come
= Contract value of uncompleted work - Estimated Cost to Complete = 1,080 - 500 = 580
Estimated final gross profit
= Credit or debit to date + Credit or debit to come = - 80. + 580. = 500
Estimated total project costs
= Contract price - Gross profit = 4,600 - 500 = 4,100
Estimated Profit to date
= Estimated final gross profit x Proportion of work complete = 500. (3600/4100)) = 439
Similar calculations for the other jobs underway indicate estimated profits to date of $166,000 for Job 5 and -$32,000 for Job 6. As a result, the net profit using the "percentage-of-completion" method would be $1,627,000 for the year. Note that this figure would be altered in the event of multi-year projects in which net profits on projects completed or underway in this year were claimed in earlier periods.
5 Control of Project Cash Flows
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Section 3 described the development of information for the control of project costs with respect to the various functional activities appearing in the project budget. Project managers also are involved with assessment of the overall status of the project, including the status of activities, financing, payments and receipts. These various items comprise the project and financing cash flows described in earlier chapters. These components include costs incurred (as described above), billings and receipts for billings to owners (for contractors), payable amounts to suppliers and contractors, financing plan cash flows (for bonds or other financial instruments), etc.
As an example of cash flow control, consider the report shown in Table 12-8. In this case, costs are not divided into functional categories as in Table 12-4, such as labor, material, or equipment. Table 12-8 represents a summary of the project status as viewed from different components of the accounting system. Thus, the aggregation of different kinds of cost exposure or cost commitment shown in Table 12-0 has not been performed. The elements in Table 12-8 include:
• Costs This is a summary of charges as reflected by the job cost accounts, including expenditures and estimated costs. This row provides an aggregate summary of the detailed activity cost information described in the previous section. For this example, the total costs as of July 2 (7/02) were $ 8,754,516, and the original cost estimate was $65,863,092, so the approximate percentage complete was 8,754,516/65,863,092 or 13.292%. However, the project manager now projects a cost of $66,545,263 for the project, representing an increase of $682,171 over the original estimate. This new estimate would reflect the actual percentage of work completed as well as other effects such as changes in unit prices for labor or materials. Needless to say, this increase in expected costs is not a welcome change to the project manager.
• Billings This row summarizes the state of cash flows with respect to the owner of the facility; this row would not be included for reports to owners. The contract amount was $67,511,602, and a total of $9,276,621 or 13.741% of the contract has been billed. The amount of allowable billing is specified under the terms of the contract between an owner and an engineering, architect, or constructor. In this case, total billings have exceeded the estimated project completion proportion. The final column includes the currently projected net earnings of $966,339. This figure is calculated as the contract amount less projected costs: 67,511,602 - 66,545,263 = $966,339. Note that this profit figure does not reflect the time value of money or discounting.
• Payables The Payables row summarizes the amount owed by the contractor to material suppliers, labor or sub-contractors. At the time of this report, $6,719,103 had been paid to subcontractors, material suppliers, and others. Invoices of $1,300,089 have accumulated but have not yet been paid. A retention of $391,671 has been imposed on subcontractors, and $343,653 in direct labor expenses have been occurred. The total of payables is equal to the total project expenses shown in the first row of costs.
• Receivables This row summarizes the cash flow of receipts from the owner. Note that the
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actual receipts from the owner may differ from the amounts billed due to delayed payments or retainage on the part of the owner. The net-billed equals the gross billed less retention by the owner. In this case, gross billed is $9,276,621 (as shown in the billings row), the net billed is $8,761,673 and the retention is $514,948. Unfortunately, only $7,209,344 has been received from the owner, so the open receivable amount is a (substantial!) $2,067,277 due from the owner.
• Cash Position
This row summarizes the cash position of the project as if all expenses and receipts for the project were combined in a single account. The actual expenditures have been $7,062,756 (calculated as the total costs of $8,754,516 less subcontractor retentions of $391,671 and unpaid bills of $1,300,089) and $ 7,209,344 has been received from the owner. As a result, a net cash balance of $146,588 exists which can be used in an interest earning bank account or to finance deficits on other projects.
Each of the rows shown in Table 12-8 would be derived from different sets of financial accounts. Additional reports could be prepared on the financing cash flows for bonds or interest charges in an overdraft account.
TABLE 12-8 An Example of a Cash Flow Status Report
Costs 7/02
Charges 8,754,516
Estimated 65,863,092
% Complete13.292
Projected 66,545,263
Billings 7/01
Contract 67,511,602
Gross Bill 9,276,621
% Billed 13.741
Profit 966,339
Change 682,171
Payables 7/01
Paid 6,719,103
Open 1,300,089
Retention 391,671
Labor 343,653
Receivable 7/02
Net Bill 8,761,673
Received 7,209,344
Retention 514,948
Cash Position
Paid 7,062,756
Received 7,209,344
Position 146,588
Open 2,067,277
Total 8,754,516
The overall status of the project requires synthesizing the different pieces of information summarized in Table 12-8. Each of the different accounting systems contributing to this table provides a different view of the status of the project. In this example, the budget information indicates that costs are higher than expected, which could be troubling. However, a profit is still expected for the project. A substantial amount of money is due from the owner, and this could turn out to be a problem if the owner continues to lag in payment. Finally, the positive cash position for the project is highly desirable since financing charges can be avoided.
The job status reports illustrated in this and the previous sections provide a primary tool for project cost control. Different reports with varying amounts of detail and item reports would be prepared for different individuals involved in a project. Reports to upper management would be summaries, reports to particular staff individuals would emphasize their responsibilities (eg. purchasing, payroll, etc.), and detailed reports
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would be provided to the individual project managers. Coupled with scheduling reports described in Chapter 10, these reports provide a snapshot view of how a project is doing. Of course, these schedule and cost reports would have to be tempered by the actual accomplishments and problems occurring in the field. For example, if work already completed is of sub-standard quality, these reports would not reveal such a problem. Even though the reports indicated a project on time and on budget, the possibility of re-work or inadequate facility performance due to quality problems would quickly reverse that rosy situation.
6 Schedule Control
In addition to cost control, project managers must also give considerable attention to monitoring schedules. Construction typically involves a deadline for work completion, so contractual agreements will force attention to schedules. More generally, delays in construction represent additional costs due to late facility occupancy or other factors. Just as costs incurred are compared to budgeted costs, actual activity durations may be compared to expected durations. In this process, forecasting the time to complete particular activities may be required.
The methods used for forecasting completion times of activities are directly analogous to those used for cost forecasting. For example, a typical estimating formula might be:
( 5)
where Df is the forecast duration, W is the amount of work, and ht is the observed productivity to time t. As with cost control, it is important to devise efficient and cost effective methods for gathering information on actual project accomplishments. Generally, observations of work completed are made by inspectors and project managers and then work completed is estimated as described in Section 3. Once estimates of work complete and time expended on particular activities is available, deviations from the original duration estimate can be estimated. The calculations for making duration estimates are quite similar to those used in making cost estimates in Section 3.
For example, Figure 12-2 shows the originally scheduled project progress versus the actual progress on a project. This figure is constructed by summing up the percentage of each activity which is complete at different points in time; this summation can be weighted by the magnitude of effort associated with each activity. In Figure 12-2, the project was ahead of the original schedule for a period including point A, but is now late at point B by an amount equal to the horizontal distance between the planned progress and the actual progress observed to date.
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Figure 12-2 Illustration of Planned versus Actual Progress over Time on a Project
Schedule adherence and the current status of a project can also be represented on geometric models of a facility. For example, an animation of the construction sequence can be shown on a computer screen, with different colors or other coding scheme indicating the type of activity underway on each component of the facility. Deviations from the planned schedule can also be portrayed by color coding. The result is a mechanism to both indicate work in progress and schedule adherence specific to individual components in the facility.
In evaluating schedule progress, it is important to bear in mind that some activities possess float or scheduling leeway, whereas delays in activities on the critical path will cause project delays. In particular, the delay in planned progress at time t may be soaked up in activities' float (thereby causing no overall delay in the project completion) or may cause a project delay. As a result of this ambiguity, it is preferable to update the project schedule to devise an accurate portrayal of the schedule adherence. After applying a scheduling algorithm, a new project schedule can be obtained. For cash flow planning purposes, a graph or report similar to that shown in Figure 12-3 can be constructed to compare actual expenditures to planned expenditures at any time. This process of re-scheduling to indicate the schedule adherence is only one of many instances in which schedule and budget updating may be appropriate, as discussed in the next section.
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Figure 12-3 Illustration of Planned versus Actual Expenditures on a Project
7 Schedule and Budget Updates
Scheduling and project planning is an activity that continues throughout the lifetime of a project. As changes or discrepancies between the plan and the realization occur, the project schedule and cost estimates should be modified and new schedules devised. Too often, the schedule is devised once by a planner in the central office, and then revisions or modifications are done incompletely or only sporadically. The result is the lack of effective project monitoring and the possibility of eventual chaos on the project site.
On "fast track" projects, initial construction activities are begun even before the facility design is finalized. In this case, special attention must be placed on the coordinated scheduling of design and construction activities. Even in projects for which the design is finalized before construction begins, change orders representing changes in the "final" design are often issued to incorporate changes desired by the owner.
Periodic updating of future activity durations and budgets is especially important to avoid excessive optimism in projects experiencing problems. If one type of activity experiences delays on a project, then related activities are also likely to be delayed unless managerial changes are made. Construction projects normally involve numerous activities which are closely related due to the use of similar materials, equipment, workers or site characteristics. Expected cost changes should also be propagated throughout a project plan. In essence, duration and cost estimates for
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future activities should be revised in light of the actual experience on the job. Without this updating, project schedules slip more and more as time progresses. To perform this type of updating, project managers need access to original estimates and estimating assumptions.
Unfortunately, most project cost control and scheduling systems do not provide many aids for such updating. What is required is a means of identifying discrepancies, diagnosing the cause, forecasting the effect, and propagating this effect to all related activities. While these steps can be undertaken manually, computers aids to support interactive updating or even automatic updating would be helpful. [8]
Beyond the direct updating of activity durations and cost estimates, project managers should have mechanisms available for evaluating any type of schedule change. Updating activity duration estimations, changing scheduled start times, modifying the estimates of resources required for each activity, and even changing the project network logic (by inserting new activities or other changes) should all be easily accomplished. In effect, scheduling aids should be directly available to project managers. [9] Fortunately, local computers are commonly available on site for this purpose.
Example 12-6: Schedule Updates in a Small Project
As an example of the type of changes that might be required, consider the nine activity project described in Section 10.3 and appearing in Figure 12-4. Also, suppose that the project is four days underway, with the current activity schedule and progress as shown in Figure 12-5. A few problems or changes that might be encountered include the following:
1. An underground waterline that was previously unknown was ruptured during the fifth day of the project. An extra day was required to replace the ruptured section, and another day will be required for clean-up. What is the impact on the project duration?
o To analyze this change with the critical path scheduling procedure, the manager has the options of (1) changing the expected duration of activity C, General Excavation, to the new expected duration of 10 days or (2) splitting activity C into two tasks (corresponding to the work done prior to the waterline break and that to be done after) and adding a new activity representing repair and clean-up from the waterline break. The second approach has the advantage that any delays to other activities (such as activities D and E) could also be indicated by precedence constraints.
o Assuming that no other activities are affected, the manager decides to increase the expected duration of activity C to 10 days. Since activity C is on the critical path, the project duration also increases by 2 days. Applying the critical path scheduling procedure would confirm this change and also give a new set of earliest and latest starting times for the various activities.
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2. After 8 days on the project, the owner asks that a new drain be installed in addition to the sewer line scheduled for activity G. The project manager determines that a new activity could be added to install the drain in parallel with Activity G and requiring 2 days. What is the effect on the schedule?
o Inserting a new activity in the project network between nodes 3 and 4 violates the activity-on-branch convention that only one activity can be defined between any two nodes. Hence, a new node and a dummy activity must be inserted in addition to the drain installation activity. As a result, the nodes must be re-numbered and the critical path schedule developed again. Performing these operations reveals that no change in the project duration would occur and the new activity has a total float of 1 day.
o To avoid the labor associated with modifying the network and re-numbering nodes, suppose that the project manager simply re-defined activity G as installation of sewer and drain lines requiring 4 days. In this case, activity G would appear on the critical path and the project duration would increase. Adding an additional crew so that the two installations could proceed in parallel might reduce the duration of activity G back to 2 days and thereby avoid the increase in the project duration.
3. At day 12 of the project, the excavated trenches collapse during Activity E. An additional 5 days will be required for this activity. What is the effect on the project schedule? What changes should be made to insure meeting the completion deadline?
o Activity E has a total float of only 1 day. With the change in this activity's duration, it will lie on the critical path and the project duration will increase.
o Analysis of possible time savings in subsequent activities is now required, using the procedures described in Section 10.9.
Figure 12-4 A Nine Activity Example Project
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Figure 12-5 Current Schedule for an Example Project Presented as a Bar Chart
As can be imagined, it is not at all uncommon to encounter changes during the course of a project that require modification of durations, changes in the network logic of precedence relationships, or additions and deletions of activities. Consequently, the scheduling process should be readily available as the project is underway.
8 Relating Cost and Schedule Information
The previous sections focused upon the identification of the budgetary and schedule status of projects. Actual projects involve a complex inter-relationship between time and cost. As projects proceed, delays influence costs and budgetary problems may in turn require adjustments to activity schedules. Trade-offs between time and costs were discussed in Section 10.9 in the context of project planning in which additional resources applied to a project activity might result in a shorter duration but higher costs. Unanticipated events might result in increases in both time and cost to complete an activity. For example, excavation problems may easily lead to much lower than anticipated productivity on activities requiring digging.
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While project managers implicitly recognize the inter-play between time and cost on projects, it is rare to find effective project control systems which include both elements. Usually, project costs and schedules are recorded and reported by separate application programs. Project managers must then perform the tedious task of relating the two sets of information.
The difficulty of integrating schedule and cost information stems primarily from the level of detail required for effective integration. Usually, a single project activity will involve numerous cost account categories. For example, an activity for the preparation of a foundation would involve laborers, cement workers, concrete forms, concrete, reinforcement, transportation of materials and other resources. Even a more disaggregated activity definition such as erection of foundation forms would involve numerous resources such as forms, nails, carpenters, laborers, and material transportation. Again, different cost accounts would normally be used to record these various resources. Similarly, numerous activities might involve expenses associated with particular cost accounts. For example, a particular material such as standard piping might be used in numerous different schedule activities. To integrate cost and schedule information, the disaggregated charges for specific activities and specific cost accounts must be the basis of analysis.
A straightforward means of relating time and cost information is to define individual work elements representing the resources in a particular cost category associated with a particular project activity. Work elements would represent an element in a two-dimensional matrix of activities and cost accounts as illustrated in Figure 12-6. A numbering or identifying system for work elements would include both the relevant cost account and the associated activity. In some cases, it might also be desirable to identify work elements by the responsible organization or individual. In this case, a three dimensional representation of work elements is required, with the third dimension corresponding to responsible individuals. [10] More generally, modern computerized databases can accomadate a flexible structure of data representation to support aggregation with respect to numerous different perspectives; this type of system will be discussed in Chapter 14.
With this organization of information, a number of management reports or views could be generated. In particular, the costs associated with specific activities could be obtained as the sum of the work elements appearing in any row in Figure 12-6.
Cost Amount for Superstructure
Project Activity Group
204.1
204.2
204.3
204.4
204.5
204.6
First Floor
x
x
x
x
Second Floor
x
x
x
Third Floor
x
x
x
x
Fourth Floor
x
x
x
Fifth Floor
x
x
x
x
Figure 12-6 Illustration of a Cost Account and Project Activity Matrix
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Unfortunately, the development and maintenance of a work element database can represent a large data collection and organization effort. As noted earlier, four hundred separate cost accounts and four hundred activities would not be unusual for a construction project. The result would be up to 400x400 = 160,000 separate work elements. Of course, not all activities involve each cost account. However, even a density of two percent (so that each activity would have eight cost accounts and each account would have eight associated activities on the average) would involve nearly thirteen thousand work elements. Initially preparing this database represents a considerable burden, but it is also the case that project bookkeepers must record project events within each of these various work elements. Implementations of the "work element" project control systems have typically foundered on the burden of data collection, storage and book-keeping.
Until data collection is better automated, the use of work elements to control activities in large projects is likely to be difficult to implement. However, certain segments of project activities can profit tremendously from this type of organization. In particular, material requirements can be tracked in this fashion. Materials involve only a subset of all cost accounts and project activities, so the burden of data collection and control is much smaller than for an entire system. Moreover, the benefits from integration of schedule and cost information are particularly noticeable in materials control since delivery schedules are directly affected and bulk order discounts might be identified. Consequently, materials control systems can reasonably encompass a "work element" accounting system.
In the absence of a work element accounting system, costs associated with particular activities are usually estimated by summing expenses in all cost accounts directly related to an activity plus a proportion of expenses in cost accounts used jointly by two or more activities. The basis of cost allocation would typically be the level of effort or resource required by the different activities. For example, costs associated with supervision might be allocated to different concreting activities on the basis of the amount of work (measured in cubic yards of concrete) in the different activities. With these allocations, cost estimates for particular work activities can be obtained.
9 References
1. American Society of Civil Engineers, "Construction Cost Control," ASCE Manuals and Reports of Engineering Practice No. 65, Rev. Ed., 1985.
2. Coombs, W.E. and W.J. Palmer, Construction Accounting and Financial Management, McGraw-Hill, New York, 1977.
3. Halpin, D. W., Financial and Cost Concepts for Construction Management, John Wiley & Sons, New York, 1985.
4. Johnson, H. Thomas and Robert S. Kaplan, Relevance Lost, The Rise and Fall of Management Accounting, Harvard Business School Press, Boston, MA 1987.
5. Mueller, F.W. Integrated Cost and Schedule Control for Construction Projects, Van Nostrand Reinhold Company, New York, 1986.
6. Tersine, R.J., Principles of Inventory and Materials Management, North Holland, 1982.
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10 Problems
1. Suppose that the expected expenditure of funds in a particular category was expected to behave in a piecewise linear fashion over the course of the project. In particular, the following points have been established from historical records for the percentage of completion versus the expected expenditure (as a percentage of the budget):
Percentage of Completion
Expected Expenditure
0% 20% 40% 60% 80% 100%
0% 10% 25% 55% 90% 100%
• Graph the relationship between percentage complete and expected expenditure.
• Develop a formula or set of formulas for forecasting the ultimate expenditure on this activity given the percentage of completion. Assume that any over or under expenditure will continue to grow proportionately during the course of the project.
• Using your formula, what is the expected expenditure as a percentage of the activity budget if:
i. 15% of funds have been expended and 15% of the activity is complete.
ii. 30% of funds have been expended and 30% of the activity is complete.
iii. 80% of funds have been expended and 80% of the activity is complete.
2. Repeat Problem 1 parts (b) and (c) assuming that any over or under expenditure will not continue to grow during the course of the project.
3. Suppose that you have been asked to take over as project manager on a small project involving installation of 5,000 linear feet (LF) of metal ductwork in a building. The job was originally estimated to take ten weeks, and you are assuming your duties after three weeks on the project. The original estimate assumed that each linear foot of ductwork would cost $10, representing $6 in labor costs and $4 in material cost. The expected production rate was 500 linear feet of ductwork per week. Appearing below is the data concerning this project available from your firm's job control information system:
Weekly Unit Costs ($/Lf)
Quantity Placed (Lf)
Total Cost
Week
Labor
Materials
Total
Week
To Date
Week
To Date
1 2 3
12.00 8.57 6.67
4.00 4.00 4.00
16.00 12.57 10.67
250 350 450
250 600 1,050
4,000 4,400 4,800
4,000 8,400 13,200
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a. Based on an extrapolation using the average productivity and cost for all three weeks, forecast the completion time, cost and variance from original estimates.
b. Suppose that you assume that the productivity achieved in week 3 would continue for the remainder of the project. How would this affect your forecasts in (a)? Prepare new forecasts based on this assumption.
4. What criticisms could you make of the job status report in the previous problem from the viewpoint of good project management?
5. Suppose that the following estimate was made for excavation of 120,000 cubic yards on a site:
Resource
Quantity
Cost
Machines Labor Trucks
Total
1,200 hours 6,000 hours 2,400 hours
$60,000 150,000 75,000 $285,000
After 95,000 cubic yards of excavation was completed, the following expenditures had been recorded:
Resource
Quantity
Cost
Machines Labor Trucks
Total
1,063 hours 7,138 hours 1,500 hours
$47,835 142,527 46,875 $237,237
a. Calculate estimated and experienced productivity (cubic yards per hour) and unit cost (cost per cubic yard) for each resource.
b. Based on straight line extrapolation, do you see any problem with this activity? If so, can you suggest a reason for the problem based on your findings in (a)?
6. Suppose the following costs and units of work completed were recorded on an activity:
Month
Monthly Expenditure
Number of Work
Units Completed
1 2 3 4 5 6
$1,200 $1,250 $1,260 $1,280 $1,290 $1,280
30 32 38 42 42 42
Answer the following questions:
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a. For each month, determine the cumulative cost, the cumulative work completed, the average cumulative cost per unit of work, and the monthly cost per unit of work.
b. For each month, prepare a forecast of the eventual cost-to-complete the activity based on the proportion of work completed.
c. For each month, prepare a forecast of the eventual cost-to-complete the activity based on the average productivity experienced on the activity.
d. For each month, prepare a forecast of the eventual cost-to-complete the activity based on the productivity experienced in the previous month.
e. Which forecasting method (b, c or d) is preferable for this activity? Why?
7. Repeat Problem 6 for the following expenditure pattern:
Month
Monthly Expenditure
Number of Work
Units Completed
1 2 3 4 5 6
$1,200 $1,250 $1,260 $1,280 $1,290 $1,300
30 35 45 48 52 54
8. Why is it difficult to integrate scheduling and cost accounting information in project records?
9. Prepare a schedule progress report on planned versus actual expenditure on a project (similar to that in Figure 12-5) for the project described in Example 12-6.
10. Suppose that the following ten activities were agreed upon in a contract between an owner and an engineer.
Original Work Plan Information
Activity
Duration
(months)
Predecessors
Estimated Cost
($ thousands)
A B C D E F G H I J
2 5 5 2 3 8 4 4 11 2
--- --- B C B --- E, F E, F B E, F
7 9 8 4 1 7 6 5 10 7
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Original Contract Information
Total Direct Cost Overhead Total Direct and Overhead Profit Total Contract Amount
$64 64 128 12.8 $140.8
First Year Cash Flow
Expenditures Receipts
$56,000 $60,800
The markup on the activities' costs included 100% overhead and a profit of 10% on all costs (including overhead). This job was suspended for one year after completion of the first four activities, and the owner paid a total of $60,800 to the engineer. Now the owner wishes to re-commence the job. However, general inflation has increased costs by ten percent in the intervening year. The engineer's discount rate is 15 percent per year (in current year dollars). For simplicity, you may assume that all cash transactions occur at the end of the year in making discounting calculations in answering the following questions:
a. How long will be remaining six activities require?
b. Suppose that the owner agrees to make a lump sum payment of the remaining original contract at the completion of the project. Would the engineer still make a profit on the job? If so, how much?
c. Given that the engineer would receive a lump sum payment at the end of the project, what amount should he request in order to earn his desired ten percent profit on all costs?
d. What is the net future value of the entire project at the end, assuming that the lump sum payment you calculated in (c) is obtained?
11. Based on your knowledge of coding systems such as MASTERFORMAT and estimating techniques, outline the procedures that might be implemented to accomplish:
a. automated updating of duration and cost estimates of activities in light of experience on earlier, similar activities.
b. interactive computer based aids to help a project manager to accomplish the same task.
11 Footnotes
1. Cited in Zoll, Peter F., "Database Structures for Project Management," Proceedings of the Seventh Conference on Electronic Computation, ASCE, 1979.
2. Thomas Gibb reports a median number of 400 cost accounts for a two-million dollar projects in a sample of 30 contractors in 1975. See T.W. Gibb, Jr., "Building Construction in Southeastern United States," School of Civil Engineering, Georgia Institute of Technology, 1975, reported in D.W. Halpin, Financial and Cost Concepts for Construction Management, John Wiley and Sons, 1985.
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3. This illustrative set of accounts was adapted from an ASCE Manual of Practice: Construction Cost Control, Task Committee on Revision of Construction Cost Control Manual, ASCE, New York, 1985.
4. For a fuller exposition of this point, see W.H. Lucas and T.L. Morrison, "Management Accounting for Construction Contracts," Management Accounting, 1981, pp. 59-65.
5. For a description of these methods and examples as used by a sample of construction companies, see L.S. Riggs, Cost and Schedule Control in Industrial Construction, Report to The Construction Industry Institute, Dec. 1986.
6. As reported in the Wall Street Journal, Feb. 19, 1986, pg. A1, c. 4.
7. H.T. Johnson and R.S. Kaplan, Relevance Lost, The Rise and Fall of Management Accounting, Harvard Business School Press, pg. 1, 1987.
8. One experimental program directed at this problem is a knowledge based expert system described in R.E. Levitt and J.C. Kunz, "Using Knowledge of Construction and Project Management for Automated Schedule Updating," Project Management Journal, Vol. 16, 1985, pp. 57-76.
9. For an example of a prototype interactive project management environment that includes graphical displays and scheduling algorithms, see R. Kromer, "Interactive Activity Network Analysis Using a Personal Computer," Unpublished MS Thesis, Department of Civil Engineering, Carnegie-Mellon University, Pittsburgh, PA, 1984.
10. A three dimensional work element definition was proposed by J.M. Neil, "A System for Integrated Project Management," Proceedings of the Conference on Current Practice in Cost Estimating and Cost Control, ASCE, Austin, Texas, 138-146, April 1983.
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Economic Evaluation of Facility Investments
1 Project Life Cycle and Economic Feasibility
Facility investment decisions represent major commitments of corporate resources and have serious consequences on the profitability and financial stability of a corporation. In the public sector, such decisions also affect the viability of facility investment programs and the credibility of the agency in charge of the programs. It is important to evaluate facilities rationally with regard to both the economic feasibility of individual projects and the relative net benefits of alternative and mutually exclusive projects.
This chapter will present an overview of the decision process for economic evaluation of facilities with regard to the project life cycle. The cycle begins with the initial conception of the project and continues though planning, design, procurement, construction, start-up, operation and maintenance. It ends with the disposal of a facility when it is no longer productive or useful. Four major aspects of economic evaluation will be examined:
1. The basic concepts of facility investment evaluation, including time preference for consumption, opportunity cost, minimum attractive rate of return, cash flows over the planning horizon and profit measures.
2. Methods of economic evaluation, including the net present value method, the equivalent uniform annual value method, the benefit-cost ratio method, and the internal rate of return method.
3. Factors affecting cash flows, including depreciation and tax effects, price level changes, and treatment of risk and uncertainty.
4. Effects of different methods of financing on the selection of projects, including types of financing and risk, public policies on regulation and subsidies, the effects of project financial planning, and the interaction between operational and financial planning.
In setting out the engineering economic analysis methods for facility investments, it is important to emphasize that not all facility impacts can be easily estimated in dollar amounts. For example, firms may choose to minimize environmental impacts of
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construction or facilities in pursuit of a "triple bottom line:" economic, environmental and social. By reducing environmental impacts, the firm may reap benefits from an improved reputation and a more satisfied workforce. Nevertheless, a rigorous economic evaluation can aid in making decisions for both quantifiable and qualitative facility impacts.
It is important to distinguish between the economic evaluation of alternative physical facilities and the evaluation of alternative financing plans for a project. The former refers to the evaluation of the cash flow representing the benefits and costs associated with the acquisition and operation of the facility, and this cash flow over the planning horizon is referred to as the economic cash flow or the operating cash flow. The latter refers to the evaluation of the cash flow representing the incomes and expenditures as a result of adopting a specific financing plan for funding the project, and this cash flow over the planning horizon is referred to as the financial cash flow. In general, economic evaluation and financial evaluation are carried out by different groups in an organization since economic evaluation is related to design, construction, operations and maintenance of the facility while financial evaluations require knowledge of financial assets such as equities, bonds, notes and mortgages. The separation of economic evaluation and financial evaluation does not necessarily mean one should ignore the interaction of different designs and financing requirements over time which may influence the relative desirability of specific design/financing combinations. All such combinations can be duly considered. In practice, however, the division of labor among two groups of specialists generally leads to sequential decisions without adequate communication for analyzing the interaction of various design/financing combinations because of the timing of separate analyses.
As long as the significance of the interaction of design/financing combinations is understood, it is convenient first to consider the economic evaluation and financial evaluation separately, and then combine the results of both evaluations to reach a final conclusion. Consequently, this chapter is devoted primarily to the economic evaluation of alternative physical facilities while the effects of a variety of financing mechanisms will be treated in the next chapter. Since the methods of analyzing economic cash flows are equally applicable to the analysis of financial cash flows, the techniques for evaluating financing plans and the combined effects of economic and financial cash flows for project selection are also included in this chapter.
2 Basic Concepts of Economic Evaluation
A systematic approach for economic evaluation of facilities consists of the following major steps:
1. Generate a set of projects or purchases for investment consideration.
2. Establish the planning horizon for economic analysis.
3. Estimate the cash flow profile for each project.
4. Specify the minimum attractive rate of return (MARR).
5. Establish the criterion for accepting or rejecting a proposal, or for selecting the best among a group of mutually exclusive proposals, on the basis of the objective of the investment.
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6. Perform sensitivity or uncertainty analysis.
7. Accept or reject a proposal on the basis of the established criterion.
It is important to emphasize that many assumptions and policies, some implicit and some explicit, are introduced in economic evaluation by the decision maker. The decision making process will be influenced by the subjective judgment of the management as much as by the result of systematic analysis.
The period of time to which the management of a firm or agency wishes to look ahead is referred to as the planning horizon. Since the future is uncertain, the period of time selected is limited by the ability to forecast with some degree of accuracy. For capital investment, the selection of the planning horizon is often influenced by the useful life of facilities, since the disposal of usable assets, once acquired, generally involves suffering financial losses.
In economic evaluations, project alternatives are represented by their cash flow profiles over the n years or periods in the planning horizon. Thus, the interest periods are normally assumed to be in years t = 0,1,2, ...,n with t = 0 representing the present time. Let Bt,x be the annual benefit at the end of year t for a investment project x where x = 1, 2, ... refer to projects No. 1, No. 2, etc., respectively. Let Ct,x be the annual cost at the end of year t for the same investment project x. The net annual cash flow is defined as the annual benefit in excess of the annual cost, and is denoted by At,x at the end of year t for an investment project x. Then, for t = 0,1, . . . ,n:
( 1)
where At,x is positive, negative or zero depends on the values of Bt,x and Ct,x, both of which are defined as positive quantities.
Once the management has committed funds to a specific project, it must forego other investment opportunities which might have been undertaken by using the same funds. The opportunity cost reflects the return that can be earned from the best alternative investment opportunity foregone. The foregone opportunities may include not only capital projects but also financial investments or other socially desirable programs. Management should invest in a proposed project only if it will yield a return at least equal to the minimum attractive rate of return (MARR) from foregone opportunities as envisioned by the organization.
In general, the MARR specified by the top management in a private firm reflects the opportunity cost of capital of the firm, the market interest rates for lending and borrowing, and the risks associated with investment opportunities. For public projects, the MARR is specified by a government agency, such as the Office of Management and Budget or the Congress of the United States. The public MARR thus specified reflects social and economic welfare considerations, and is referred to as the social rate of discount.
Regardless of how the MARR is determined by an organization, the MARR specified for the economic evaluation of investment proposals is critically important in
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determining whether any investment proposal is worthwhile from the standpoint of the organization. Since the MARR of an organization often cannot be determined accurately, it is advisable to use several values of the MARR to assess the sensitivity of the potential of the project to variations of the MARR value.
3 Costs and Benefits of a Constructed Facility
The basic principle in assessing the economic costs and benefits of new facility investments is to find the aggregate of individual changes in the welfare of all parties affected by the proposed projects. The changes in welfare are generally measured in monetary terms, but there are exceptions, since some effects cannot be measured directly by cash receipts and disbursements. Examples include the value of human lives saved through safety improvements or the cost of environmental degradation. The difficulties in estimating future costs and benefits lie not only in uncertainties and reliability of measurement, but also on the social costs and benefits generated as side effects. Furthermore, proceeds and expenditures related to financial transactions, such as interest and subsidies, must also be considered by private firms and by public agencies.
To obtain an accurate estimate of costs in the cash flow profile for the acquisition and operation of a project, it is necessary to specify the resources required to construct and operate the proposed physical facility, given the available technology and operating policy. Typically, each of the labor and material resources required by the facility is multiplied by its price, and the products are then summed to obtain the total costs. Private corporations generally ignore external social costs unless required by law to do so. In the public sector, externalities often must be properly accounted for. An example is the cost of property damage caused by air pollution from a new plant. In any case, the measurement of external costs is extremely difficult and somewhat subjective for lack of a market mechanism to provide even approximate answers to the appropriate value.
In the private sector, the benefits derived from a facility investment are often measured by the revenues generated from the operation of the facility. Revenues are estimated by the total of price times quantity purchased. The depreciation allowances and taxes on revenues must be deducted according to the prevailing tax laws. In the public sector, income may also be accrued to a public agency from the operation of the facility. However, several other categories of benefits may also be included in the evaluation of public projects. First, private benefits can be received by users of a facility or service in excess of costs such as user charges or price charged. After all, individuals only use a service or facility if their private benefit exceeds their cost. These private benefits or consumer surplus represent a direct benefit to members of the public. In many public projects, it is difficult, impossible or impractical to charge for services received, so direct revenues equal zero and all user benefits appear as consumers surplus. Examples are a park or roadways for which entrance is free. As a second special category of public benefit, there may be external or secondary beneficiaries of public projects, such as new jobs created and profits to private suppliers. Estimating these secondary benefits is extremely difficult since resources
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devoted to public projects might simply be displaced from private employment and thus represent no net benefit.
4 Interest Rates and the Costs of Capital
Constructed facilities are inherently long-term investments with a deferred pay-off. The cost of capital or MARR depends on the real interest rate (i.e., market interest rate less the inflation rate) over the period of investment. As the cost of capital rises, it becomes less and less attractive to invest in a large facility because of the opportunities foregone over a long period of time.
In Figure 1, the changes in the cost of capital from 1974 to 2002 are illustrated. This figure presents the market interest rate on short and long term US treasury borrowing, and the corresponding real interest rate over this period. The real interest rate is calculated as the market interest rate less the general rate of inflation. The real interest rates has varied substantially, ranging from 9% to -7%. The exceptional nature of the 1980 to 1985 years is dramatically evident: the real rate of interest reached remarkably high historic levels.
With these volatile interest rates, interest charges and the ultimate cost of projects are uncertain. Organizations and institutional arrangements capable of dealing with this uncertainty and able to respond to interest rate changes effectively would be quite valuable. For example, banks offer both fixed rate and variable rate mortgages. An owner who wants to limit its own risk may choose to take a fixed rate mortgage even though the ultimate interest charges may be higher. On the other hand, an owner who chooses a variable rate mortgage will have to adjust its annual interest charges according to the market interest rates.
In economic evaluation, a constant value of MARR over the planning horizon is often used to simplify the calculations. The use of a constant value for MARR is justified on the ground of long-term average of the cost of capital over the period of investment. If the benefits and costs over time are expressed in constant dollars, the constant value for MARR represents the average real interest rate anticipated over the planning horizon; if the benefits and costs over time are expressed in then-current dollars, the constant value for MARR reflects the average market interest rate anticipated over the planning horizon.
5 Investment Profit Measures
A profit measure is defined as an indicator of the desirability of a project from the standpoint of a decision maker. A profit measure may or may not be used as the basis for project selection. Since various profit measures are used by decision makers for different purposes, the advantages and restrictions for using these profit measures should be fully understood.
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Figure 1 Nominal and Real Interest Rates on U.S. Bonds,
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There are several profit measures that are commonly used by decision makers in both private corporations and public agencies. Each of these measures is intended to be an indicator of profit or net benefit for a project under consideration. Some of these measures indicate the size of the profit at a specific point in time; others give the rate of return per period when the capital is in use or when reinvestments of the early profits are also included. If a decision maker understands clearly the meaning of the various profit measures for a given project, there is no reason why one cannot use all of them for the restrictive purposes for which they are appropriate. With the availability of computer based analysis and commercial software, it takes only a few seconds to compute these profit measures. However, it is important to define these measures precisely:
1. Net Future Value and Net Present Value. When an organization makes an investment, the decision maker looks forward to the gain over a planning horizon, against what might be gained if the money were invested elsewhere. A minimum attractive rate of return (MARR) is adopted to reflect this opportunity cost of capital. The MARR is used for compounding the estimated cash flows to the end of the planning horizon, or for discounting the cash flow to the present. The profitability is measured by the net future value (NFV) which is the net return at the end of the planning horizon above what might have been gained by investing elsewhere at the MARR. The net present value (NPV) of the estimated cash flows over the planning horizon is the discounted value of the NFV to the present. A positive NPV for a project indicates the present value of the net gain corresponding to the project cash flows.
2. Equivalent Uniform Annual Net Value. The equivalent uniform annual net value (NUV) is a constant stream of benefits less costs at equally spaced time periods over the intended planning horizon of a project. This value can be calculated as the net present value multiplied by an appropriate "capital recovery factor." It is a measure of the net return of a project on an annualized or amortized basis. The equivalent uniform annual cost (EUAC) can be obtained by multiplying the present value of costs by an appropriate capital recovery factor. The use of EUAC alone presupposes that the discounted benefits of all potential projects over the planning horizon are identical and therefore only the discounted costs of various projects need be considered. Therefore, the EUAC is an indicator of the negative attribute of a project which should be minimized.
3. Benefit Cost Ratio. The benefit-cost ratio (BCR), defined as the ratio of discounted benefits to the discounted costs at the same point in time, is a profitability index based on discounted benefits per unit of discounted costs of a project. It is sometimes referred to as the savings-to-investment ratio (SIR) when the benefits are derived from the reduction of undesirable effects. Its use also requires the choice of a planning horizon and a MARR. Since some savings may be interpreted as a negative cost to be deducted from the denominator or as a positive benefit to be added to the numerator of the ratio, the BCR or SIR is not an absolute numerical measure. However, if the ratio of the present value of benefit to the present value of cost exceeds one, the project is profitable irrespective of different interpretations of such benefits or costs.
4. Internal Rate of Return. The internal rate of return (IRR) is defined as the discount
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rate which sets the net present value of a series of cash flows over the planning horizon equal to zero. It is used as a profit measure since it has been identified as the "marginal efficiency of capital" or the "rate of return over cost". The IRR gives the return of an investment when the capital is in use as if the investment consists of a single outlay at the beginning and generates a stream of net benefits afterwards. However, the IRR does not take into consideration the reinvestment opportunities related to the timing and intensity of the outlays and returns at the intermediate points over the planning horizon. For cash flows with two or more sign reversals of the cash flows in any period, there may exist multiple values of IRR; in such cases, the multiple values are subject to various interpretations.
5. Adjusted Internal Rate of Return. If the financing and reinvestment policies are incorporated into the evaluation of a project, an adjusted internal rate of return (AIRR) which reflects such policies may be a useful indicator of profitability under restricted circumstances. Because of the complexity of financing and reinvestment policies used by an organization over the life of a project, the AIRR seldom can reflect the reality of actual cash flows. However, it offers an approximate value of the yield on an investment for which two or more sign reversals in the cash flows would result in multiple values of IRR. The adjusted internal rate of return is usually calculated as the internal rate of return on the project cash flow modified so that all costs are discounted to the present and all benefits are compounded to the end of the planning horizon.
6. Return on Investment. When an accountant reports income in each year of a multi-year project, the stream of cash flows must be broken up into annual rates of return for those years. The return on investment (ROI) as used by accountants usually means the accountant's rate of return for each year of the project duration based on the ratio of the income (revenue less depreciation) for each year and the undepreciated asset value (investment) for that same year. Hence, the ROI is different from year to year, with a very low value at the early years and a high value in the later years of the project.
7. Payback Period. The payback period (PBP) refers to the length of time within which the benefits received from an investment can repay the costs incurred during the time in question while ignoring the remaining time periods in the planning horizon. Even the discounted payback period indicating the "capital recovery period" does not reflect the magnitude or direction of the cash flows in the remaining periods. However, if a project is found to be profitable by other measures, the payback period can be used as a secondary measure of the financing requirements for a project.
6 Methods of Economic Evaluation
The objective of facility investment in the private sector is generally understood to be profit maximization within a specific time frame. Similarly, the objective in the public sector is the maximization of net social benefit which is analogous to profit maximization in private organizations. Given this objective, a method of economic analysis will be judged by the reliability and ease with which a correct conclusion may be reached in project selection.
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The basic principle underlying the decision for accepting and selecting investment projects is that if an organization can lend or borrow as much money as it wishes at the MARR, the goal of profit maximization is best served by accepting all independent projects whose net present values based on the specified MARR are nonnegative, or by selecting the project with the maximum nonnegative net present value among a set of mutually exclusive proposals. The net present value criterion reflects this principle and is most straightforward and unambiguous when there is no budget constraint. Various methods of economic evaluation, when properly applied, will produce the same result if the net present value criterion is used as the basis for decision. For convenience of computation, a set of tables for the various compound interest factors is given in Appendix A.
Net Present Value Method
Let BPVx be the present value of benefits of a project x and CPVx be the present value of costs of the project x. Then, for MARR = i over a planning horizon of n years,
( 2)
( 3)
where the symbol (P|F,i,t) is a discount factor equal to (1+i)-t and reads as follows: "To find the present value P, given the future value F=1, discounted at an annual discount rate i over a period of t years." When the benefit or cost in year t is multiplied by this factor, the present value is obtained. Then, the net present value of the project x is calculated as:
( 4)
or
( 5)
If there is no budget constraint, then all independent projects having net present values
greater than or equal to zero are acceptable. That is, project x is acceptable as long as
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( 6)
For mutually exclusive proposals (x = 1,2,...,m), a proposal j should be selected if it has the maximum nonnegative net present value among all m proposals, i.e.
( 7)
provided that NPVj 0.
Net Future Value Method
Since the cash flow profile of an investment can be represented by its equivalent value at any specified reference point in time, the net future value (NFVx) of a series of cash flows At,x (for t=0,1,2,...,n) for project x is as good a measure of economic potential as the net present value. Equivalent future values are obtained by multiplying a present value by the compound interest factor (F|P,i,n) which is (1+i)n. Specifically,
( 8)
Consequently, if NPVx 0, it follows that NFVx 0, and vice versa.
Net Equivalent Uniform Annual Value Method
The net equivalent uniform annual value (NUVx) refers to a uniform series over a planning horizon of n years whose net present value is that of a series of cash flow At,x (for t= 1,2,...,n) representing project x. That is,
( 9)
where the symbol (U|P,i,n) is referred to as the capital recovery factor and reads as follows: "To find the equivalent annual uniform amount U, given the present value P=1, discounted at an annual discount rate i over a period of t years." Hence, if NPVx 0, it follows that NUVx 0, and vice versa.
Benefit-Cost Ratio Method
The benefit-cost ratio method is not as straightforward and unambiguous as the net present value method but, if applied correctly, will produce the same results as the net present value method. While this method is often used in the evaluation of public projects, the results may be misleading if proper care is not exercised in its application to mutually exclusive proposals.
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The benefit-cost ratio is defined as the ratio of the discounted benefits to the discounted cost at the same point in time. In view of Eqs. ( 4) and ( 6), it follows that the criterion for accepting an independent project on the basis of the benefit-cost ratio is whether or not the benefit-cost ratio is greater than or equal to one:
( 10)
However, a project with the maximum benefit-cost ratio among a group of mutually exclusive proposals generally does not necessarily lead to the maximum net benefit. Consequently, it is necessary to perform incremental analysis through pairwise comparisons of such proposals in selecting the best in the group. In effect, pairwise comparisons are used to determine if incremental increases in costs between projects yields larger incremental increases in benefits. This approach is not recommended for use in selecting the best among mutually exclusive proposals.
Internal Rate of Return Method
The term internal rate of return method has been used by different analysts to mean somewhat different procedures for economic evaluation. The method is often misunderstood and misused, and its popularity among analysts in the private sector is undeserved even when the method is defined and interpreted in the most favorable light. The method is usually applied by comparing the MARR to the internal rate of return value(s) for a project or a set of projects.
A major difficulty in applying the internal rate of return method to economic evaluation is the possible existence of multiple values of IRR when there are two or more changes of sign in the cash flow profile At,x (for t=0,1,2,...,n). When that happens, the method is generally not applicable either in determining the acceptance of independent projects or for selection of the best among a group of mutually exclusive proposals unless a set of well defined decision rules are introduced for incremental analysis. In any case, no advantage is gained by using this method since the procedure is cumbersome even if the method is correctly applied. This method is not recommended for use either in accepting independent projects or in selecting the best among mutually exclusive proposals.
Example 1: Evaluation of Four Independent Projects
The cash flow profiles of four independent projects are shown in Table 1. 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.
Using i = 20%, we can compute NPV for x = 1, 2, 3, and 4 from Eq. ( 5). Then, the acceptability of each project can be determined from Eq. ( 6). Thus,
TABLE 1 Cash Flow Profiles of Four Independent Projects (in $ million)
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t
At,1
At,2
At,3
At,4
0 1 2 3 4 5
-77.0 0 0 0 0 235.0
-75.3 28.0 28.0 28.0 28.0 28.0
-39.9 28.0 28.0 28.0 28.0 -80.0
18.0 10.0 -40.0 -60.0 30.0 50.0
[NPV1]20% = -77 + (235)(P|F, 20%, 5) = -77 + 94.4 = 17.4
[NPV2]20% = -75.3 + (28)(P|U, 20%, 5) = -75.3 + 83.7 = 8.4
[NPV3]20% = -39.9 + (28)(P|U, 20%, 4) - (80)(P|F, 20%, 5)
= -39.9 + 72.5 - 32.2 = 0.4
[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
Hence, the first three independent projects are acceptable, but the last project should be rejected.
It is interesting to note that if the four projects are mutually exclusive, the net present value method can still be used to evaluate the projects and, according to Eq. ( 7), the project (x = 1) which has the highest positive NPV should be selected. The use of the net equivalent uniform annual value or the net future value method will lead to the same conclusion. However, the project with the highest benefit-cost ratio is not necessarily the best choice among a group of mutually exclusive alternatives. Furthermore, the conventional internal rate of return method cannot be used to make a meaningful evaluation of these projects as the IRR for both x=1 and x=2 are found to be 25% while multiple values of IRR exist for both the x=3 and x=4 alternatives.
7 Depreciation and Tax Effects
For private corporations, the cash flow profile of a project is affected by the amount of taxation. In the context of tax liability, depreciation is the amount allowed as a deduction due to capital expenses in computing taxable income and, hence, income tax in any year. Thus, depreciation results in a reduction in tax liabilities.
It is important to differentiate between the estimated useful life used in depreciation computations and the actual useful life of a facility. The former is often an arbitrary length of time, specified in the regulations of the U.S. Internal Revenue Service or a comparable organization. The depreciation allowance is a bookkeeping entry that does not involve an outlay of cash, but represents a systematic allocation of the cost of a physical facility over time.
There are various methods of computing depreciation which are acceptable to the U.S. Internal Revenue Service. The different methods of computing depreciation have different effects on the streams of annual depreciation charges, and hence on the stream of taxable income and taxes paid. Let P be the cost of an asset, S its estimated salvage value, and N the estimated useful life (depreciable life) in years. Furthermore, let Dt denote the depreciation amount in year t, Tt denote the accumulated
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depreciation up to year t, and Bt denote the book value of the asset at the end of year t, where t=1,2,..., or n refers to the particular year under consideration. Then,
( 11)
and
( 12)
The depreciation methods most commonly used to compute Dt and Bt are the straight line method, sum-of-the-years'-digits methods, and the double declining balanced method. The U.S. Internal Revenue Service provides tables of acceptable depreciable schedules using these methods. Under straight line depreciation, the net depreciable value resulting from the cost of the facility less salvage value is allocated uniformly to each year of the estimated useful life.
Under the sum-of-the-year's-digits (SOYD) method, the annual depreciation allowance is obtained by multiplying the net depreciable value multiplied by a fraction, which has as its numerator the number of years of remaining useful life and its denominator the sum of all the digits from 1 to n. The annual depreciation allowance under the double declining balance method is obtained by multiplying the book value of the previous year by a constant depreciation rate 2/n.
To consider tax effects in project evaluation, the most direct approach is to estimate the after-tax cash flow and then apply an evaluation method such as the net present value method. Since projects are often financed by internal funds representing the overall equity-debt mix of the entire corporation, the deductibility of interest on debt may be considered on a corporate-wide basis. For specific project financing from internal funds, let after-tax cash flow in year t be Yt. Then, for t=0,1,2,...,n,
( 13)
where At is the net revenue before tax in year t, Dt is the depreciation allowable for year t and Xt is the marginal corporate income tax rate in year t.
Besides corporate income taxes, there are other provisions in the federal income tax laws that affect facility investments, such as tax credits for low-income housing. Since the tax laws are revised periodically, the estimation of tax liability in the future can only be approximate.
Example 2: Effects of Taxes on Investment
A company plans to invest $55,000 in a piece of equipment which is expected to produce a uniform annual net revenue before tax of $15,000 over the next five years. The equipment has a salvage value of $5,000 at the end of 5 years and the depreciation allowance is computed on the basis of the straight line depreciation method. The marginal income tax rate for this company is 34%, and there is no
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expectation of inflation. If the after-tax MARR specified by the company is 8%, determine whether the proposed investment is worthwhile, assuming that the investment will be financed by internal funds.
Using Equations ( 11) and ( 13), the after-tax cash flow can be computed as shown in Table 2. Then, the net present value discounted at 8% is obtained from Equation ( 5) as follows:
510,1$)5%,8,|)(000,5()%,8,|)(300,13(000,55][51%8=++.=Ó=FPtFPNPVt
The positive result indicates that the project is worthwhile.
TABLE 2 After-Tax Cash Flow Computation
Year
t
Before-tax Cash Flow At
Straight-line Depreciation Dt
Taxable Income At-Dt
Income Tax Xt(At-Dt)
After-Tax Cash-Flow Yt
0 1-5 each 5 only
- $55,000 + $15,000 + $5,000
$10,000
$5,000
$1,700
- $55,000 + $13,300 + $5,000
8 Price Level Changes: Inflation and Deflation
In the economic evaluation of investment proposals, two approaches may be used to reflect the effects of future price level changes due to inflation or deflation. The differences between the two approaches are primarily philosophical and can be succinctly stated as follows:
1. The constant dollar approach. The investor wants a specified MARR excluding inflation. Consequently, the cash flows should be expressed in terms of base-year or constant dollars, and a discount rate excluding inflation should be used in computing the net present value.
2. The inflated dollar approach. The investor includes an inflation component in the specified MARR. Hence, the cash flows should be expressed in terms of then-current or inflated dollars, and a discount rate including inflation should be used in computing the net present value.
If these approaches are applied correctly, they will lead to identical results.
Let i be the discount rate excluding inflation, i' be the discount rate including inflation, and j be the annual inflation rate. Then,
( 14)
and
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( 15)
When the inflation rate j is small, these relations can be approximated by
( 16)
Note that inflation over time has a compounding effect on the price levels in various periods, as discussed in connection with the cost indices in Chapter 5.
If At denotes the cash flow in year t expressed in terms of constant (base year) dollars, and A't denotes the cash flow in year t expressed in terms of inflated (then-current) dollars, then
( 17)
or
( 18)
It can be shown that the results from these two equations are identical. Furthermore, the relationship applies to after-tax cash flow as well as to before-tax cash flow by replacing At and A't with Yt and Y't respectively in Equations ( 17) and ( 18).
Example 3: Effects of Inflation
Suppose that, in the previous example, 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.
In this case, the before-tax cash flow At in terms of constant dollars at base year 0 is inflated at j = 5% to then-current dollars A't for the computation of the taxable income (A't - Dt) and income taxes. The resulting after-tax flow Y't in terms of then-current dollars is converted back to constant dollars. That is, for Xt = 34% and Dt = $10,000. The annual depreciation charges Dt are not inflated to current dollars in conformity with the practice recommended by the U.S. Internal Revenue Service. Thus:
A't = At(1 + j)t = At(1 + 0.05)t
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Y't = A't - Xt(A't - Dt) = A't - (34%)(A't - $10,000)
Yt = Y't(1 + j)t = Y't(1 + 0.05)t
The detailed computation of the after-tax cash flow is recorded in Table 3. The net present value discounted at 8% excluding inflation is obtained by substituting Yt for At in Eq. ( 17). Hence,
[NPV]8%) = -55,000 + (13,138)(P|F,8%,1) + (12,985)(P|F,8%,2) + (12,837)(P|F,8%,3) + (12,697)(P|F, 8%, 4) + (12,564 + 5,000)(P|F, 8%, 5)
= -$227
With 5% inflation, the investment is no longer worthwhile because the value of the depreciation tax deduction is not increased to match the inflation rate.
TABLE 3 After-Tax Cash Flow Including Inflation
Time t
Constant $ B-Tax CF At
Current $ B-Tax CF A't
Current $ depreciation Dt
Current $ after depreciation A't-Dt
Current $ income tax Xt(A't-Dt)
Current $ A-Tax CF Y't
Constant $ A-Tax CF Yt
0 1 2 3 4 5 5
-$55,000 +15,000 +15,000 +15,000 +15,000 +15,000 +5,000
+$55,000 +15,750 16,540 17,365 18,233 19,145
$10,000 10,000 10,000 10,000 10,000
$5,750 6,540 7,365 8,233 9,145
$1,955 2,224 2,504 2,799 3,109
-$55,000 +13,795 +14,316 +14,861 +15,434 +16,036
-$55,000 +13,138 +12,985 +12,837 +12,697 +12,564 +5,000
Note: B-Tax CF refers to Before-Tax Cash Flow; A-Tax CF refers to After-Tax Cash Flow
Example 4: Inflation and the Boston Central Artery Project
The cost of major construction projects are often reported as simply the sum of all expenses, no matter what year the cost was incurred. For projects extending over a lengthy period of time, this practice can combine amounts of considerably different inherent values. A good example is the Boston Central Artery/Tunnel Project, a very large project to construct or re-locate two Interstate highways within the city of Boston.
In Table 4, we show one estimate of the annual expenditures for the Central Artery/Tunnel from 1986 to 2006 in millions of dollars, appearing in the column labelled "Expenses ($ M)." We also show estimates of construction price inflation in the Boston area for the same period, one based on 1982 dollars (so the price index equals 100 in 1982) and one on 2002 dollars. If the dollar expenditures are added up, the total project cost is $ 14.6 Billion dollars, which is how the project cost is often reported in summary documents. However, if the cost is calculated in constant 1982 dollars (when the original project cost estimate was developed for planning purposes),
48
the project cost would be only $ 8.4 Billion, with price inflation increasing expenses by $ 6.3 Billion. As with cost indices discussed in Chapter 5, the conversion to 1982 $ is accomplished by dividing by the 1982 price index for that year and then multiplying by 100 (the 1982 price index value). If the cost is calculated in constant 2002 dollars, the project cost increases to $ 15.8 Billion. When costs are incurred can significantly affect project expenses!
TABLE 4 Cash Flows for the Boston Central Artery/Tunnel Project
Year t
Price Index 1982 $
Price Index 2002 $
Project Expenses ($ M)
Project Expenses (1982 $ M)
Project Expenses (2002 $ M)
1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Sum
100 104 111 118 122 123 130 134 140 144 146 154 165 165 165 175 172 176 181 183 189 195 202 208 215
53 55 59 62 65 65 69 71 74 76 77 82 88 88 87 93 91 94 96 97 100 103 107 110 114
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 1,115,000 779,000 441,000 133,000 14,625,000
27,000 67,000 101,000 122,000 153,000 137,000 169,000 372,000 517,000 515,000 464,000 687,000 853,000 863,000 735,000 682,000 674,000 572,000 386,000 212,000 62,000 8,370,000
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 1,079,000 729,000 399,000 117,000 15,797,000
9 Uncertainty and Risk
Since future events are always uncertain, all estimates of costs and benefits used in economic evaluation involve a degree of uncertainty. Probabilistic methods are often used in decision analysis to determine expected costs and benefits as well as to assess the degree of risk in particular projects.
49
In estimating benefits and costs, it is common to attempt to obtain the expected or average values of these quantities depending upon the different events which might occur. Statistical techniques such as regression models can be used directly in this regard to provide forecasts of average values. Alternatively, the benefits and costs associated with different events can be estimated and the expected benefits and costs calculated as the sum over all possible events of the resulting benefits and costs multiplied by the probability of occurrence of a particular event:
( 19)
and
( 20)
where q = 1,....,m represents possible events, (Bt|q) and (Ct|q) are benefits and costs respectively in period t due to the occurrence of q, Pr{q} is the probability that q occurs, and E[Bt] and E[Ct] are respectively expected benefit and cost in period t. Hence, the expected net benefit in period t is given by:
( 21)
For example, the average cost of a facility in an earthquake prone site might be calculated as the sum of the cost of operation under normal conditions (multiplied by the probability of no earthquake) plus the cost of operation after an earthquake (multiplied by the probability of an earthquake). Expected benefits and costs can be used directly in the cash flow calculations described earlier.
In formulating objectives, some organizations wish to avoid risk so as to avoid the possibility of losses. In effect, a risk avoiding organization might select a project with lower expected profit or net social benefit as long as it had a lower risk of losses. This preference results in a risk premium or higher desired profit for risky projects. A rough method of representing a risk premium is to make the desired MARR higher for risky projects. Let rf be the risk free market rate of interest as represented by the average rate of return of a safe investment such as U.S. government bonds. However, U.S. government bonds do not protect from inflationary changes or exchange rate fluctuations, but only insure that the principal and interest will be repaid. Let rp be the risk premium reflecting an adjustment of the rate of return for the perceived risk. Then, the risk-adjusted rate of return r is given by:
( 22)
50
In using the risk-adjusted rate of return r to compute the net present value of an estimated net cash flow At (t = 0, 1, 2, ..., n) over n years, it is tacitly assumed that the values of At become more uncertain as time goes on. That is:
( 23)
More directly, a decision maker may be confronted with the subject choice among alternatives with different expected benefits of levels of risk such that at a given period t, the decision maker is willing to exchange an uncertain At with a smaller but certain return atAt where at is less than one. Consider the decision tree in Figure 2 in which the decision maker is confronted with a choice between the certain return of atAt and a gamble with possible outcomes (At;)q and respective probabilities Pr{q} for q = 1,2,...,m.
Figure 2 Determination of a Certainty Equivalent Value
Then, the net present value for the series of "certainty equivalents" over n years may be computed on the basis of the risk free rate. Hence:
( 24)
Note that if rfrp is negligible in comparison with r, then
(1 + rf)(1 + rp) = 1 +rf + rp + rfrp = 1 + r
Hence, for Eq. ( 23)
At(1 + r)-t = (atAt/at)(1 + rf)-t(1 + rp)-t =[(atAt)(1 + rf)-t][(1 + rp)-t/at]
51
If at = (1 + rp)-t for t = 1,2,...,n, then Eqs. ( 23) and ( 24) will be identical. Hence, the use of the risk-adjusted rate r for computing NPV has the same effect as accepting at = (1 + rp)-t as a "certainty equivalent" factor in adjusting the estimated cash flow over time.
10 Effects of Financing on Project Selection
Selection of the best design and financing plans for capital projects is typically done separately and sequentially. Three approaches to facility investment planning most often adopted by an organization are:
1. Need or demand driven: Public capital investments are defined and debated in terms of an absolute "need" for particular facilities or services. With a pre-defined "need," design and financing analysis then proceed separately. Even when investments are made on the basis of a demand or revenue analysis of the market, the separation of design and financing analysis is still prevalent.
2. Design driven: Designs are generated, analyzed and approved prior to the investigation of financing alternatives, because projects are approved first and only then programmed for eventual funding.
3. Finance driven: The process of developing a facility within a particular budget target is finance-driven since the budget is formulated prior to the final design. It is a common procedure in private developments and increasingly used for public projects.
Typically, different individuals or divisions of an organization conduct the analysis for the operating and financing processes. Financing alternatives are sometimes not examined at all since a single mechanism is universally adopted. An example of a single financing plan in the public sector is the use of pay-as-you-go highway trust funds. However, the importance of financial analysis is increasing with the increase of private ownership and private participation in the financing of public projects. The availability of a broad spectrum of new financing instruments has accentuated the needs for better financial analysis in connection with capital investments in both the public and private sectors. While simultaneous assessment of all design and financing alternatives is not always essential, more communication of information between the two evaluation processes would be advantageous in order to avoid the selection of inferior alternatives.
There is an ever increasing variety of borrowing mechanisms available. First, the extent to which borrowing is tied to a particular project or asset may be varied. Loans backed by specific, tangible and fungible assets and with restrictions on that asset's use are regarded as less risky. In contrast, specific project finance may be more costly to arrange due to transactions costs than is general corporate or government borrowing. Also, backing by the full good faith and credit of an organization is considered less risky than investments backed by generally immovable assets. Second, the options of fixed versus variable rate borrowing are available. Third, the repayment schedule and time horizon of borrowing may be varied. A detailed discussion of financing of constructed facilities will be deferred until the next chapter.
52
As a general rule, it is advisable to borrow as little as possible when borrowing rates exceed the minimum attractive rate of return. Equity or pay-as-you-go financing may be desirable in this case. It is generally preferable to obtain lower borrowing rates, unless borrowing associated with lower rates requires substantial transaction costs or reduces the flexibility for repayment and refinancing. In the public sector, it may be that increasing taxes or user charges to reduce borrowing involves economic costs in excess of the benefits of reduced borrowing costs of borrowed funds. Furthermore, since cash flow analysis is typically conducted on the basis of constant dollars and loan agreements are made with respect to current dollars, removing the effects of inflation will reduce the cost of borrowing. Finally, deferring investments until pay-as-you-go or equity financing are available may unduly defer the benefits of new investments.
It is difficult to conclude unambiguously that one financing mechanism is always superior to others. Consequently, evaluating alternative financing mechanisms is an important component of the investment analysis procedure. One possible approach to simultaneously considering design and financing alternatives is to consider each combination of design and financing options as a specific, mutually exclusive alternative. The cash flow of this combined alternative would be the sum of the economic or operating cash flow (assuming equity financing) and the financial cash flow over the planning horizon.
11 Combined Effects of Operating and Financing Cash Flows
A general approach for obtaining the combined effects of operating and financing cash flows of a project is to make use of the additive property of net present values by calculating an adjusted net present value. The adjusted net present value (APV) is the sum of the net present value (NPV) of the operating cash flow plus the net present value of the financial cash flow due to borrowing or raising capital (FPV). Thus,
( 25)
where each function is evaluated at i=MARR if both the operating and the financing cash flows have the same degree of risk or if the risks are taken care of in other ways such as by the use of certainty equivalents. Then, project selection involving both design and financing alternatives is accomplished by selecting the combination which has the highest positive adjusted present value. The use of this adjusted net present value method will result in the same selection as an evaluation based on the net present value obtained from the combined cash flow of each alternative combination directly.
To be specific, let At be the net operating cash flow, be the net financial cash flow resulting from debt financing, and AAt be the combined net cash flow, all for year t before tax. Then:
53
( 26)
Similarly, let and YYt be the corresponding cash flows after tax such that:
( 27)
The tax shields for interest on borrowing (for t = 1, 2, ..., n) are usually given by
( 28)
where It is the interest paid in year t and Xt is the marginal corporate income tax rate in year t. In view of Eqs. ( 13), ( 27) and ( 28), we obtain
( 29)
When MARR = i is applied to both the operating and the financial cash flows in Eqs. ( 13) and ( 28), respectively, in computing the net present values, the combined effect will be the same as the net present value obtained by applying MARR = i to the combined cash flow in Eq. ( 29).
In many instances, a risk premium related to the specified type of operation is added to the MARR for discounting the operating cash flow. On the other hand, the MARR for discounting the financial cash flow for borrowing is often regarded as relatively risk-free because debtors or holders of corporate bonds must be paid first before stockholders in case financial difficulties are encountered by a corporation. Then, the adjusted net present value is given by
( 30)
where NPV is discounted at r and FPV is obtained from the rf rate. Note that the net present value of the financial cash flow includes not only tax shields for interest on loans and other forms of government subsidy, but also on transactions costs such as those for legal and financial services associated with issuing new bonds or stocks.
54
The evaluation of combined alternatives based on the adjusted net present value method should also be performed in dollar amounts which either consistently include or remove the effects of inflation. The MARR value used would reflect the inclusion or exclusion of inflation accordingly. Furthermore, it is preferable to use after-tax cash flows in the evaluation of projects for private firms since different designs and financing alternatives are likely to have quite different implications for tax liabilities and tax shields.
In theory, the corporate finance process does not necessarily require a different approach than that of the APV method discussed above. Rather than considering single projects in isolation, groups or sets of projects along with financing alternatives can be evaluated. The evaluation process would be to select that group of operating and financing plans which has the highest total APV. Unfortunately, the number of possible combinations to evaluate can become very large even though many combinations can be rapidly eliminated in practice because they are clearly inferior. More commonly, heuristic approaches are developed such as choosing projects with the highest benefit/cost ratio within a particular budget or financial constraint. These heuristic schemes will often involve the separation of the financing and design alternative evaluation. The typical result is design-driven or finance-driven planning in which one or the other process is conducted first.
Example 5: Combined Effects of Operating and Financing Plans
A public agency plans to construct a facility and is considering two design alternatives with different capacities. The operating net cash flows for both alternatives over a planning horizon of 5 years are shown in Table 4. For each design alternative, the project can be financed either through overdraft on bank credit or by issuing bonds spanning over the 5-year period, and the cash flow for each financing alternative is also shown in Table 4. The public agency has specified a MARR of 10% for discounting the operating and financing cash flows for this project. Determine the best combination of design and financing plan if
(a) a design is selected before financing plans are considered, or
(b) the decision is made simultaneously rather than sequentially.
The net present values (NPV) of all cash flows can be computed by Eq.( 5), and the results are given at the bottom of Table 4. The adjusted net present value (APV) combining the operating cash flow of each design and an appropriate financing is obtained according to Eq. ( 25), and the results are also tabulated at the bottom of Table 4.
Under condition (a), design alternative 2 will be selected since NPV = $767,000 is the higher value when only operating cash flows are considered. Subsequently, bonds financing will be chosen because APV = $466,000 indicates that it is the best financing plan for design alternative 2.
Under condition (b), however, the choice will be based on the highest value of APV, i.e., APV = $484,000 for design alternative one in combination will overdraft financing. Thus, the simultaneous decision approach will yield the best results.
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TABLE 5 Illustration of Different Design and Financing Alternatives (in $ thousands)
Design Alternative One
Design Alternative Two
Year
Operating Cash Flow
Overdraft Financing
Bond Financing
Operating Cash Flow
Overdraft Financing
Bond Financing
0 1 2 3 4 5
-$1,000 -2,500 1,000 1,500 1,500 1,700
$1,000 2,500 -1,000 -1,500 -1,500 -921
$3,653 -418 -418 -418 -418 -4,217
$-2,500 -1,000 1,000 1,500 1,500 1,930
$2,500 1,000 -1,000 -1,500 -1,500 -1,254
$3,805 -435 -435 -435 -435 -4,392
NPV or FPV at 10%
761
-277
-290
767
-347
-301
APV = NPV + FPV
484
471
420
466
12 Public versus Private Ownership of Facilities
In recent years, various organizational ownership schemes have been proposed to raise the level of investment in constructed facilities. For example, independent authorities are assuming responsibility for some water and sewer systems, while private entrepreneurs are taking over the ownership of public buildings such as stadiums and convention centers in joint ventures with local governments. Such ownership arrangements not only can generate the capital for new facilities, but also will influence the management of the construction and operation of these facilities. In this section, we shall review some of these implications.
A particular organizational arrangement or financial scheme is not necessarily superior to all others in each case. Even for similar facilities, these arrangements and schemes may differ from place to place or over time. For example, U.S. water supply systems are owned and operated both by relatively large and small organizations in either the private or public sector. Modern portfolio theory suggest that there may be advantages in using a variety of financial schemes to spread risks. Similarly, small or large organizations may have different relative advantages with respect to personnel training, innovation or other activities.
Differences in Required Rates of Return
A basic difference between public and private ownership of facilities is that private organizations are motivated by the expectation of profits in making capital investments. Consequently, private firms have a higher minimum attractive rate of return (MARR) on investments than do public agencies. The MARR represents the desired return or profit for making capital investments. Furthermore, private firms
56
often must pay a higher interest rate for borrowing than public agencies because of the tax exempt or otherwise subsidized bonds available to public agencies. International loans also offer subsidized interest rates to qualified agencies or projects in many cases. With higher required rates of return, we expect that private firms will require greater receipts than would a public agency to make a particular investment desirable.
In addition to different minimum attractive rates of return, there is also an important distinction between public and private organizations with respect to their evaluation of investment benefits. For private firms, the returns and benefits to cover costs and provide profit are monetary revenues. In contrast, public agencies often consider total social benefits in evaluating projects. Total social benefits include monetary user payments plus users' surplus (e.g., the value received less costs incurred by users), external benefits (e.g., benefits to local businesses or property owners) and nonquantifiable factors (e.g., psychological support, unemployment relief, etc.). Generally, total social benefits will exceed monetary revenues.
While these different valuations of benefits may lead to radically different results with respect to the extent of benefits associated with an investment, they do not necessarily require public agencies to undertake such investments directly. First, many public enterprises must fund their investments and operating expenses from user fees. Most public utilities fall into this category, and the importance of user fee financing is increasing for many civil works such as waterways. With user fee financing, the required returns for the public and private firms to undertake the aforementioned investment are, in fact, limited to monetary revenues. As a second point, it is always possible for a public agency to contract with a private firm to undertake a particular project.
All other things being equal, we expect that private firms will require larger returns from a particular investment than would a public agency. From the users or taxpayers point of view, this implies that total payments would be higher to private firms for identical services. However, there are a number of mitigating factors to counterbalance this disadvantage for private firms.
Tax Implications of Public Versus Private Organizations
Another difference between public and private facility owners is in their relative liability for taxes. Public entities are often exempt from taxes of various kinds, whereas private facility owners incur a variety of income, property and excise taxes. However, these private tax liabilities can be offset, at least in part, by tax deductions of various kinds.
For private firms, income taxes represent a significant cost of operation. However, taxable income is based on the gross revenues less all expenses and allowable deductions as permitted by the prevalent tax laws and regulations. The most significant allowable deductions are depreciation and interest. By selecting the method of depreciation and the financing plan which are most favorable, a firm can exert a certain degree of control on its taxable income and, thus, its income tax.
Another form of relief in tax liability is the tax credit which allows a direct deduction for income tax purposes of a small percentage of the value of certain newly acquired
57
assets. Although the provisions for investment tax credit for physical facilities and equipment had been introduced at different times in the US federal tax code, they were eliminated in the 1986 Tax Reformation Act except a tax credit for low-income housing.
Of course, a firm must have profits to take direct advantage of such tax shields, i.e., tax deductions only reduce tax liabilities if before-tax profits exist. In many cases, investments in constructed facilities have net outlays or losses in the early years of construction. Generally, these losses in early years can be offset against profits occurred elsewhere or later in time. Without such offsetting profits, losses can be carried forward by the firm or merged with other firms' profits, but these mechanisms will not be reviewed here.
Effects of Financing Plans
Major investments in constructed facilities typically rely upon borrowed funds for a large portion of the required capital investments. For private organizations, these borrowed funds can be useful for leverage to achieve a higher return on the organizations' own capital investment.
For public organizations, borrowing costs which are larger than the MARR results in increased "cost" and higher required receipts. Incurring these costs may be essential if the investment funds are not otherwise available: capital funds must come from somewhere. But it is not unusual for the borrowing rate to exceed the MARR for public organizations. In this case, reducing the amount of borrowing lowers costs, whereas increasing borrowing lowers costs whenever the MARR is greater than the borrowing rate.
Although private organizations generally require a higher rate of return than do public bodies (so that the required receipts to make the investment desirable are higher for the private organization than for the public body), consideration of tax shields and introduction of a suitable financing plan may reduce this difference. The relative levels of the MARR for each group and their borrowing rates are critical in this calculation.
Effects of Capital Grant Subsidies
An important element in public investments is the availability of capital grant subsidies from higher levels of government. For example, interstate highway construction is eligible for federal capital grants for up to 90% of the cost. Other programs have different matching amounts, with 50/50 matching grants currently available for wastewater treatment plants and various categories of traffic systems improvement in the U.S. These capital grants are usually made available solely for public bodies and for designated purposes.
While the availability of capital grant subsidies reduces the local cost of projects, the timing of investment can also be affected. In particular, public subsidies may be delayed or spread over a longer time period because of limited funds. To the extent that (discounted) benefits exceed costs for particular benefits, these funding delays
58
can be costly. Consequently, private financing and investment may be a desirable alternative, even if some subsidy funds are available.
Implications for Design and Construction
Different perspectives and financial considerations also may have implications for design and construction choices. For example, an important class of design decisions arises relative to the trade-off between capital and operating costs. It is often the case that initial investment or construction costs can be reduced, but at the expense of a higher operating costs or more frequent and extensive rehabilitation or repair expenditures. It is this trade-off which has led to the consideration of "life cycle costs" of alternative designs. The financial schemes reviewed earlier can profoundly effect such evaluations.
For financial reasons, it would often be advantageous for a public body to select a more capital intensive alternative which would receive a larger capital subsidy and, thereby, reduce the project's local costs. In effect, the capital grant subsidy would distort the trade-off between capital and operating costs in favor of more capital intensive projects.
The various tax and financing considerations will also affect the relative merits of relatively capital intensive projects. For example, as the borrowing rate increases, more capital intensive alternatives become less attractive. Tax provisions such as the investment tax credit or accelerated depreciation are intended to stimulate investment and thereby make more capital intensive projects relatively more desirable. In contrast, a higher minimum attractive rate of return tends to make more capital intensive projects less attractive.
13 Economic Evaluation of Different Forms of Ownership
While it is difficult to conclude definitely that one or another organizational or financial arrangement is always superior, different organizations have systematic implications for the ways in which constructed facilities are financed, designed and constructed. Moreover, the selection of alternative investments for constructed facilities is likely to be affected by the type and scope of the decision-making organization.
As an example of the perspectives of public and private organizations, consider the potential investment on a constructed facility with a projected useful life of n years. Let t = 0 be the beginning of the planning horizon and t = 1, 2, ... n denote the end of each of the subsequent years. Furthermore, let Co be the cost of acquiring the facility at t = 0, and Ct be the cost of operation in year t. Then, the net receipts At in year t is given by At = Bt - Ct in which Bt is the benefit in year t and At may be positive or negative for t = 0, 1, 2, ..., n.
59
Let the minimum attractive rate of return (MARR) for the owner of the facility be denoted by i. Then, the net present value (NPV) of a project as represented by the net cash flow discounted to the present time is given by
( 31) Ó=.+=ntti0t)1(A NPVÓÓ=.=.+.+=nttnttii0t0t)1(C)1(B
Then, a project is acceptable if NPV0. When the annual gross receipt is uniform, i.e., Bt = B for t = 1, 2, ..., n and B0 = 0, then, for NPV = 0:
( 32) ÓÓ=.=.+=+nttnttii0t1)1(C)1(B
Thus, the minimum uniform annual gross receipt B which makes the project economically acceptable can be determined from Equation ( 32), once the acquisition and operation costs Ct of the facility are known and the MARR is specified.
Example 6: Different MARRs for Public and Private Organizations
For the facility cost stream of a potential investment with n = 7 in Table 5, the required uniform annual gross receipts B are different for public and private ownerships since these two types of organizations usually choose different values of MARR. With a given value of MARR = i in each case, the value of B can be obtained from Eq. ( 32).
With a MARR of 10%, a public agency requires at least B = $184,000. By contrast, a private firm using a 20% MARR before tax while neglecting other effects such as depreciation and tax deduction would require at least B = $219,000. Then, according to Eq. ( 31), the gross receipt streams for both public and private ownerships in Table 5 will satisfy the condition NPV = 0 when each of them is netted from the cost stream and discounted at the appropriate value of MARR, i.e., 10% for a public agency and 20% (before tax) for a private firm. Thus, this case suggests that public provision of the facility has lower user costs.
Example 7: Effects of Depreciation and Tax Shields for Private Firms
Using the same data as in Example 6, we now consider the effects of depreciation and tax deduction for private firms. Suppose that the marginal tax rate of the firm is 34% in each year of operation, and losses can always be offset by company-wide profits. Suppose further that the salvage value of the facility is zero at the end of seven years so that the entire amount of cost can be depreciated by means of the sum-of-the-years'-digits (SOYD) method. Thus, for the sum of digits 1 through 7 equal to 28, the depreciation allowances for years 1 to 7 are respectively 7/28, 6/28, ..., 1/28 of the total depreciable value of $ 500,000, and the results are recorded in column 3 of Table 6.
TABLE 6 Required Uniform Annual Gross Receipts for Public and Private
60
Ownership of a Facility (in $ thousands)
Public Ownership
Private Ownership
Year
t
Facility cost, Ct
Gross Receipt, Bt
Net Receipt At=Bt - Ct
Gross Receipt, Bt
Net Receipt At=Bt - Ct
0 1 2 3 4 5 6 7
$500 76 78 80 82 84 86 88
$0 184 184 184 184 184 184 184
-$500 108 106 104 102 100 98 96
$0 219 219 219 219 219 219 219
-$500 143 141 139 137 135 133 131
For a uniform annual gross receipt B = $219,000, the net receipt before tax in Column 6 of Table 5 in Example 5 can be used as the starting point for computing the after-tax cash flow according to Equation ( 13) which is carried out step-by-step in Table 6. (Dollar amounts are given to the nearest $1,000). By trial and error, it is found that an after-tax MARR = 14.5% will produce a zero value for the net present value of the discounted after-tax flow at t = 0. In other words, the required uniform annual gross receipt for this project at 14.5% MARR after tax is also B = $219,000. It means that the MARR of this private firm must specify a 20% MARR before tax in order to receive the equivalent of 14.5% MARR after tax.
Example 8: Effects of Borrowing on Public Agencies
Suppose that the gross uniform annual receipt for public ownership is B = $190,000 instead of $184,000 for the facility with cost stream given in Column 2 of Table 5. Suppose further that the public agency must borrow $400,000 (80% of the facility cost) at 12% annual interest, resulting in an annual uniform payment of $88,000 for the subsequent seven years. This information has been summarized in Table 7. The use of borrowed funds to finance a facility is referred to as debt financing or leveraged financing, and the combined cash flow resulting from operating and financial cash flows is referred to as the levered cash flow.
To the net receipt At in Column 4 of Table 7, which has been obtained from a uniform annual gross receipt of $190,000, we add the financial cash flow, which included a loan of $400,000 with an annual repayment of $88,000 corresponding to an interest rate of 12%. Then the resulting combined cash flow AAt as computed according to Equation ( 26) is shown in column 6 of Table 7.
TABLE 7 Effects of Depreciation and Tax Deductions for Private Ownership in a Facility (in $ thousands)
Year t
Net Receipt Before-tax At
Depreciation (SOYD) Dt
Taxable Income (At - Dt)
Income Tax Xt(At - Dt)
After-tax Cash Flow < td>
0
-$500
$0
$0
$0
-$500
61
1 2 3 4 5 6 7
143 141 139 137 135 133 131
125 107 89 71 54 36 18
18 34 50 66 81 97 113
6 12 17 22 28 33 38
137 129 122 115 107 100 93
Note that for a loan at 12% interest, the net present value of the combined cash flow AAt is zero when discounted at a 10% MARR for the public agency. This is not a coincidence, but several values of B have been tried until B = $190,000 is found to satisfy NPV = 0 at 10% MARR. Hence, the minimum required uniform annual gross receipt is B = $190,000.
Example 9: Effects of Leverage and Tax Shields for Private Organizations
Suppose that the uniform annual gross receipt for a private firm is also B = $190,000 (the same as that for the public agency in Example 7). The salvage value of the facility is zero at the end of seven years so that the entire amount of cost can be depreciated by means of the sum-of-the-years'-digit (SOYD) method. The marginal tax rate of the firm is 34% in each year of operation, and losses can always be offset by company-wide profits.
Suppose further that the firm must borrow $400,000 (80% of the facility cost) at a 12% annual interest, resulting in an annual uniform payment of $88,000 for the subsequent seven years. The interest charge each year can be computed as 12% of the remaining balance of the loan in the previous year, and the interest charge is deductible from the tax liability.
For B = $190,000 and a facility cost stream identical to that in Example 7, the net receipts before tax At (operating cash flow with no loan) in Table 7 can be used as the starting point for analyzing the effects of financial leverage through borrowing. Thus, column 4 of Table 7 is reproduced in column 2 of Table 8.
The computation of the after-tax cash flow of the private firm including the effects of tax shields for interest is carried out in Table 8. The financial - cash stream in Column 4 of Table 8 indicates a loan of $400,000 which is secured at t = 0 for an annual interest of 12%, and results in a series of uniform annual payments of $88,000 in order to repay the principal and interest.
TABLE 8 Effects of Borrowing on a Publicly Owned Facility (in $ thousands)
Year t
Gross receipt Bt
Facility cost Ct
Net receipt (no loan) At
Loan and payment(12% interest)
Combined cash flow (12% interest) AAt
0
$0
$500
-$500
+$400
-$100
62
1 2 3 4 5 6 7
190 190 190 190 190 190 190
76 78 80 82 84 86 88
114 112 110 108 106 104 102
-88 -88 -88 -88 -88 -88 -88
26 24 22 20 18 16 14
The levered after-tax cash flow YYt can be obtained by Eq. ( 29), using the same investment credit, depreciation method and tax rate, and is recorded in Column 7 of Table 8. Since the net present value of YYt in Column 7 of Table 8 discounted at 14.5% happens to be zero, the minimum required uniform annual gross receipt for the potential investment is $190,000. By borrowing $400,000 (80% of the facility cost) at 12% annual interest, the investment becomes more attractive to the private firm. This is expected because of the tax shield for the interest and the 12% borrowing rate which is lower than the 14.5% MARR after-tax for the firm.
TABLE 9 Effects of Financial Leverage and Tax Shields on Private Ownership of a Facility (in $ thousands)
Year t
Net Receipt Before Tax (no loan) At
Depreciation(SOYD) Dt
Loan and ScheduledPayment
Interest On LoanIt
Income Tax (34% rate) Xt(At - Dt - It)
After Tax Cash Flow(levered) YYt
0 1 2 3 4 5 6 7
-$500 114 112 110 108 106 104 102
$0 125 107 89 71 54 36 18
$400 -88 -88 -88 -88 -88 -88 -88
$0 48 43 38 32 25 18 9
$0 -19 -13 -6 2 9 17 26
-$100 45 37 28 18 9 -1 -12
Example 10: Comparison of Public and Private Ownership.
In each of the analyses in Examples 5 through 8, a minimum required uniform annual gross receipt B is computed for each given condition whether the owner is a public agency or a private firm. By finding the value of B which will lead to NPV = 0 for the specified MARR for the organization in each case, various organizational effects with or without borrowing can be analyzed. The results are summarized in Table 9 for comparison. In this example, public ownership with a 80% loan and a 10% MARR has the same required benefit as private ownership with an identical 80% loan and a 14.5% after-tax MARR.
TABLE 10 Summary effects of Financial Leverage and Tax Shields on Private Ownership
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Organizational condition
Financial arrangement
Minimum benefit required
Public, no tax (MARR = 10%)
No loan 80% loan at 12% interest
$184,000 190,000
Private, before tax (MARR = 20%)
No loan
219,000
Private, after tax (MARR = 14.5%)
No loan 80% loan at 12% interest
219,000 190,000
14 References
1. Au, T., "Profit Measures and Methods of Economic Analysis for Capital Project Selection," ASCE Journal of Management in Engineering, Vol. 4, No. 3, 1988.
2. Au, T. and T. P. Au, Engineering Economics for Capital Investment Analysis, Allyn and Bacon, Newton, MA, 1983.
3. Bierman, H., Jr., and S. Smidt, The Capital Budgeting Decision, 5th Ed., Macmillan, New York, 1984.
4. Brealey, R. and S. Myers, Principles of Corporate Finance, Second Edition, McGraw-Hill, New York, 1984.
5. Edwards, W.C. and J.F. Wong, "A Computer Model to Estimate Capital and Operating Costs," Cost Engineering, Vol. 29, No. 10, 1987, pp. 15-21.
6. Hendrickson, C. and T. Au, "Private versus Public Ownership of Constructed Facilities," ASCE Journal of Management in Engineering, Vol. 1, No. 3, 1985, pp. 119-131.
7. Wohl, M. and C. Hendrickson, Transportation Investment and Pricing Principles, John Wiley, New York, 1984.
15 Problems
1. The Salisbury Corporation is considering four mutually exclusive alternatives for a major capital investment project. All alternatives have a useful life of 10 years with no salvage value at the end. Straight line depreciation will be used. The corporation pays federal and state tax at a rate of 34%, and expects an after-tax MARR of 10%. Determine which alternative should be selected, using the NPV method.
Alternatives
Initial cost ($million)
Before-tax uniform annual net benefits ($million)
1 2 3 4
$4.0 3.5 3.0 3.7
$1.5 1.1 1.0 1.3
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2. The operating cash flow for the acquisition and maintenance of a clamshell for excavation is given by At in the table below. Three financing plans, each charging a borrowing rate of 8% but having a different method of - repayment, are represented by three different cash flows of. Find the net present value for each of the three combined cash flows AAt for operating and financing if the MARR is specified to be 8%.
Financing
Year t Operating
(a)
(b)
(c)
0 1 2 3 4 5
-$80,000 30,000 30,000 30,000 30,000 30,000
$40,000 -10,020 -10,020 -10,020 -10,020 -10,020
$40,000 -3,200 -3,200 -3,200 -3,200 -43,200
$40,000-13,200-12,400-11,600-10,8000
3. Find the net present value for each of the three cases in Problem 2 if the MARR is specified to be: (a) 5% (b) 10%.
4. Suppose the clamshell in Problem 2 is purchased by a private firm which pays corporate taxes at a rate of 34%. Depreciation is based on the straight line method with no salvage value at the end of five years. If the after-tax MARR of the firm is 8%, find the net present value for each of the combined cash flows for operating and financing, including the interest deduction. The interest payments included in the annual repayments of each of the loans are 8% times the unpaid principal in each year, with the following values:
Year (t)
(a)
(b)
(c)
1 2 3 4 5
$800 664 516 357 185
$3,200 3,200 3,200 3,200 3,200
$3,200 2,400 1,600 800 0
5. An investment in a hauler will cost $40,000 and have no salvage value at the end of 5 years. The hauler will generate a gross income of $12,000 per year, but its operating cost will be $2,000 during the first year, increasing by $500 per year until it reaches $5,000 in the fifth year. The straight line depreciation method is used. The tax rate is 34% and the after-tax MARR is 10%. Determine the net present value of the hauler purchase for a five year planning horizon.
6. The Bailey Construction Company is considering the purchase of a diesel power shovel to improve its productivity. The shovel, which costs $80,000, is expected to produce a before-tax benefit of $36,000 in the first year, and $4,000 less in each succeeding year for a total of five years (i.e., before tax benefit of $32,000 in the second year, $28,000 in the third year, continuing to $20,000 in the fifth year). The salvage value of the equipment will be $5,000
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at the end of 5 years. The firm uses the sum-of-years'-digits depreciation for the equipment and has an annual tax rate of 34%. If the MARR after tax is 10%, is the purchase worthwhile?
7. The ABC Corporation is considering the purchase of a number of pipe-laying machines in order to facilitate the operation in a new pipeline project expected to last six years. Each machine will cost $26,000 and will have no salvage value after the project is complete. The firm uses the straight line depreciation method and pays annual income taxes on profits at the rate of 34%. If the firm's MARR is 8%, which is the minimum uniform annual benefit before tax that must be generated by this machine in order to justify its purchase?
8. The Springdale Corporation plans to purchase a demolition and wrecking machine to save labor costs. The machine costs $60,000 and has a salvage value of $10,000 at the end of 5 years. The machine is expected to be in operation for 5 years, and it will be depreciated by the straight line method up to the salvage value. The corporation specifies an after-tax MARR including inflation of 10% and has an income tax rate of 34%. The annual inflation rate is expected to be 5% during the next 5 years. If the uniform annual net benefit before tax in terms of base-year dollars for the next 5 years is $20,000, is the new investment worthwhile?
9. XYZ Company plans to invest $2 million in a new plant which is expected to produce a uniform annual net benefit before tax of $600,000 in terms of the base-year dollars over the next 6 years. The plant has a salvage value of $250,000 at the end of 6 years and the depreciation allowance is based on the straight line depreciation method. The corporate tax rate is 34%, and the after-tax MARR specified by the firm is 10% excluding inflation. If the annual inflation rate during the next 6 years is expected to be 5%, determine whether the investment is worthwhile.
10. A sewage treatment plant is being planned by a public authority. Two proposed designs require initial and annual maintenance costs as shown below.
Year t
Design No. 1 ($1000s)
Design No. 2 ($1000s)
0 1-16(each)
1,000 150
900 180
11. Both designs will last 16 years with no salvage value. The federal government will subsidize 50% of the initial capital cost, and the state government has a policy to subsidize 10% of the annual maintenance cost. The local community intends to obtain a loan to finance 30% of the initial capital cost at a borrowing rate of 10% with sixteen equal annual payments including principal and interest. The MARR for this type of project is 12% reflecting its operating risk. What is the uniform annual revenue that must be collected in the next 16 years to make each of the two designs worthwhile from the view of the local authority? Which design has lower cost from this perspective? 66
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