Principles of Financial Feasibility ARCH 738: REAL ESTATE PROJECT MANAGEMENT. Morgan State University

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1 Principles of Financial Feasibility ARCH 738: REAL ESTATE PROJECT MANAGEMENT Morgan State University Jason E. Charalambides, PhD, MASCE, AIA, ENV_SP (This material has been prepared for educational purposes) Introduction 2

2 Introduction! FEASIBILITY vs VIABILITY! The question of Desirability is what must have been extensively addressed during the process of Site Analysis! There is where the questions of filling a need, introducing something appealing, that will fit people's lives and environment's necessities was addressed. 3 Introduction " FEASIBILITY vs VIABILITY! The question of weather the financial requirement of a developer will be satisfied, has been extruded through the studies of Cost Estimating and Scheduling! The Financial Feasibility can be more accurately described as a Viability Study 4

3 ! VIABILITY STUDY Introduction! The purpose of a viability study is to determine whether the proposed project will pay, or in other words, whether it will satisfy the financial criteria of the parties involved! In accounting terms, it is like the budget of expected future yield. 5 " VIABILITY STUDY Introduction! A thorough marketing analysis should precede the financial feasibility study to prevent an optimistic assessment being made of the rental levels, which may result in an unsuccessful development and very unhappy financiers. One should take care not to be tempted to manipulate the figures of the financial feasibility study to show a desired result. " The purpose of the study is to determine the probability of the success of a planned development - not to manipulate the figures until a desired result is reached. If the figures of the financial feasibility study do not comply with reality it could prove disastrous for the developer. 6

4 ! VIABILITY STUDY Introduction! The feasibility is a powerful and necessary tool to be used to establish the economic desirability of investing in a development. It should not however be treated as a mechanical tool where decisions are automatically taken on the result of the study.! The personal "gut feel" and experience of the developer is still of inestimable importance and common sense should always be exercised in all decision making. 7 " INVESTOR'S FUTURE YIELD Introduction! The developer wants to see quick profit.! The professional consultants want to earn fees.! The leasing agent wants to get a commission.! The investor will want a long term yield. That is an acceptable income stream in relation to the capital employment. 8

5 ! Income Stream Introduction! The process is simple: " First one must determine the capital employment, i.e. the initial costs for the development plus the maintenance costs. " Then calculate the stream of anticipated annual income. " Bring all the +ve and -ve cash flow to PV and determine the timing of profit. F v =P v (1+R) n OR P v = (1+R) n 9 F v Financial Feasibility 10

6 Types of Financial Feasibility Reports! The following types of financial viability reports can be distinguished:! (a) Estimate of current building cost only (usually based on either the square foot or the elemental method of estimating)! (b) As above, but escalated to bid date or to the date of practical completion! (c) Estimate of escalated final building cost with only the estimated cost of professional fees! (d) Estimate of total capital outlay! (e) Replacement valuation (for insurance purposes, etc.)! (f) Economic viability analysis incorporating (d) above. 11 Types of Financial Feasibility Reports! For (f) above: " A letting or leasing scheme (refers to the discussion hereunder) " A marginal return letting scheme " A sectional title/shareblock selling scheme " A leasehold scheme " A timeshare scheme. 12

7 Types of Financial Feasibility Reports! All of the above types of viabilities may be based on varying stages of completion of the architects drawings with, at the one end of the scale, no drawings with only the local authority byelaws to go on, and at the other end of the scale full working drawings. The financial feasibility may also be done to establish any one of a number of other variables in the equation, for example " the price that may be paid for a parcel of land at a given required yield; " the rentals to be obtained to achieve a required yield; " the optimum contract period (with reference to the size of the project); " the optimum construction cost (again with reference to the size and specification of the development).! Given a set of parameters with one of the above as the unknown, it is possible to quickly establish the value of that unknown. Once this is done the parameters may be changed to establish the sensitivity of the unknown to any change in these parameters. 13 Structure of the Financial Feasibility Study! The financial feasibility study consists of five steps: " 1. Estimate the total capital outlay of the project. " 2. Estimate the total net project income. " 3. Do a cash flow projection for the development period. " 4. Estimate the profitability of the project and compare with the investor's objectives. " 5. Do a risk analysis on the proposed project.! In this presentation, the first step is skipped as it was already covered in the course, and the fifth will be omitted because that is a whole different chapter to address later in the course 14

8 ! A Supply line Finance " In its broadest sense, finance is concerned with the processes, institutions, markets, and instruments involved with the transfer of money from the provider to the destination. " The money finds its destination in some kind of investment 15 Investment 16

9 Investment! Definition: The purchase of goods that are not consumed today, or services that are used to create wealth in the future. It can also be viewed as a monetary asset purchased with the idea that the asset will provide income in the future or appreciate and be sold at a higher price. " Investment decisions determine both the mix and type of holdings found on the left hand side of the balance sheet.! Left for liabilities and right for assets " Mix refers to the amount of money of current' and fixed assets. " Once a good mix is established, a manager adjusts the levels of these assets to maximize the wealth through modification, liquidation, and replacement. 17 Justified Investment Value! An advanced formula developed by Dr. Manfried Köster for more precise work on calculation of Net Present Value " Where: JIV = t=1 n [ i t+t t (1+i) ] + [ i n UM n Gt n (1+i) n ]! i t = Net operating income for year t! T t = Tax savings (shelters or shields )! i n = Capital gains (at point of disinvestment)! U mn = Unpaid debt! Gtn = Capital gains tax payable in year n (if payable)! i = Discount rate! n = Period 18

10 Depriciation 19 Depreciation! It is important to consider the Salvage value of a project at any year of its anticipated life cycle span: " It is anticipated that any built project will suffer value depreciation as time passes. There is a number of methods to calculate the level of depreciation that a project will be subjected to. Two of the most popular are indicated:! Sum of Year's Digits Depreciation: " This method is more applicable if an asset depreciates more quickly or has greater production capacity in the earlier years than it does as it ages! Declining Balance Depreciation: " Declining balance is also another method of calculation of accelerated depreciation in which the amount of depreciation that is charged to an asset declines over time. # More common is the Double Declining Balance Depreciation which applies a factor of 2 to accelerate the process. 20

11 Depreciation! SOYD: " A formula for this method is the following: y SOYD= [ 2Δ v(l n+1) ] n=1 l 2 +l " Where:! l = life of project in years! y = target year for estimated depreciation (e.g. year 3)! Δ v = Difference between Present value and Salvation value 21! SOYD Example: Depreciation " A project is built at the cost of $100 mil. It has an estimated salvage value of $10 mil and a useful life of five years. What would be the value of the project in year 2? " Δ v =$90 mil, y=2, l=5 so process from n=1 to n=y=2 =[ SOYD 2 $ 90mil (5 1+1) ] =$ 30mil =[ SOYD 2 $90 mil (5 2+1) ] 2 =$ mil +5 " Therefore the value of the project based on the SOYD method is equal to its present value minus the total depreciation, i.e. $100 mil - $54 mil = $46 mil 22

12 Depreciation! Declining Balance Depreciation: " The Declining Balance depreciation method is applied through the use of the Present value and a calculated depreciation rate, which is merely a straight line rate multiplied by an accelerator. " The accelerator is nothing other than a percentage value to be used in the formula: " Depreciation is charged according to the Declining Balance method as long as book value is less than the salvage value of the asset. No more depreciation is provided when book value equals salvage value. " A variation is the Double Declining Balance method in which the accelerator is simply doubled 23 Depreciation! Declining Balance Depreciation: " A formula for this method is the following: " Where:! f = factor of depreciation (1 for single, 2 for double)! l = life of project in years! y = target year for estimated depreciation (e.g. year 3)! P v = Present value DBD= P v[ 1 ( 1 f l ) y] " Note: One can take the salvation value as the calculated remainder of this function, or set a salvation value and apply only a portion of the last year's depreciation. Usually this method provides a remainder that is less than the salvation value other methods provide. 24

13 Depreciation! Example of Declining Balance Depreciation: " Using the Double Declining Balance Depreciation method, calculate the 2 nd year value of an asset that is worth $24,500, has a life expectancy of 5 years and Salvation value $4,500: " P v =$24,500, y=2, l=5, y=2 and f=2. 2] =$ 15,680 DBD=$ 24,500 [ 1 ( ) " Therefore the value of the asset after two years is $8,820! " For the record, the salvation value that is given by this method, i.e. the value after 5 years is $1, Control of Wealth 26

14 Formulae on Wealth! Interest: Why is it applied? " Why is it applied? " Risk " Administration " Inflation " Opportunity cost! Rental charge for the use of money! Interest existed in Babylon as early as 2000 B.C.! Well-established international banks in 575 B.C.! Home offices in Babylon! Charged 6-25%! Outlawed in Middle Ages on Scriptural grounds! Usury mentioned in Exodus 22: Basic Formulae on Wealth! The most basic formula compares the worth of something in present and in the future: F v = P v (1+R) n " Where:! Pv = Present Value! Fv = Future Value! n = number of years (or periods applied)! R = rate of return (usually some given percentage) 28

15 Basic Formulae on Wealth! How to calculate or what to use for the Rate of Return: " Inflation rate (f):! Decrease of purchasing power " Real Interest rate (i'): i '= i f 1+ f! Also known as the Inflation-Free-Rate or effective rate required by an investor " Market Interest rate (i):! This is the rate of interest the market quotes (financial institutions)! Sometimes called the combined interest rate because it includes real interest rate plus inflation 29 Basic Formulae on Wealth! Example: " You want to invest in a new theme park. If the bank pays 5% per annum on savings and inflation is 2% per annum. What is your real rate? i '= =2.94% 30

16 Basic Formulae on Wealth! Beyond a basic relation, it is important to consider the gains and losses per annum. " A formula that incorporates Annuities with respect to Future value is the following: F v = A [ (1+R)n 1] R " And one that uses Annuities with Present value is the following: P v = A [ (1+ R)n 1 ] R (1+R) n! Pv = Present Value! Fv = Future Value! A = Annuity! n = number of years (or periods applied)! R = rate of return (given percentage) 31 Basic Formulae on Wealth! Example 1: " If ten annual deposits of $210 are placed into an account earning n=8%, how much would accumulate after the last year? F v =A [ (1+ R)n 1] R =210 [ (1+.08)10 1 ].08 =$3, " The diagram of this cash flow projection will be: 32

17 Basic Formulae on Wealth! Example 2: " If a project will produce $2mil per annum for five years, and the real rate is 4%, what is the maximum monetary value worth investing in at present? P v = A [ (1+ R)n 1 R (1+R) n ] =2,000,000 [ (1+0.04) 5 1 ] =$ 8,903, (1+0.04) 5 " The diagram of this cash flow projection will be: 33 Basic Formulae Combined! Example using Depreciation and Investment vs Annuities: " A project will cost an initial sum of $12mil. It will have a life expectancy of seven years, and the real rate is 5%. Determine the salvation value using the Double Declining Balance Depreciation and the minimum annuities necessary to make this a worthwhile project to proceed:! Calculating the depreciation: [ 7] DBD=$ 12 mil =$ 10,861,626 1 ( )! Therefore, the salvation value would be about $1,13mil in year 7. Bringing that amount to present value to calculate the minimum annuities: P v = F v (1+R) n = ( ) 7=$ 1,601,

18 Basic Formulae Combined! Example using Depreciation and Investment vs Annuities:! Solving for annuities that will be the minimum income to make this project worth proceeding with: A= " Note that the salvation value that was estimated was brought to present worth, and subtracted from the $12 mil that we use as present value in the following relation: P v [(1+ R) n 1 ] R (1+R) n = 10,398,194 [ (1+0.05) (1+0.05) 7 ] =$1,797,014 per annum " Considering minimal risk factors, any income less than approximately $1.8 million per annum should be of no interest to any investor. 35 Basic Formulae Combined! Example using Depreciation and Investment vs Annuities:! Generating the Cash Flow Diagram: # The initial amount that the project costs is $12 million, each year a value of at least $1.8 million of clear gains is necessary to be received together with the $1.13 million of salvage value to make this project minimally profitable or barely break even. Naturally, any benefits higher than $1.8 million per annum will make this project of higher interest to an investor. 36

19 Basic Formulae Combined! Example using variation in annuities.:! Determine the present value based on the following Cash Flow Diagram given rate of return of 6.5%: # Step 1: Take the first three annuities and determine a P v1 on the beginning of year 1. # Step 2: Take the remaining annuities and bring them to a P v2' at the beginning of year 3. # Step 3: Take P v2' and with the formula without annuities bring it to the beginning of year 1 to a value P v2 # Final step: Add P v1 and P v2 37 Basic Formulae Combined! Example using variation in annuities.:! Solving for P v1 : P v1 = A [ (1+R)n 1 ] R (1+R) =2,000,000 [ n! Solving for P v2' P v2' = A [ (1+R)n 1 ] R (1+R) =5,200,000 [ n! Solving for P v2 ( ) ( ) 3 ] ( ) ( ) 2 ] =$ 5,296,951 =$ 9,467,257 F v P v2 = (1+R) n= (1+0.65) 3=$ 7,837,460 38

20 Basic Formulae Combined! Example using variation in annuities:! Adding the two Present values: P v =P v1 +P v2 =$ 5,296,951+$ 7,837,460=$ 13,134, Decision Making with Annuities! Example using options of Annuities:! An investment may be completed following one of the four methods of investment and annual annuities as indicated in the following table. Which option is the best to chose if the rate of interest is 8% for 10 years? End of Year Option A Option B Option C Option null 0 -$400 -$800 -$1200 $ $70 $150 $180 $0 " For this problem it is necessary to consider the invested value, bring all annuities to present value, and sum it all up. Whichever brings the largest positive present value is the one to chose: 40

21 Decision Making with Annuities! Example using options of Annuities:! Analyzing all of these: P v A = $ 400+[ $ 70 [ (1+8)10 1 ]] = $ 400+$ =$ (1+8) 10 P v B = $800+[ $ 150 [ (1+8)10 1 ]] = $ 800+$ =$ (1+8) 10 P vc = $1200+[ $180 [ (1+8)10 1 ]] = $ 1200+$ =$ (1+8) Decision Making 42

22 Decision Making with Annuities! Example using options of Annuities:! Option null was not analyzed naturally because it it simply returns zero value.! Of the three remaining options, the one with the most positive outcome was Option B that returns the highest Present value. " So by bringing all the expenses and returns into present value one can determine which option is the optimal for an investment. " Note that by taking all the values to any point, i.e. Present value or any future value (final or any in between at any given point of time) would yield results that would lead to the same decision. 43 Incremental Analysis! Minimum Attractive Rate of Return:! The value of R (Rater or Return) used to calculate the Pv or the Fv depends upon a series of factors, such as: " The available capital, " The risk, " Administration and overhead costs, " Quantity of good projects (essential vs. elective)! Minimum rate of return on a project is what a manager or a company is willing to accept before starting a project, given its risk and the opportunity cost of forgoing other projects. 44

23 Incremental Analysis! Minimum Attractive Rate of Return:! The value of MARR can be determined by establishing a minimum anticipated annual income based on the expenses for overheads, administration, risk, etc. " e.g. a company may determine a MARR that will be worth the risk of undertaking a project in addition the payment of all expenses, i.e. it will not be adequate to merely break even as there are risks. " Usually risks drive the value of Minimum Attractive Rate of Return. 45 Incremental Analysis! Incremental Analysis is the most effective technique applied toward Benefit vs Cost ratio analysis! Investments are to be ranked in an increasing order of initial investment cost. " Least cost alternative is current best.! Analysis to take place between current best and next alternative until all alternatives are tested. " 1. Take the current best in the order of initial investment cost. " 2. If the Rate of Return (RR) of the increment is larger than the Minimum Attractive Rate of Return (MARR), then the higher cost alternative becomes the current best. Compare to next. " 3. If RR<MARR, reject higher cost alternative, keep current, and compare to next until no more alternatives. 46

24 Incremental Analysis! Using the previous example: End of Year Option A Option B Option C Option null 0 -$400 -$800 -$1200 $ $70 $150 $180 $0 " Ranked by initial investment: Null A B C! Null being best as it has the least initial investment! Starting with A vs Null, the question is is the $400 worth the $70 for the number of years?! Using the Present value formula with annuities, one can reverse it to calculate the rate of return (R) with the use of initial investment (e.g. $400 for Option A) as Present Value. P v = A [ (1+ R)n 1 ] R (1+R) n 47 Incremental Analysis! Using the previous example: " Ranked by initial investment: Null A B C EOY - Null - A - B - A - C - B 0 - $0-$400 = -$400 - $800-$400 = -$400 - $800-$1200 = -$ $70 $150-$70 = $80 $180-$150 = $30 R 11.73% 15.10% % A wins over Null B wins over A B wins over C! The values in the gray cells are the differences of the options chosen.! The top value is used as Initial Investment (P v ) and the bottom value as Annuities (A) in the formula. P v = A [ (1+R)n 1 R (1+R) n ]! This function may be performed either through a series of iterations or through the use of a solver function in a calculator 48

25 Cost/Benefit Incremental Analysis! If Annual costs and benefits are given data! If the assets and the costs are available data, a simple ratio may determine the most beneficial option: Annual Benefit Project A Project B Project C Project D $450 $740 $1100 $345 Annual Cost $120 $350 $880 $90 B/C ratio ! In the above example, the best Benefit over cost ratio is given by Project D.! But is that what an Incremental analysis will give? 49 Cost/Benefit Incremental Analysis! Is it worth raising costs for higher revenue at lower ratio " Comparing Option D to Option A: Benefit $ 450 $ 345 = Cost $120 $90 =3.5 " With Benefit/Cost ratio (significantly) greater than 1, A is a superior option to D. Continuing with A vs B which is the next least costly: Benefit $ 740 $ 450 = Cost $350 $120 =1.26 " Given the ratio above 1 the Incremental Analysis continues with the next least costly project,...comparing B to C: Benefit $ 1100 $ 740 = Cost $ 880 $ 350 =0.68 " The ratio is below 1 so B is the best option 50

26 Conclusion 51 Conclusion " A series of decisions based upon numerical values and processes drive the financial incentives of every project. " Financial risks are to be taken according to calculated benefits. " A salvage value when project's lifetime expires should be accounted for and included in the calculations for investment and returns. " Incremental analysis allows investors to determine an optimum option among a number of possible projects. " Yet, Emotion, together with Process, and Function can be driving force in decision making.! All of these are quantifiable and metrics can determine factors of importance and anticipated returns. " A final decision shall need to be driven by numbers. 52

8: Economic Criteria

8.1 Economic Criteria Capital Budgeting 1 8: Economic Criteria The preceding chapters show how to discount and compound a variety of different types of cash flows. This chapter explains the use of those