Methods of Financial Appraisal

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Rodney Mills
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1 Appendix 2 Methods of Financial Appraisal The of money over time There are a number of financial appraisal techniques, ranging from the simple to the sophisticated, that can be of use as an aid to decision-making in many areas of building design and evaluation, as well as during the management of the building in use. The simplest technique, the straightforward payback approach, suffers from a failure to take into account the time of money. Offered 000 today, or the same amount in a year s time, it will be beneficial to take the money now, on the basis that it can be invested, and therefore will be worth more in the future. At an interest rate of 0%, 000 invested today will be worth 00 in a year s time. Viewed conversely it can be said that 00 in a year s time has a of 000. The sum of 000 to be received in a year s time has a of: = In mathematical terms, the (PV) of after n years with an interest rate of: i = /( + i) n In practice, tables of discount s are available, to enable future cash flows to be discounted to a. Figure A2. shows an extract from such a table. Thus, if the cost of replacing a component in ten years time is 500 then the s of replacement are: PV = = 6% discount rate PV = = 9% discount rate Many costs are recurring annual ones, and whilst each year could be discounted separately, there is also a formula, and corresponding table, that facilitates the determination of the of a regular series of cash flows over a period of years. An extract of a table is shown in figure A

2 308 Building Maintenance Management Present of no. of years interest 6% 9% Figure A2. Present (PV) of in the future. Present of per annum no. of years interest 6% 9% Figure A2.2 Present (PV) of per annum in the future. Thus, if there is an annual cleaning cost, over a presumed 60-year building life, of 500 per annum, the respective s are: PV = = 24 6% discount rate PV = = 6 9% discount rate There are a number of variations on the same theme, all based around the same mathematical principles. Net s The net technique (NPV) involves discounting all future cash flows to a common base year. Suppose that a design team is faced with the following scenario. There are two alternative ways of providing the cladding to a building. Alternative A involves an initial outlay of with predicted annual maintenance costs of Alternative B has an initial outlay of with predicted annual maintenance costs of 500.

3 Appendix 2 Methods of Financial Appraisal 309 The cash flow, and discounted equivalents, at a rate of 9%, are shown in figure A2.3. Whilst, in simple cash flow terms, option A appears to be the most expensive option, when the figures are discounted it has the lower. This can be put another way. An investment now of will pay the total cost of alternative A over its design life, but an equivalent investment now of will be required to pay for option B. Alternative A cash flow year(s) discount ( 60 yrs ) Alternative B cash flow year(s) discount ( 60 yrs ) Figure A2.3 Comparison of alternatives using s. Annual equivalent Another approach that can be taken, based on the same principles, is the so-called annual equivalent method. In this technique, the cash flows throughout the life of an asset are converted into an equivalent annual cost. In terms of evaluation, it will rank alternatives in exactly the same order as the net approach, but will the figures in a more meaningful way for the building owner. To obtain the annual equivalent, the NPV is divided by the PV of per annum for the appropriate number of years. For example, to convert the PV for alternative A above

4 30 Building Maintenance Management to an annual equivalent, divided by.048 gives 05. In other words, an expenditure of 05 per year over 60 years has a of The usefulness of the technique for life cycle costing is shown in figure A2.4, where a series of cash flows over time, that are not recurring in phase, can be converted to an equivalent annual expenditure. Softwood windows require a capital outlay of 4500 and renewal every 5 years at a cost of 5000 at today s prices, including an allowance for removing the old ones. Redecoration will be required every five years at a cost of 400. The economic life of the building is taken to be 60 years. The annual equivalent cost is determined below. cash flow year(s) discount total year per annum discount.048 Annual Equivalent = 694/.048 annual equivalent 628 Figure A2.4 Determination of annual equivalent over 60-year life.

5 Appendix 2 Methods of Financial Appraisal 3 Internal rate of return Another derivative technique is the determination of a so-called internal rate of return. The object of the exercise, in this case, is to determine the interest rate that will produce, when all future cash flows, positive and negative, are taken into account, a net of zero; that is, when discounted costs equate to discounted benefits. Determination of the internal rate of return is most simply carried out by determining the NPV of a set of cash flows at various discount rates and plotting them onto a graph, from which the IRR can be found. Sinking funds When allowance has to be made to meet a known future capital expenditure, one of the more prudent ways of doing this is to set up a sinking fund. This involves setting aside a regular sum of money that, when invested, will accumulate sufficiently to meet that future commitment. A good example is the requirement for housing associations to allow for major renewal programmes. The requirement in this case is to determine the amount of money that needs to be set aside annually, at a given discount rate, to amount to the capital requirement in a number of years time. An industrial organisation predicts that it needs to carry out a major refurbishment to a production unit in five years time, which will cost Determine the amount it needs to invest in a sinking fund to achieve this, assuming a discount rate of 8%. Discount tables provide a uniform series sinking fund. For five years at 8%, this is The required amount per year is therefore: = In other words, the setting aside of each year for the next five years will accumulate to at an interest rate of 8%.

Describe the importance of capital investments and the capital budgeting process

Chapter 20 Making capital investment decisions Affects operations for many years Requires large sums of money Describe the importance of capital investments and the capital budgeting process 3 4 5 6 Operating