Financial appraisal in construction - Revision history

Tkokotas at 19:25, 20 November 2018

2018-11-20T19:25:44Z

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			''Developed by Apostolos Bougas''


	[[File:Capture2.PNG\|thumb\|right\|300px\|Figure 1: Stages of a project process]]		[[File:Capture2.PNG\|thumb\|right\|300px\|Figure 1: Stages of a project process]]
	'''Financial appraisal in construction''' is one of the most important and earliest stages of the construction project planning process. The purpose of the financial appraisal is to determine whether the project is worthwhile, comparing its costs with its expected benefits. It stands as a key element for deciding whether or not to proceed with a construction project and any project in general. Also, it stands as a key element for choosing between alternative construction projects. Financial appraisal addresses not only the adequacy of funds, but also the financial vialibity of the project, estimating in the end if and when the project returns a profit or not. This article analyzes, at first, the elements, construction cost, and overall costs and benefits of a construction project that the reader has to be familiarized with, in order to understand the costs that need to be considered for a financial appraisal of a construction project. Then, some methods of financial appraisal are presented, highlighting the <span class="plainlinks">[https://en.wikipedia.org/wiki/Net_present_value Net present value]</span>, which is one the most common criteria for project decision and selection. Finally, the application of these methods and the considerations about the financial appraisal of construction are mentioned in this article, referring also to strategic misrepresentation and <span class="plainlinks">[https://en.wikipedia.org/wiki/Optimism_bias optimism bias]</span>, challenges which lead to false financial appraisal and have to be overcome.		'''Financial appraisal in construction''' is one of the most important and earliest stages of the construction project planning process. The purpose of the financial appraisal is to determine whether the project is worthwhile, comparing its costs with its expected benefits. It stands as a key element for deciding whether or not to proceed with a construction project and any project in general. Also, it stands as a key element for choosing between alternative construction projects. Financial appraisal addresses not only the adequacy of funds, but also the financial vialibity of the project, estimating in the end if and when the project returns a profit or not. This article analyzes, at first, the elements, construction cost, and overall costs and benefits of a construction project that the reader has to be familiarized with, in order to understand the costs that need to be considered for a financial appraisal of a construction project. Then, some methods of financial appraisal are presented, highlighting the <span class="plainlinks">[https://en.wikipedia.org/wiki/Net_present_value Net present value]</span>, which is one the most common criteria for project decision and selection. Finally, the application of these methods and the considerations about the financial appraisal of construction are mentioned in this article, referring also to strategic misrepresentation and <span class="plainlinks">[https://en.wikipedia.org/wiki/Optimism_bias optimism bias]</span>, challenges which lead to false financial appraisal and have to be overcome.

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2017-06-22T09:50:30Z

Strategic misrepresentation of financial appraisal

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	==Strategic misrepresentation of financial appraisal==		==Strategic misrepresentation of financial appraisal==
	Research has shown that decision-makers project managers act in bad faith when estimating financial project appraisals. Strategic misrepresentation is closely related with the NPV calculation. One of the main uses of NPV calculation is to provide a tool for choosing the most profitable project. As the NPV calculation projects cost and benefits for the project in the future, some benefits and costs are judgements not facts. Also, some benefits can be interpreted in real prices, but instead they are based in shadow pricing techniques. Inevitably, it is clear that NPV calculation is subjective, a fact that managers who want to promote certain construction projects tend to take advantage of it. Research has shown also that strategic misrepresentation is happening not only in private projects, but also in the public sector, as construction projects are ~~intepreted~~ as an action for collecting votes. Strategic misrepresentation can be seen to political and organizational pressures, for instance, competition		Research has shown that decision-makers project managers act in bad faith when estimating financial project appraisals. Strategic misrepresentation is closely related with the NPV calculation. One of the main uses of NPV calculation is to provide a tool for choosing the most profitable project. As the NPV calculation projects cost and benefits for the project in the future, some benefits and costs are judgements not facts. Also, some benefits can be interpreted in real prices, but instead they are based in shadow pricing techniques. Inevitably, it is clear that NPV calculation is subjective, a fact that managers who want to promote certain construction projects tend to take advantage of it. Research has shown also that strategic misrepresentation is happening not only in private projects, but also in the public sector, as construction projects are interpreted as an action for collecting votes. Strategic misrepresentation can be seen to political and organizational pressures, for instance, competition
	for obtaining funds or fight for a governmental position, and to lack of incentive alignment. Consequently, strategic ~~misrepresenation~~ are one of the major factors for budget overruns and inaccurate financial appraisals in the construction industry.<ref name="Winch">Winch, G. M. (2010), "''Managing Construction projects''". Second edition</ref>.		for obtaining funds or fight for a governmental position, and to lack of incentive alignment. Consequently, strategic misrepresentation are one of the major factors for budget overruns and inaccurate financial appraisals in the construction industry.<ref name="Winch">Winch, G. M. (2010), "''Managing Construction projects''". Second edition</ref>.

	= References =		= References =

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2017-06-22T09:49:15Z

Payback analysis – payback period

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	==Payback analysis – payback period==		==Payback analysis – payback period==
	{{#ev:youtube\|https://www.youtube.com/watch?v=YX4NoZN8YWU\|300\|right\|'''Video 1:'''Internal Payback Analysis\|frame}}		{{#ev:youtube\|https://www.youtube.com/watch?v=YX4NoZN8YWU\|300\|right\|'''Video 1:'''Internal Payback Analysis\|frame}}
	The payback period is the exact length of time needed for a company /client to have a positive return of its initial investment as it is calculated by the cash flows. The income that will be generated from a construction project is compared with the overall cost of the project (construction cost, maintenance cost e.t.c). For example, an initial investment of 50 million DKK will pe paid back in 10 years if the cash inflows are 5 million DKK each year. The payback analysis is the least precise of the capital budgeting techniques, because the time value of money is not taken into consideration. As a result, payback analysis has a potential for inaccurate results, when it is used for projects with longer investments, as inflation during that time may raise significantly <ref name="Invest">Investopedia:Net Present Value[URL:http://www.investopedia.com/terms/n/npv.asp]Retrieved on 22J June 2017</ref>. Furthermore, it ignores the lifecycle costs of the project, so it does not stand as a good financial model for construction projects. <ref name="Maylor"></ref>		The payback period is the exact length of time needed for a company /client to have a positive return of its initial investment as it is calculated by the cash flows. The income that will be generated from a construction project is compared with the overall cost of the project (construction cost, maintenance cost e.t.c). For example, an initial investment of 50 million DKK will be paid back in 10 years if the cash inflows are 5 million DKK each year. The payback analysis is the least precise of the capital budgeting techniques, because the time value of money is not taken into consideration. As a result, payback analysis has a potential for inaccurate results, when it is used for projects with longer investments, as inflation during that time may raise significantly <ref name="Invest">Investopedia:Net Present Value[URL:http://www.investopedia.com/terms/n/npv.asp]Retrieved on 22J June 2017</ref>. Furthermore, it ignores the lifecycle costs of the project, so it does not stand as a good financial model for construction projects. <ref name="Maylor"></ref>

	==Net Present Value==		==Net Present Value==

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2017-06-22T09:43:17Z

Discounting

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	===Discounting===		===Discounting===
	The value of money today is greater than the value of money at a future point in time. <ref name="Kerzner"><ref> <span class="plainlinks">[https://en.wikipedia.org/wiki/Discounting Discounting]</span> are the techniques applied so that this time value of money can be calculated.<ref name="Maylor"><ref>. The basis of discounting is the comparison between the value of the return of an investment and the value of the same amount of money deposited in a bank account for the same period of time. Discounting considers the opportunity cost of the project.<ref name="Winch"><ref>		The value of money today is greater than the value of money at a future point in time. <ref name="Kerzner"></ref> <span class="plainlinks">[https://en.wikipedia.org/wiki/Discounting Discounting]</span> are the techniques applied so that this time value of money can be calculated.<ref name="Maylor"></ref>. The basis of discounting is the comparison between the value of the return of an investment and the value of the same amount of money deposited in a bank account for the same period of time. Discounting considers the opportunity cost of the project.<ref name="Winch"></ref>

	===Discounted cash flow===		===Discounted cash flow===

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2017-06-22T09:42:58Z

Discounting

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	===Discounting===		===Discounting===
	The value of money today is greater than the value of money at a future point in time. <ref name="Kerzner"><ref><span class="plainlinks">[https://en.wikipedia.org/wiki/Discounting Discounting]</span> are the techniques applied so that this time value of money can be calculated.<ref name="Maylor"><ref>. The basis of discounting is the comparison between the value of the return of an investment and the value of the same amount of money deposited in a bank account for the same period of time. Discounting considers the opportunity cost of the project.<ref name="Winch"><ref>		The value of money today is greater than the value of money at a future point in time. <ref name="Kerzner"><ref> <span class="plainlinks">[https://en.wikipedia.org/wiki/Discounting Discounting]</span> are the techniques applied so that this time value of money can be calculated.<ref name="Maylor"><ref>. The basis of discounting is the comparison between the value of the return of an investment and the value of the same amount of money deposited in a bank account for the same period of time. Discounting considers the opportunity cost of the project.<ref name="Winch"><ref>

	===Discounted cash flow===		===Discounted cash flow===

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2017-06-22T09:42:06Z

Discounting

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	===Discounting===		===Discounting===
	The value of money today is greater than the value of money at a future point in time. ~~(1).~~<span class="plainlinks">[https://en.wikipedia.org/wiki/Discounting Discounting]</span> are the techniques applied so that this time value of money can be calculated. ~~(2)~~. The basis of discounting is the comparison between the value of the return of an investment and the value of the same amount of money deposited in a bank account for the same period of time. Discounting considers the opportunity cost of the project.		The value of money today is greater than the value of money at a future point in time. <ref name="Kerzner"><ref><span class="plainlinks">[https://en.wikipedia.org/wiki/Discounting Discounting]</span> are the techniques applied so that this time value of money can be calculated.<ref name="Maylor"><ref>. The basis of discounting is the comparison between the value of the return of an investment and the value of the same amount of money deposited in a bank account for the same period of time. Discounting considers the opportunity cost of the project.<ref name="Winch"><ref>

	===Discounted cash flow===		===Discounted cash flow===

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2017-06-22T09:40:25Z

Annotated bibliography

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	=Annotated bibliography=		=Annotated bibliography=
	:'''1. Winch, G. M. (2010), "Managing Construction projects". Second edition'''		:'''1. Winch, G. M. (2010), "Managing Construction projects". Second edition'''
	::<u>Summary:</u> The book presents a holistic approach of construction management ~~from inspection to completion~~. The basic principles of construction project management are presented along with different tools and techniques that aims to ~~improve~~ construction performance. The use of information and communication technologies is also a point of interest in the book.		::<u>Summary:</u> The book presents a holistic approach of construction management. The basic principles of construction project management are presented along with different tools and techniques that aims to enhance construction performance and provide innovative techniques. The use of information and communication technologies is also a point of interest in the book.

	:'''2. Kerzner, H., Ph.D., (2006), "Project Management: A systems approach to planning, scheduling and controlling". Ninth edition'''		:'''2. Kerzner, H., Ph.D., (2006), "Project Management: A systems approach to planning, scheduling and controlling". Ninth edition'''
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	:'''3. Maylor, H. (2010), "Project Management". Fourth Edition'''		:'''3. Maylor, H. (2010), "Project Management". Fourth Edition'''
	::<u>Summary:</u>		::<u>Summary:</u> This book cover all the topics of project management, focusing in the theory, as well as in the application and usage of the ideas discussed in it. The book points great emphasis into the 4D-model of the project.

	:'''4. Flyvbjerg, B. (2008) "Curbing Optimism Bias and Strategic Misrepresentation in Planning": Reference Class Forecasting in Practice, European Planning Studies Vol. 16, No. 1'''		:'''4. Flyvbjerg, B. (2008) "Curbing Optimism Bias and Strategic Misrepresentation in Planning": Reference Class Forecasting in Practice, European Planning Studies Vol. 16, No. 1'''
	::<u>Summary:</u> This paper presents the method and illustrates the first instance of reference class forecasting. The paper targets in the inaccuracy of the financial appraisal in planning in construction, explains them in terms of optimism bias and strategic representation and present a method of eliminating this inaccuracy.		::<u>Summary:</u> This paper presents the method and illustrates the first instance of reference class forecasting. The paper targets in the inaccuracy of the financial appraisal in planning in construction, explains them in terms of optimism bias and strategic representation and present a method of eliminating this inaccuracy.

S162469: /* Payback analysis – payback period */

2017-06-22T09:29:30Z

Payback analysis – payback period

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	==Payback analysis – payback period==		==Payback analysis – payback period==
	{{#ev:youtube\|https://www.youtube.com/watch?v=YX4NoZN8YWU\|300\|right\|'''Video 1:'''Internal Payback Analysis\|frame}}		{{#ev:youtube\|https://www.youtube.com/watch?v=YX4NoZN8YWU\|300\|right\|'''Video 1:'''Internal Payback Analysis\|frame}}
	The payback period is the exact length of time needed for a company /client to have a positive return of its initial investment as it is calculated by the cash flows. The income that will be generated from a construction project is compared with the overall cost of the project(construction cost, maintenance cost e.t.c). For example, an initial investment of 50 million DKK will pe paid back in 10 years if the cash inflows are 5 million DKK each year. The payback analysis is the least precise of the capital budgeting techniques, because the time value of money is not taken into consideration. As a result, payback analysis has a potential for inaccurate results, when it is used for projects with longer investments, as inflation during that time may raise significantly <ref name="Invest">Investopedia:Net Present Value[URL:http://www.investopedia.com/terms/n/npv.asp]Retrieved on 22J June 2017</ref>. Furthermore, it ignores the lifecycle costs of the project, so it does not stand as a good financial model for construction projects. <ref name="Maylor"></ref>		The payback period is the exact length of time needed for a company /client to have a positive return of its initial investment as it is calculated by the cash flows. The income that will be generated from a construction project is compared with the overall cost of the project (construction cost, maintenance cost e.t.c). For example, an initial investment of 50 million DKK will pe paid back in 10 years if the cash inflows are 5 million DKK each year. The payback analysis is the least precise of the capital budgeting techniques, because the time value of money is not taken into consideration. As a result, payback analysis has a potential for inaccurate results, when it is used for projects with longer investments, as inflation during that time may raise significantly <ref name="Invest">Investopedia:Net Present Value[URL:http://www.investopedia.com/terms/n/npv.asp]Retrieved on 22J June 2017</ref>. Furthermore, it ignores the lifecycle costs of the project, so it does not stand as a good financial model for construction projects. <ref name="Maylor"></ref>

	==Net Present Value==		==Net Present Value==

S162469: /* Payback analysis – payback period */

2017-06-22T09:29:13Z

Payback analysis – payback period

← Older revision		Revision as of 09:29, 22 June 2017
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	==Payback analysis – payback period==		==Payback analysis – payback period==
	{{#ev:youtube\|https://www.youtube.com/watch?v=YX4NoZN8YWU\|300\|right\|'''Video 1:'''Internal Payback Analysis\|frame}}		{{#ev:youtube\|https://www.youtube.com/watch?v=YX4NoZN8YWU\|300\|right\|'''Video 1:'''Internal Payback Analysis\|frame}}
	The payback period is the exact length of time needed for a company /client to have a positive return of its initial investment as it is calculated by the cash flows. The income that will be generated from a construction project is compared with the overall cost of the project(construction cost, maintenance cost e.t.c). For example, an initial investment of 50 million DKK will pe paid back in 10 years if the cash inflows are 5 million DKK each year. The payback analysis is the least precise of the capital budgeting techniques, because the time value of money is not taken into consideration. As a result, ~~paypack~~ analysis has a potential for inaccurate results, when it is used for projects with longer investments, as inflation during that time may raise significantly <ref name="Invest">Investopedia:Net Present Value[URL:http://www.investopedia.com/terms/n/npv.asp]Retrieved on 22J June 2017</ref>. Furthermore, it ~~ingnores~~ the lifecycle costs of the project, so it does not stand as a good financial model for ~~constuction~~ projects. <ref name="Maylor"></ref>		The payback period is the exact length of time needed for a company /client to have a positive return of its initial investment as it is calculated by the cash flows. The income that will be generated from a construction project is compared with the overall cost of the project(construction cost, maintenance cost e.t.c). For example, an initial investment of 50 million DKK will pe paid back in 10 years if the cash inflows are 5 million DKK each year. The payback analysis is the least precise of the capital budgeting techniques, because the time value of money is not taken into consideration. As a result, payback analysis has a potential for inaccurate results, when it is used for projects with longer investments, as inflation during that time may raise significantly <ref name="Invest">Investopedia:Net Present Value[URL:http://www.investopedia.com/terms/n/npv.asp]Retrieved on 22J June 2017</ref>. Furthermore, it ignores the lifecycle costs of the project, so it does not stand as a good financial model for construction projects. <ref name="Maylor"></ref>

	==Net Present Value==		==Net Present Value==

S162469: /* NPV vs IRR */

2017-06-22T09:27:42Z

NPV vs IRR

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	*IRR cannot cope with the rapid changes of the discount rate over time <ref name="Maylor">3. Maylor, H. (2010), "Project Management". Fourth Edition</ref>		*IRR cannot cope with the rapid changes of the discount rate over time <ref name="Maylor">3. Maylor, H. (2010), "Project Management". Fourth Edition</ref>
	*IRR may not be unique as the benefit and cost increases.		*IRR may not be unique as the benefit and cost increases.
	If two projects have the same IRR, the NPV of the projects is compared. The project with the higher NPV is chosen. The best way for deciding or comparing different projects is the use both of NPV and IRR together, in order to calculate both the size of and the rate of the return, respectively. However, NPV is the only criterion that ensures wealth ~~maximazation~~. <ref name="MIT"></ref>		If two projects have the same IRR, the NPV of the projects is compared. The project with the higher NPV is chosen. The best way for deciding or comparing different projects is the use both of NPV and IRR together, in order to calculate both the size of and the rate of the return, respectively. However, NPV is the only criterion that ensures wealth maximization. <ref name="MIT"></ref>

	=Application=		=Application=