2. SCOPE ECONOMIC ASSESSMENT
SOURCES OF FINANCE
Conventional and Islamic Financing Projects & Activities
CONSTRUCTION ENTERPRISE/FIRM
Financial Management
(raise funding)
Management Accounting
(control firm’s activities)
Financial management: aims to
raise funds in most suitable and
economical manner, to guide
investment and to maintain
liquidity
Life Cycle Costing
Management accounting:
aims to assist manager in
planning, decision-making
and controlling firm’s activities
3. The Importance of Financial Management in construction projects
Up to date financial records
Monitor your financial position
-Plan your expenditure to be match with
the income; plan the sources of finance
Credit Control
-checking the money status
Knowing day-to day costs
-operational costs
Have a business plan
- cash flow (money in and out)
-Where your money will need to be targeted
-How much emergency fund the company
will be required
4. Cost Control Techniques
Five (5) important methods used for Cost Control Techniques for Construction Projects.
• WBS: is an organised structure that illustrates the scope of work into manageable concepts. Can illustrate
graphically in boxes, text indents, coding, insert some details such as the floor levels
• Method Statement: is a description of how work will be carried out safely by providing information on how
the work to be done. These include: coding, methodology, quantity of work, machinery, manpower and
duration
• Bar Chart: To plan and control documents for communicating schedule information using Project Management
Software
• CPM: Critical path methods
• Cash Flow Diagram:Used to visualize the project progress over time which include of projected expenditure,
actual expenditure and project income
5. Project-Construction and completion of greenhouse for UiTM Jengka
Green House
Prelims-1110 Services-1400
Superstructure-
1300
External work 1500
Substructure-
1200
Example: WBS (Work breakdown structure)
6. Method Statement-Example
Bil Activity Methods Approach Quantity Machinery Manpower Duration
1100 Preliminaries Mobilisation, access
road, excavation
15m JCB 7B 3 workers
1-Kepala
3 days
700 days
10. Cash Flow Diagram
• The cash flow statement is a document which models the flow of money in
(positive cash Flow) and money out (negative cash flow)
• A graph of cost expenditure V time is needed to derived the cash out and cash in
for the project. The S curve is drawn to represent the plan cost incurred in doing
the project
• A stepped line is plotted against the S curve represent the forecast of the money
that the contractor will be received. In some cases the client will retain a
percentage of the payment.
• The stepped line will cross the S curve and this will indicate the anticipated margin
12. S -curve
• An S-curve is the piecewise continuous graph showing the accumulated
expenditure of completed construction work of a project against its duration
from start-up to completion.
• The S-curve is considered simultaneously with a step function cumulative curve
representing the interim payments received by the contractor from the owner
according to project progress
• By combining the cost (contractor's expenses) and value (owner's payments)
profiles, having made the necessary adjustments for retention and payment
delays, one can derive the net cash-flow project profile.
• By that, the maximum working capital required by the contractor for the project
and the cost of its lock-up working capital; i.e. the amount of interest charged
to the contractor due to the execution of the project, if the lock-up working
capital is financed by a lending institution
13. Income
Actual
Expenditure
Projected
Expenditure
Project
Cost
(RM)
Construction Time
Cash Flow S-Curve
Projected Expenditure
- Projected expenditure is an
anticipated expenses prior to
sales product in due time.
Actual Expenditure
- Results when money is actually
spent on the various supplies,
services and other expense
categories used by the business.
Income
- The revenues allocated
to projects for a given time
period (i.e., payment by client).
Break-even
Point
Profit
14. Financial issues in most construction projects
• Contractors incur costs as the construction progresses. As such, contractors have to meet the
ongoing weekly payroll and monthly material payment obligations while waiting for owners'
discrete payments. The gap (capital lock up)between cumulative expenses and actual payments
received needs to be financed.
• `Financial management', plays the most important role in cash-flow forecasting and that special
caution must be taken in anticipating the occurrence of the following project factors:
change of progress;
payment duration;
project delay;
improper planning;
inability to manage change orders;
number of claims.
These factors contributed very high percentages on cash-flow risk compared with the other
factors
15. Improving Project cash Flow
Several financial manipulations that may improve contractors' project cash-flow/
working capital.
• `Front-end rate loading' is the practice of increasing the rates for items of the
construction work that take place early in the project. This keeps the overall
cost of the work the same but has the effect of increasing the level of payments
early in the project and reducing borrowing costs.
• Advance payment at project initiation as a percentage of the total contract sum.
This payment is then subtracted from the interim payments to the contractor.
• A possible reduction in the retainage percentage, if accepted by the owner, will
have a positive effect on contractor's cash-flow/working capital needs.
16. Normal Vs Non-normal cash Flow
• Normal cash flow project:
- Cost negative follow by a series of positive cash inflow
- One change of sign
17. Non-normal cash flow project
• Two or more changes of sign
• Example mining project
18. Capital Expenditure: Importance
• Importance: stems from 3 inter-related reasons:
Long term
Effects
• Current capital expenditure
provide framework for future
activities
Irreversibility
• Reversal of decision on capital
expenditure may occur a substantial
loss
• No wrong judgment on capital
expenditure
Substantial
capital outlay
• Usually involve substantial capital
outlays.
19. Capital Budgeting
• Therefore, capital budgeting is a systematic approach to
determining whether a company’s planned major capital
investments are worth pursuing.
• Capital budgeting is concerned with the justification of capital
expenditures. It can provide a rationale to select between
alternative projects:
• The QUESTION IS………….Which proposed project will most
increase the company’s value over time?
20. Phases of Capital budgeting
Planning
SELECTION
Implementation
Review
Analysis
Is the project
worthwhile to
invest ?
Figure 1: Capital Budgeting Process
21. Selection rules (Appraisal criteria)
Criterion Accept Reject Indifferent
1 NPV (Net Present value) NPV>0 NPV <0 NPV=0
2 IRR (internal rate of return) IRR> cost of capital IRR< cost of capital IRR=cost of
capital
3 Payback period (PBP) PBP< target period PBP>target period PBP= target
period
4 Profitability Index
(PI)/Benefit cost ratio
PI>1 PI<1 PI=1
5 MIRR (Modified Internal
Rate of Return)
MIRR> cost of capital MIRR< cost of
capital
MIRR= Cost of
capital
6 Accounting Rate of Return
(ARR) (ROI)
ARR>target rate ARR< target rate ARR= target rate
22. Time value of money
• Money has time value. A dollar received today has a greater value
than a dollar received at some future time .
• Time value of money is the idea that money available at present time
is worth more than the same amount in the future, due to its potential
earning capacity.
• When money is borrowed, the interest paid is charge to the
borrower. Interest compensates the depositor/lender for the time
value of money.
23. Time value of money (cont..)
• Therefore when deciding among alternative projects to invest, we
must take into account the operation of interest and the time value of
money.
• For example investors are willing to forgo spending their money now
if they expect a favorable return on their investment in the future
24. Interest –time relationship
6 Factors Find Given
1 Future value of a single sum
(Compound amount)
S P
2 Present value of a single sum
(Present worth)
P S
3 Future value of annuity
( uniform series of compound amount)
S R
4 Present value of annuity
(Present worth of uniform series)
P R
5 Sinking fund deposit R S
6 Capital recovery R P
25. Cash Flow diagram
• Cash flow diagrams are visual representations of cash inflows and outflows along
a time line.
• They are used to detect which of the five patterns of cash flow is represented by
a particular problem.
• The cash flow patterns are significant because they allow us to develop interest
formulas. The five patterns of a cash flow are:
26. Cash Flow diagram
• Eg. A company plans to invest RM 500,000 (p) (downward-pointing arrow) to manufacture a new product. The sale of this
product is expected to provide a net income of RM 70,000 (upward pointing arrow) a year for 5 years , beginning at the
end of the first year
S=70,000 70,000 70,000 70,000 70,000
P=500,000
1 2 3 4 5
N=year
i=?
27. • Single payment: Present worth; future worth
• Equal payment series: Future worth; present worth factor; sinking fund;
capital recovery
• Linear gradient: gradient present worth; gradient equal payment
• Geometric pattern series: present worth
• Uneven series: A series of cash flows exhibiting no overall pattern.
28. QUIZ 1
• Eg: If RM 500,000 is deposited in a bank today for 8 years at a compound
interest rate of 10% per year. What is the amount in the account at the end
of 8 years?
29. QUIZ 2
• A man has deposited RM 50,000 in a retirement income plan with a
local bank. The bank pays 10% per year, compounded annually. What
is the maximum amount the man can withdraw at the end of each
year for 10 years
30. QUIZ 3
Eg: A contractor’s bank statement shows a credit of RM
500,000 as a result of a small investment made 6 years
ago. Interest over this period has been 15%. What was
the original investment?
31. QUIZ 4
• Eg: Given an interest rate 15% per year, what sum would be accumulated
after 10 years if RM 5,000 were invested at the end of each years for
10years
32. QUIZ 5
Eg: What sum of money should be deposited in a bank in order to
provide 12 equal annual withdrawals of RM 3,000, the first of which
will be made one year after the deposit. The fund pays 15%
33. QUIZ 6
Eg: Your sister is currently 3 years old and will go to college at
the age of 18. Assuming that when she starts college, she will
need at least RM 80,000 in a bank. How much do you need to
save each year in order to have enough funds if the current rate
of interest is 10%.
34. QUIZ 7
• Mary wishes to determine the equal annual end-of-year deposits
required to accumulate RM 30,000 at the end of 5 years when her
son enters collage .
• The interest rate is 10%. Calculate the annual deposit
35. QUIZ 8
Eg: Your father deposits RM 680,000 on retirement into a bank
which pays 10% annually interest. How much he can withdraw
annually for a period of 15 years
36. QUIZ 9
• A woman deposits RM 2000 in a saving account that pays interest
10% per year compounded annually. If all the money is allowed to
accumulate, how much will she have at the end of 10 years?
37. Quiz 10
• How much must a family invest now to provide a lump sum of
RM 2,500, 4,500 4,500, 4,500 and 5,500 for a school fees at the
end of 2yrs, 4yrs 6yrs, 8yrs and 10yrs if the interest is 5%?
38. Quiz 11
• An investor buys a site near KLCC for RM 30,000,000. Annual
outgoings on the site for maintenance is RM 30,000. It is estimated
that the site will not be sold for 5 yrs.
• For what minimum price must the site be sold at break even cost
(5yrs) if the purchase price and the annual outgoings were borrowed
at 10% per year?
39. Quiz 12
• You borrow RM 50,000 to finance educational expenses for your
senior year of collage. The loan will be paid over 5 yrs. The loan
carries interest rate 5% per year and is to be repaid in equal annual
instalments over the next 5 yrs.
• Compute the annual instalment.
40. Quiz 13
• Ron Jafee has been given an opportunity to receive RM 20,000, 6
years from now. If he can earns 10% on his investment, what is the
most he should pay for his opportunity?
41. QUIZ 14
• You borrow RM 21,061.82 to finance educational expenses and will be paid over 7 years time with
an interest rate 5%. Compute the annual installment.
• Suppose you wanted to defer the first installment until end of year 2, what should be the annual
installment for 5 equal installment
42. Quiz 15
• If Laurel made a RM 30,000 investment in a friend’s business and
received RM 50,000 five years later, determine the rate of return ,i
43. Net Present Value (NPV )
• The basis of NPV method is that all future payments/receipts are
converted to present value.
• NPV can be used as to determine whether a project is profitable enough to
be considered a worthwhile investment.
• Accept the project if positive NPV, reject if negative NPV
• Project with the highest NPV is the most favorable to invest
44. Internal Rate of Return (IRR)
• The internal rate of return (IRR) of a project is the discount rate
(interest) which makes NPV=0
• The purpose is to differentiate between 2 or more projects in order to
choose the least expensive.
• The IRR sometimes is called as discounted cash flow yield (DCF)
Yield
• IRR is the maximum interest rate that could be paid on borrowed
capital
45. Minimum Attractive Rate of Return (MARR)
• MARR is a reasonable rate of return established for the
evaluation and selection of alternatives.
• A project is not economically viable unless it is expected to
return at least the MARR
• MARR sometimes called as hurdle rate, cutoff rate, benchmark
rate and minimum acceptable rate of return
46. Size of MARR relative to other rate of return values
47. Incremental analysis
• incremental analysis is used to analyze the difference between
the two projects;
• Compute the cash flow for the difference between the projects
by subtracting the cash flow for the lower investment from that
of the higher investment
48. Interest paid & Interest Earned
• Two perspectives of interests are: interest paid and interest earned.
• Interest is paid when a person/organization borrowed money/loan and
repays a larger amount over time
• Interest is earned when a person/organization saved/invested/or lent
money and obtains a return of a larger amount over time
49. Example: NPV & IRR
Accept the project if NPV is positive; Reject the project if NPV is negative;
Project with the highest NPV is the most favorable to invest
MARR=10%
Case 1: To find IRR; interpolating between 10% and 20%; IRRA=10%+{10X76700/76700+22100}
IRRA=17.763%; therefore < than 17.63% accept the proposal and > than 17,763% reject the proposal.
Case 2: IRR=33.01%; Less than < 33.01% accept the proposal; > 33.01% reject the proposal
Case 1
Year Cash Flow PW Factor (10%) PW PW Factor (20%) PW
0
(1,105,000)
1 (1,105,000) 1 (1,105,000)
1
1,300,000
0.909 1,181,700 0.833 1,082,900
NPV 195,000 NPV= 76,700 NPV= (22,100)
Year C/F PW factor (10%) PW factor PW factor (35%) PW
0 (900,000.00) 1 (900,000.00) 1 (900,000.00)
1 1,300,000.00 0.909 1,181,700.00 0.741 875,639.70
NPV 400,000.00 281,700.00 (24,360.30)
Case 2
50. Example 1: NPV & IRR (Equal service lives)
IRR C1= Between 12% and 22% IRRC2= Between 12% and 22%
IRRC1= 18.42% IRR C2 =20.20%
Intersection point =15%; > 15% select project c2; less than 15% select project C1 since Marr is 12%
less than 15% select project C1
9 C1 C2 C1 C2 22.0% C1 C2
years C/F C/F PW factor
0 -9,000 -9,000
1 480 5800
2 3700 3230
3 6550 2000
4 3780 1561
5510 3611 NPV 1993.31 1508.34
If MARR=10%; which project shall you select, C1 or C2
51. Intersection point and Incremental analysis
• When NPV and IRR conflicts with each other, solve the problem:
a) determining the intersection (fisher’s) (using graph paper). An
intersection between the slopes of the cash flow profiles is called Fisher’s
intersection- after the economist Irving Fisher.
b) incremental analysis is used to analyze the difference between the
two projects; Compute the cash flow for the difference between the
projects by subtracting the cash flow for the lower investment from that
of the higher investment;
c) Solve the problem by MIRR (Modified Internal Rate of Return)
52. NPV and IRR: Equal service lives
C1 C2
years C/F C/F
0 -9,000 -9,000
1 480 5800
2 3700 3230
3 6550 2000
4 3780 1561
5510 3611
IRR C1-C2= Between 10% and 16%
IRR C1-C2 =14.85%;
Intersection point =15%; > 15% select project C2; less than 15% select project C1
Since MARR= 12% less than 15% select project C1
53. Example 2: NPV, IRR and intersection point
Two mutually exclusive projects to be chosen, project B1 or B2 ? Which
project would you select at MARR (minimum attractive rate of return) =10%
Both projects have positive NPV, therefore they are both attractive and can be accepted.
Year B1 B2
PW factor
(10%)
PW B1 PW B2
PW factor
(26%) B1 B2
0 -3,000 -12,000
1 1350 4200
2 1800 6225
3 1500 6330
NPV @ 0
interest
1650 4755
Intersection
point
15.07%
54. Incremental analysis
Year B1 B2
0 -3,000 -12,000
1 1350 4200
2 1800 6225
3 1500 6330
NPV@0
interest
1650 4755
IRR 25.55% 18.33%
The intersection is at point 15.07%
If >15.07%, select project B1 while if <15.07%, then select project B2
55. Comments-NPV
• NPV is absolute measure. It is dependent on the size of the
contribution of the project to the wealth of the company.
Projects that maximizes the total NPV will maximize the total
value of a company.
• The main difficulty is the choice of discount rate.
• The discount rate on the curve where the NPV changes from
positive to negative represents IRR.
• IRR/DCF yield is the max interest rate that could be paid on
borrowed capital.
56. Comments on IRR
• IRR is the value of the discount rate at which NPV=0
• IRR is a relative measure, it does not depend upon the size
of the project or the investment.
57. QUIZ 16: Which project shall you select, A, B or C; If MARR=15%;
YEAR A B C
0 -1000 -5000 -2000
1 500 7,500 1,500
2 2500 600 2,000
58. A B C A B C A
YEAR A B C
0 -1000 -5000 -2000
1 500 7,500 1,500
2 2500 600 2,000
NPV
@0 2000 3100 1500
B-A
A B C
IRRA=Interpolating between 60% & 90%;
IRRA= 86.00%
Int Npv Int Npv Int Npv
IRRB=Interpolating between 15% & 60%
IRRB=58.29%
IRRC= Interpolating between 15% & 60%
IRRC= 48. 47%
Intersection point is 45%; B-A=45%>15%; select B; drop A
SOLUTION
59. QUIZ 17
• Alternative A, B, C have lives of 5 years. Which is the best alternatives if the
MARR is 10%. Doing nothing is allowed, but the alternatives are mutually
exclusive.
alternatives First cost (RM) Annual Return (RM)
A 10,000 2913
B 15,000 4266
C 18,000 5037
60. Answer QUIZ 17
Year A B C
Pw factor
(10%) A B C
PW factor
(15%) A B C
0 -10,000 -15,000 -18,000 1 -10000 -15000 -18000 1 -10000 -15000 -18000
1 2,913 4266 5037 0.909 2647.917 3877.794 4578.633 0.87 2534.31 3711.42 4382.19
2 2913 4266 5037 0.826 2406.138 3523.716 4160.562 0.756 2202.228 3225.096 3807.972
3 2913 4266 5037 0.751 2187.663 3203.766 3782.787 0.658 1916.754 2807.028 3314.346
4 2913 4266 5037 0.683 1989.579 2913.678 3440.271 0.572 1666.236 2440.152 2881.164
5 2913 4266 5037 0.621 1808.973 2649.186 3127.977 0.497 1447.761 2120.202 2503.389
Total NPV
@0
interest 4,565 6,330 7,185 1040.27 1168.14 1090.23 -232.711 -696.102 -1110.94
A B C
Fisher's
intersection
Total NPV @
0 interest 4565 6330 7185
IRR 14.08% 13.13% 12.47%
C-B 9.00% <10% , the increment not justified; B is preferred than C
C-A 10.75% > 10% ; C is preferred
B-A 11.00% > 10%, B is preferred
Therefore, B is the preferred alternatives, since it has the highest NPV (1168.14) at 10%.
