Construction Loans and Investment Appraisal in Construction management

Investment appraisal

Construction loans and investment appraisal

Contractors use investment appraisal techniques to assess their own capital investments (plant, equipment, buildings, etc.) and in their assessment of their potential projects, i.e. it is part of their bidding process. In the context of bidding investment appraisal is used to evaluate the envisaged capital requirements of projects.

In an investment appraisal only the incremental expenditure and receipts directly attributable to the project under scrutiny should be included; sunk costs ( i.e. those which have already been incurred) should be ignored as they are irrelevant to decisions about the future.

Methods of investment appraisal

Payback period.

This method calculates how long it takes for a project to repay its original invested capital. The shorter the payback period the greater is the likelihood that the project will be profitable. Projects 1 and 2 below are examples of projects with payback periods 3.25 and 2.5 years respectively. Therefore, project 2 is to be preferred to project 1.

This method is a very simple one but fails to take into account the pattern of inflows beyond break even point, which constitutes the revenue of the project in the long run. Nor does it take into account the pattern of payment stream prior to beak even point and subsequent additional costs in the form of interest rate on unpaid back invested capital.

Present Worth

The typical use of present worth is to compare two or more schemes each with a different initial investment and different running costs. 
For example assume a contractor has two alternatives either to purchase construction equipment equipment A with an initial cost $5000 and annual running cost of $500, or to buy construction equipment B with an initial cost of $4000 and annual running cost of $800. Life time for both equipments is 6 years.

Go to misronet Present worth calculator page

Using the above tool, If interest rate is 10% the present worth for two alternatives would be:
Equipment A: $7,177.63
Equipment B: $7,484.21
Thus since equipment A has the smaller present worth it is said that it is more economic to purchase equipment A.
The above comparison assumes same life time for both equipments. However, if the two equipments of different lives are being compared it is necessary to take steps to have an analogy that presents two alternatives of the same life.

Back to: Construction Loans and Alternative Finance sources - Top of the page