CIVL3103 Construction Project Management 1
Topic 8 – Part 2
Sustainability in Construction Projects
Ir. Dr. Cliff LEUNG
Department of Civil Engineering
Revision: R0
CIVL3103 Construction Project Management 2
Economic Sustainability Assessment
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Economic Sustainability Assessment
Recall that there are three attributes in sustainable development, which are economic, social
and environmental sustainability, and we must achieve all the attributes and strike a balance
between them in order for a development to be sustainable.
There are many methods and tools to assess economic, social, and environment sustainability
for a development project. We will now focus on a few methods for assessing economic
sustainability.
Motivation to Economic Sustainability Assessment
To give you an idea of what economic sustainability assessment is and what motivates it,
consider this question:
The government is presented with a development option that would cost $80 billion to
complete. Should the government invest in it?
Economic sustainability would obviously be one of the many factors that the government would
need to consider in order to make the decision.
For such an enormous investment, the government would of course need to make sure the
investment is worthwhile. Remember, the idea of sustainability is to make efficient use of
resources so that future need would not be compromise.
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Motivation to Economic Sustainability Assessment (Cont’d)
In considering the economic sustainability of the development option, the government would
ask the following:
• Will it create a large financial burden in the future?
• Will the development drain the government’s reserve to an alarming level in the long run?
• Will the return from the investment not being able to repay the investment?
If the answers to these questions are yes, then the development is actually not economically
sustainable. If the government still go ahead with the investment, then it would have
compromised the financial resource for future needs, i.e. a violation of economic sustainability.
In light of the motivational example above, two methods will now be introduced, namely
• net present value; and
• internal rate of return,
that would help us assess a development option / asset or make comparison between
development options / assets in terms of
• the time taken for the return of an investment to repay the investment; and
• the total costs incurred throughout the life cycle, i.e. life cycle cost, of the development /
asset.
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Simple Payback
Simple payback is the time taken for the return of an investment to repay the investment, and
is given by
Investment amount
Simple payback (or payback period) =
Annual return
Illustrative Example
Suppose you have invested in a project that costs $2000K and the expected annual return of
the investment is $200K per year. How long would it take for the amount you invested in to be
paid back by the return of your investment?
Investment amount = $2000K
Annual return = $200K per year
Therefore, the payback period of the investment = $2000K / $200K per year = 10 years
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Economic Sustainability Assessment
Life Cycle Costing
Life cycle costing (LCC) belongs to a set of economic sustainability tools to identify the total
costs of an asset for its full life cycle, i.e. from design and construction all the way to scrapping
or demolition. LCC is particularly useful when we need to make cost comparisons
between different investment options.
The problem with life cycle costing is the time value of money, which means a sum of money
is worth more now than the same sum will be at a future date due to its earning potential.
For example, if you are paid with $100 today, that $100 would worth more than $100 that is
paid to you 10 years later, since you could use that $100 today to earn more money by, say,
investing. As such, we must take the time value of money into account when determining life
cycle cost.
Net present value is a measure of life cycle cost that would taken into account the time value
of money by converting monies spent over different times to the same base, i.e. the present.
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Life Cycle Costing (Cont’d)
Net Present Value
As aforementioned, money has its time value. A sum of money can grow over time through
investment to earn a rate of interest or a rate of return. The future value of a sum of money
invested at a certain rate of interest or rate of return is given by
C = P (1 + r)n
where
C and P are the future value and present value of the sum of money invested
r is the rate of interest or rate of return
n is the period of investment
For example a sum of $1,000,000 could be invested on an investment opportunity with a rate of
return of 10% per annum. Therefore, by the end of 3 year, the value of this sum of money will
be
C = 1,000,000 (1 + 0.10)3 = 1,331,000
If this $1,000,000 had not been used for making this investment opportunity but for something
else instead, then $331,000, i.e. the interest, would have been lost.
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Life Cycle Costing (Cont’d)
Net Present Value (Cont’d)
Rearranging the formula on the previously slide, the present value could be given by
C 1
P= C
(1 + r)n (1 + r) n
where
1
is known as the present worth factor, which is provided on Slide 9.
(1 + r)n
r here is also referred to as the discount rate
Thus, any cash flow in a project that is to be made in the future can be converted or
“discounted” back to its present value by using the formula above. The net present value is
simply the sum of the present value of all cash flows within the time period under
consideration.
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Life Cycle Costing (Cont’d)
Net Present Value (Cont’d)
The table below provides the present worth factor at various discount rates and periods.
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Illustrative Example 1 z
An initial investment of a project of $8,320M is expected to generate cash inflows of $3,411M,
$4,070M, $5,824M and $2,065M at the end of first, second, third and fourth year respectively.
At the end of the fourth year, the project will be sold for $900M. Calculate the net present
value for the investment if the discount rate is 18%.
Illustrative Example 1 – Solution
We need to find the present value (PV) of all the cash flows based on the discount rate first.
The net present value will be the sum of all the calculated present values.
Recall that the present value is given by the following formula…
1
𝑃 𝐶
1 𝑟
We will apply this formula to determine the PV for all the outflows and inflows.
1. Present value for cash outflows
The cash outflow in this case is the initial investment only. The present value of the initial
investment is…
1
PV for initial investment (in millions): 𝑃 8320 8320 (-ve indicates outflow)
1 0.18
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Illustrative Example 1 – Solution (Cont’d)
2. Present value for cash inflows
The cash inflows in this case are the monthly inflows generated and the salvage value of the
project when it is to be sold at the end of the 4th year. The PV for all these inflows are calculated
as follows (all values are in millions).
1
PV for cash inflow at the end of Year 1: 𝑃 3411 2890.68
1 0.18
1
PV for cash inflow at the end of Year 2: 𝑃 4070 2923.01
1 0.18
1
PV for cash inflow at the end of Year 3: 𝑃 5824 3544.67
1 0.18
1
PV for cash inflow at the end of Year 4: 𝑃 2065 902.63
1 0.18
1
PV for the salvage value at the end of Year 4: 𝑃 900 464.21
1 0.18
3. Net present value
The net present value will then be the sum of the PVs of outflows and inflows…
𝑁𝑃𝑉 𝑃𝑉 of outflow 𝑃𝑉 of inflows 8320 2890.68 2923.01 3544.67 902.63 464.21
𝟐𝟒𝟎𝟓. 𝟐𝟎 millions (ANS.)
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Life Cycle Costing (Cont’d)
Net Present Value (Cont’d)
NPV is also an indicator of whether or not a project is worthwhile to be invested from a financial
perspective.
Indication Decision on the investment
It indicates that the investment would likely The investment could be
If NPV > 0
generate positive return accepted
It indicates that the investment would likely The investment should be
If NPV < 0
generate negative return, i.e. a loss rejected
Decision to accept or reject
If NPV = 0 It indicates the investment would break even
should be based on other criteria.
When comparing projects based on NPV value, the project with higher NPV is more
favourable.
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Illustrative Example 2
The estimated cash flow of an investment is given in the table below.
Year 0 1 2 3 4 5
Cash flow -15,000k 4000k 4000k 4000k 5000k 4000k
Determine the validity of this investment when the forecasted discount rate is to be in case (i)
11%; and in case (ii) 13%.
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Illustrative Example 2 – Solution
We would use the net present value to determine the validity of the investment in the two
cases. The investment would be worthwhile to invest if NPV yields a value greater than 1. If
NPV yields a negative value, then the investment should be rejected.
The calculated present value of the cash flows and net present value for each case are
summarized in the table below. The PVs were calculated using the present worth factor
(PWF).
Case (i) Disc. Rate of 11% Case (ii) Disc. Rate of 13%
Year Net Cash Flow
PWF PV of Net Cash Flow PWF PV of Net Cash Flow
0 -15000K 1.000 -15000K 1.000 -15000K
1 +4000K 0.901 +3604K 0.885 +3540K
2 +4000K 0.812 +3248K 0.783 +3132K
3 +4000K 0.731 +2924K 0.693 +2772K
4 +5000K 0.659 +3295K 0.613 +3065K
5 +4000K 0.593 +2372K 0.543 +2172K
NPV of the investment +443K -319K
From the table above, it can be seen that the net present value is negative for Case (ii). As such, the
investment should be rejected if the anticipated discount rate is 13%. (ANS.)
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Illustrative Example 2 – Solution (Cont’d)
Example calculations for the present values in Year 2 that are given in the table are provided
below.
For Case (i) 𝒓 = 11%
PWF can be found by the formula given in Slide 8, or from the table in Slide 9. That is…
1 1
𝑃𝑊𝐹 0.812
1 𝑟 1 0.11
or
𝑃𝑊𝐹 0.812 (from table in Slide 9)
Therefore, the present value is
𝑃 𝐶 𝑃𝑊𝐹 4000K 0.812 3248K
Likewise, for Case (ii) 𝒓 = 13%
1 1
𝑃𝑊𝐹 0.783
1 𝑟 1 0.13
𝑃 𝐶 𝑃𝑊𝐹 4000K 0.783 3132K
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Internal Rate of Return
The internal rate of return (IRR) on an investment is the rate of return that makes the NPV of
all cash flows from a particular investment equal to zero. That is…
𝐶 𝐶 𝐶
⋯ 𝟎
1 𝑰𝑹𝑹 1 𝑰𝑹𝑹 1 𝑰𝑹𝑹
where
𝐶 is the cash flow (or net cash flow) in the 𝑖th time interval (e.g. month or year), 𝑖 = 0 to 𝑛
𝑛 is period of the investment
IRR can also be defined as the interest or discount rate at which the present value of all future
cash flows is equal to the initial investment or in other words the rate at which an investment
breaks even.
Any project having an IRR higher than the cost of borrowing (e.g interest rate of loan) is
fundamentally profitable.
IRR could be worked out by mathematical trial-and-error to derive the appropriate rate.
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Illustrative Example 3
An investment that initially costs $2,000 is expected to yield annual return of $100 for 3 years.
The investment promises a final payment of $2,500 at the end of the 3rd year. What is the
internal rate of return (IRR) for this investment?
Illustrative Example 3 – Solution
The IRR is to be obtained through trial-and-error with different rates of return, i.e. 𝒓. The rate
that yields NPV of zero (or close to zero) will be the IRR.
Trial 1 – Try 𝒓 = 10%
The PVs of the yearly net cash flow and the resulting NPV with 𝑟 = 10% are presented in the table below.
𝒓 = 10%
Year Net Cash Flow
PWF PV of Net Cash Flow
0 -$2000 1.000 -$2000
1 +$100 0.909 +$90.9
2 +$100 0.826 +$82.6
3 +$100+$2500 0.751 +$1952.6
Net present value +$126.1
The NPV with 𝑟 = 10% is $126.1. Let’s try another value of 𝑟 to yield a NPV value of zero or close to 0.
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Illustrative Example 3 – Solution (Cont’d)
Trial 2 – Try 𝒓 = 12%
The PVs of the yearly net cash flow and the resulting NPV with 𝑟 = 12% are presented in the table below.
𝒓 = 12%
Year Net Cash Flow
PWF PV of Net Cash Flow
0 -$2000 1.000 -$2000
1 +$100 0.893 +$89.3
2 +$100 0.797 +$79.7
3 +$100+$2500 0.712 +$1851.2
Net present value +$20.2
Trial 3 – Try 𝒓 = 12.4%
The PVs of the yearly net cash flow and the resulting NPV with 𝑟 = 12.4% are presented in the table below.
𝒓 = 12.4%
Year Net Cash Flow
PWF PV of Net Cash Flow
0 -$2000 1.000 -$2000
1 +$100 0.890 +$89
2 +$100 0.792 +$79.2
3 +$100+$2500 0.704 +$1830.4
Net present value -$1.4
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Illustrative Example 3 – Solution (Cont’d)
The NPV goes from a positive value to a negative value when 𝑟 is changed from 12% to
12.4%. Therefore, NPV of 0 must lie within this range of 𝑟. You may try other values of 𝑟 within
this range that may give you a NPV that is even closer to 0.
However, since the NPV with 𝑟 = 12.4% (i.e. -1.4) is already fairly close to 0, therefore we could
accept 12.4% to be the IRR for the investment in this example.
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Illustrative Example 4
A company is deciding whether to purchase new equipment that costs $500,000. Management
estimates the life of the new asset to be four years and expects to generate $160,000 of
annual profits. In the fifth year, the company plans to sell the equipment with a salvage value
of $50,000. See also the table below for the yearly cash flows.
What is the IRR for investing in the new equipment?
Year Cash Flows
0 -$500,000
1 +$160,000
2 +$160,000
3 +$160,000
4 +$160,000
5 +$50,000
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Illustrative Example 4 – Solution
Trial-and-error is performed with different discounted rates. The IRR is the discounted rate that
would result in NPV equal to (or very close to) 0.
Trial 1 Trial 2 Trial 3
Net Cash 𝒓 = 10% 𝒓 = 13% 𝒓 = 13.2%
Year
Flow
PWF PV PWF PV PWF PV
0 -$500000 1.000 -$500000 1.000 -$500000 1.000 -$500000
1 +$160000 0.909 +$145440 0.885 +$141600 0.883 +$141280
2 +$160000 0.826 +$132160 0.783 +$125280 0.78 +$124800
3 +$160000 0.751 +$120160 0.693 +$110880 0.689 +$110240
4 +$160000 0.683 +$109280 0.613 +$98080 0.609 +$97440
5 +$50000 0.621 +$31050 0.543 +$27150 0.538 +$26900
Net present value +$38090 +$2990 +$660
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Illustrative Example 4 – Solution (Cont’d)
The trial-and-error continues as follows.
Trial 4 Trial 5
Net Cash 𝒓 = 13.25% 𝒓 = 13.27%
Year
Flow
PWF PV PWF PV
0 -$500,000 1.00 -$500000 1.000 -$500000
1 +$160,000 0.883 +$141280 0.883 +$141280
2 +$160,000 0.780 +$124800 0.779 +$124640
3 +$160,000 0.688 +$110080 0.688 +$110080
4 +$160,000 0.608 +$97280 0.607 +$97120
5 +$50,000 0.537 +$26850 0.536 +$26800
Net present value +$290 -$80
The NPV is close to 0 when 𝑟 = 13.27%. Therefore, the IRR for this investment is approximately 13.27%
(ANS.)
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End of Topic 8 – Part 2