Financial Appraisal of New Residential Housing Development - Coursework Example

Financial Appraisal of New Residential Housing Development Development Finance We have presumed that the project will be financed using our own capital and not borrowing from any sector. This is a new way in which our domestic capital stock will finance the site project. The key idea is to utilize the national accounts to create a self-financing ratio, demonstrating what may have been autarky stock of the tangible capital sustained by actual previous domestic saving, relative to actual stock of capital. We will use constructed measure of the self-financing to assess the impact of growing international financial integration on sources of financing the domestic capital stocks in the industry. According to (Collier, Collier, & Halperin, 2007: 253), on average, 90% of stock of capital in the industry is self-financed, and this figure has been surprisingly stable over time. The greater integration of the financial markets has not altered the dispersion of the self-financing rates, and correlation between changes in self-financing ratios and changes in de-facto financial integration is statistically insignificant. No evidence exists for any growth bonuses linked to increasing financing share of the external borrowing or foreign savings. In fact, the proof indicates the opposite: throughout the last years, constructions firms with a higher self-financing ratio developed significantly faster compared to firms with a low self-financing ratio. This result continues even after controlling the growth for quality housing. We also recognized that higher volatility of self-financing ratios is linked to lower growth rates, and better residential housing constructions are linked to a lower volatility of self-financing ratios. This fact is in line with the idea that financial integration might have facilitated the diversification of liabilities and assets, but failed to provide new net sources of the development finance. In order to implement this site project, for every decision like this, the project Chief Financial Officer will have to decide if return on this investment project is greater than its cost of capital; cost of money that goes into investing in the project. As expected, we could not have invest in this site projects unless the pay back on the capital we invest in the project is at least greater than or equal to the cost of capital we have to use in financing the project. Cost of capital is key to all projects decisions. According to (Jones, 1986: 194), in order to comprehend the required capital, we have to comprehend both parts of it; understand capital budgeting. For first, "capital," in our context, is the long-term fixed assets we will use in the production of the services the project will offer. "Budget" is the proposal which details planned expenses and revenue during a specific time period. The phrase "capital budgeting" is the act of determining which of the long-term capital investments ought to be chosen by the investors during a specific time period and incorporated in the capital budget. The most significant thing we will definitely do is to compare the payback period of this proposed site project to its weighted average cost of capital; what we will pay to obtain financing. The meaning of payback period in capital budgeting is simple. Payback period denotes how many years it will take the new project to payback its initial investment of capital project from cash flows which the project produces (Dayananda, 2002: 392). Though larger firms might prefer a bit complex calculation for the payback in order for them to gather more information, we will stick to an alternative calculation of payback period: Payback Period = the time in years prior to full recovery of the investment + Unrecovered cost at the start of the year/Cash flow within full recovery year Though a slightly more extensive equation, it may give a little more information. We will use it for the purpose of this appraisal. For instance, there were two different projects that were feasible in Sites and Housing Plan 2011-2026; use the site to build modern camping site (project A) and use the site to build residential or student housing (project B). Project A had a cost of $2,000,000 with an expected payback at a rate of $500,000 per annum. Project B had a cost of $1,200,000 with an expected payback of the same rate was Machine A. Payback period for project A = $15,000,000/$1,000,000 = 15 years Payback period for project B = $13,200,000/$1,000,000 = 13.2 years With every other thing constant, we chose project B type. However, we acknowledge that payback period has several deficiencies. If information is added to the analysis, one will witness some of its deficiencies. For instance, if the economic lives of these two machines were to be added, a different answer could get have emerged. So, one limitation of payback is that the useful lives of building or the equipment it is evaluating cannot be determined. Perhaps an even more significant criticism of payback period can be that it does not reflect time value of money. It`s very much possible that cash inflows from the student housing project to be received in 13-20 years, or even longer, if the future is weighted precisely the same as cash flow anticipated to be received in first year. However, due to risk, we know that is not worth it for financial practice. Lastly, payback period does not measure a project with irregular cash flow well. If the project has irregular cash flows, then the payback period is an objectively useless method of capital budgeting. Nonetheless, the proposed residential housing project is expected to yield regular cash flows throughout and payback period was viable in our case. One advantage the payback period, as a technique to evaluate viable project from the site, had was that it undoubtedly was a "quick but simple" mode of capital budgeting which gave the management some kind of rough estimate regarding when this project will pay back the initial investment (Isaac, Oleary & Daley, 2010: 319). To affirm that construction of residential housing was the most viable project ever from this site, we had to compare weighted average cost of capital (WACC) with the rate of return. (WACC) is an average interest rate that we must pay to finance our assets. And so, it`s also the least average rate of return we must earn on our current assets to satisfy our shareholders and investors. WACC is based on our existing capital structure and it consists of many sources of financing for the project; for instance, we may have, as well, used both equity financing and debt financing. the concept of cost of capital is more general and is simply what we pays to finance our operations (proposed new building) without being precise about the structure of the capital (debt and equity). So as to calculate the exact cost of capital for new building, we needed to calculate the proportion which debt and equity is of our capital structure; the weight of cost of debt and cost of equity by percentage. We then summed these weighted costs of capital so as to obtain weighted average cost of the needed capital. Calculation of Cost of Debt Capital Since our new proposed residential building will not be financed by borrowings, the cost of debt in our case was zero. However, it`s worth noting that for a business firm, cost of debt is ordinarily cheaper than cost of equity capital since the interest expense on the debt is always a tax-deductible expense for that business firm. Unless they have investors or they can manage to finance themselves (like we plan to do), most small firms will always use debt financing. Calculation of Cost of Equity Capital Cost of equity capital may be a bit more complex in calculation. It`s possible that we could use both preferred stock and common stock to raise money for this proposed new building. However, we did not plan to use preferred stock. As such, we plan to look at cost of common stock only. Majority of new equity capital which comes to us is raised through reinvesting the retained earnings. We know that even retained earnings do have a cost; opportunity cost. Our earnings could have, as well, been used in different other way. For instance, we could have used them to construct a modern camping site or pay out as dividends to the shareholders. Just as most businesses do, we will use the CAPM (Capital Asset Pricing Model) to approximate the cost of equity. Below are the steps we will use to approximate cost of retained earnings: Approximate the economy rate that is risk free. Risk-free rate is normally a rate of return on England Treasury bills. Estimate the current rate of return on stock market. We can always look at the broad stock market index and use rate of return of the index as an estimate for market rate of return. Approximate the risk of stock of proposed project compared to the market. This measure is known as beta (risk). The beta of the market is quantified as 1.0. If the proposed project`s risk is more than the market, then its beta is more than 1.0 and the reverse is true (Guerard, 2009: 243). We may utilize historical stock price information so as to measure beta and we can amend the historical beta for the basic factors specific to the proposed new building. This will be a judgment role on the side of our shareholders. Finally, we will be able to insert these variables into CAPM equation as follows: Cost of Equity = Beta (the market Rate of Return - Risk-Free Rate) + Risk-free rate Illustrated below is our projected Cost of Equity; the risk-free rate on the Treasury bonds is estimated to be 2% and the present market rate of return is about 5%. The beta of the proposed projects` stock is projected to be 1.5. Thus, projects` cost of equity or retained earnings from capital is estimated to be: Cost of Equity = 1.5(5% - 2%) + 2% = 6.5% There was no flotation or underwriting costs linked to retained earnings. Calculated Weighted Average Cost of Capital After we projected cost of capital for every source of equity and debt that we intend to use, we then plan to estimate the expected weighted average cost of capital. We will weight the percentage of capital structure which each source of equity and debt capital is by cost of the capital source. With that, heres what we expect; cost of the debt capital was zero and cost of the equity capital was projected as 6.5%. Equity capital made up 100% of capital structure and so: WACC = .0(0.00) + 1.0(6.5) = 6.5% If we plan to use equity financing as suggested above, the weighted average cost of capital of the proposed new building will be 6.5%. This is actually a general projection of the weighted average cost of proposed project`s capital using simply the common measures equity financing. However, the formula for weighted average cost of capital always can be prolonged to include some other sources of financing. The decision rule is always that if rate of return is more than weighted average cost of the propose project`s capital, then accept and proceed to invest in that project and if rate of return of proposed project is less than weighted average cost of its capital, then reject and never invest in the project. As for the case of our residential housing project, rate of return is anticipated to be more than WACC. 1.1 Residual Valuation The construction industry of UK has always used RICS measurement rules for cost management of the capital building works since 1922. Up to now, maintenance and construction industry has not had any recognized standard methodology for calculating and managing life cycle costs of renewing and maintaining constructed assets. However, this is now expected to change with the introduction of New Rules of Measurement (NRM3), that is, Order of Cost Approximation and Cost Forecasting of Building Maintenance Works. This NRM are a set of documents which have been established to offer standard measurement procedures that are understandable to everyone involved in construction projects. The NRM3 is established to offer consistent guidelines and rules for the quantification as well as measurement of construction maintenance and renewal works. Conscripted in a similar format and style as NRM1, thereby overpowering the revenue and capital divide – these new set of rules will make a huge influence on how the future buildings are handed for operation and maintenance. RICS New Rules of Measurement (NRM) mean that construction industry currently has an avenue of allowing a more dependable approach to measurement and estimation of constructions from the commencement of a project through to the end, or beyond. As such, we will break the proposed project down into phases that roughly correspond to deliverables, though certain phases include some multiple deliverables. We plan to break every phase into individual tasks while estimating the hours each task will spend on the project life cycle. These steps, appropriately followed, will result into an accurate project cost. Apply our markup, and we have a price. However, because it`s a little more time consuming, we will do it with care so as to expect a result of a sales price which is adequate to cover cost of the project. The entire project cost is estimated in phases as illustrated below: Phase 1 will include: i. Cost of site Being that the 1.58 hectare site is situated adjacent to the Paul Kent student accommodation and surrounded by existing residential properties with access off Hollow Way and The Slade, the valuation of this site expected to be around £200/m². However, £100/m² has been allowed for landscaping and paving. We have assumed this site accounts for 50% of overall project cost. As such, Residual Land Value Appraisal can be seen as follows below. ii. Stamp duty It`s disappointing that the Stamp Duty is still unreformed yet it`s a system that clearly require reform. Reforming Stamp Duty threshold may have, perhaps, removed a glass ceiling and supported more activity within the £250,000 to £300,000 bracket.  The reforms would have resulted in greater movement and transactions thereby breaking up artificial and lumpy price clusters. Moreover, since buyers of super-luxury apartments with ceilings taller than nine feet will have to pay as much as 50% stamp duty, out proposed new building in expected to incur the same cost. iii. Legal fees Considering the involvedness regarding the number of stakeholders intricate in building projects, certain legal issues are unavoidable despite the efforts being made to evade and resolve them. RICS North Legal Concerns In Building Conference is a local spin off from the national legal events in built environment. The leading experts from legal and construction industries considered a wide range of major latest legal developments, initiatives, and new trends which impact practitioners in construction industry such as the need for property lawyer and securing building permit. The proposed project estimates a cost of about £450,000 as the legal fees annually. iv. Finance charges Since we plan to offer affordable housing, we may incur a financial payment in lieu of providing units on site but we have assumed a policy compliant figure at this stage. As a result of the size of proposed development there will be financial contributions to the local community which will be agreed through a Section 106 of our proposal. An example of this is a flat rate payment; this is called a CIL payment (Community Infrastructure Levy) which is calculated as a flat rate of £100 / m2 of the total residential floor area (excluding affordable housing). This has been incorporated into our residual appraisal. We do not envisage any further Section 106 payments as we are providing a large community facility which we believe will satisfy Oxford City Council’s needs. Phase 2 will include: i. Cost of construction per sq m In order to determine build cost we looked at a number of comparable schemes in order to gain a sensible build rate. The figures were obtained using the RICS Building Cost Information Service (BCIS). The figures obtained were rebased to illustrate a cost appropriate for when construction will begin. Figures were rebased to quarter 2 2014. The comparable schemes were not located in the South East. Thus given cost disparity, the figures were further rebased to show the South East region (excluding Greater London). We have assumed our proposed development will incorporate timber frame construction. A total cost of construction of about £ 6,244,325.70 (£395.3 per sq m) is projected. ii. Professional fee As expected, the new building will see the hiring of professional staff members to help ran and manage the residential housing. These staff members will include real estate managers, company lawyer, Chief Executive Officer, and subordinate staffs among professionals. As such, the cost of wages in the name of professional fees is expected to hit a mark of £ 499,546.06 annually. iii. Building regulations Building regulation is concerned with the safety and health of people around and in the buildings. These regulations will make us guarantee that the residential housing buildings are constructed in a stable and safe manner, in compliance with the energy conservation requirements as well as have appropriate access and facilities for the building users. Building Control and Standards Team will assist us through the whole process of adhering to the national building standards at a fee of £ 352,163.60. This will include full plans fee to be paid while when submitting the application and the inspection fees. iv. Cost of letting In residential housing, developers always build condominiums and houses in expectation of demand of home buyers. Since the basic requirement of home buyers are similar and home designs may be standardized to some level, the probability of getting buyers of our residential housing units in a relatively shorter time is much high in the hands of developers. Fortunately, developers are much willing to undertake residential building and as the lending institutions, we are willing to finance the construction. As such, the cost of letting, as quoted by the developers, will be £4,450,670. The developer basically set the lease price for every housing unit and can adjust the lease prices of the remaining units at any time according to the prevailing inflation rate and market trend (future inflation). v. Advertising and marketing costs As part of the advertising cost, we plan to spend £150,670 to connect our residential housing business to the social media. According to (Asian development bank, 1978), always estimate the value of your marketing costs by computing the probable profits they’ll bring in. In that note, a development by Berkeley Homes which completed in 2011 in Reliance Way is a good example of new build development which achieved, and still is achieving high sales values. Based on this comparable evidence, market growth and the social context, we believe this new build development will exceed the current sales values and will achieve an average rate in the region of £400 / ft2 and this is the figure we have used in our appraisal. Phase 3 will include: i. Cost of furnishing and fitting (where appropriate) Furnishing and fitting our residential housing project will see us spend a total of £134,400 in tiling, appliances, painting, and furniture among others. New modular furniture and system will be bought and installed in the new facility; proposed residential housing. The Contractor shall offer all personnel, supervision, materials, tools, equipment, shipping and transportation required to meet all the furniture purchasing and installation. ii. Services and Maintenance cost After the building completion, we are expecting to incur some service costs in terms of annual land rates, annual repainting of the building as recommended by the law, replacement of worn out facilities and furniture among other services. As such, the new building is projected to spend about £1,200,000 annually. This figure is adjusted to accommodate any future inflation changes in the market. iii. Local property taxes State law demands that every real property pay the property tax (Campbell & Brown, 2003: 98). As such, we will receive property tax bill every year. Property tax rates, as usual, will be expressed in dollars per £100 value of assessment. For instance, if our property will have a market value of £10,000,000, property taxes will be computed by dividing this value by 100 and then multiplying product by the rate property tax. The tax rate is currently 1.08% and it`s expected to stay like that for the next 5 years. Therefore, we are expected to pay 1.08(10,000,000/100) = £ 108,000. iv. Insurance Currently, the cost of building insurance may range from 5% to over 9% of the contract value. For safety reasons we will estimate insurance cost at the current possible premium rate (9%) of our new building value. That is, 0.09(10,000,000) = £ 90,000 1.2 Cash flow forecasting The project developers will have to estimate cash flows which will be produced by the project. Often, cash flows are the hardest variable to approximate when trying to ascertain the rate of return the project will have (Geddes, 2002: 276). Geddes claims that before the developers begin projecting the Cash flow, it`s worth for them to acknowledge that it`s just but the difference between actual incoming cash and actual outgoing cash. To project the Cash Flow, the following guidelines will be adhered to: a) We will start with the cash on hand – our current bank account balances and actual currency. b) Prepare a list of expected inflows – home buyers (sales), collection on bad debts, investments or interest earnings among others. We will list not only the cash, but also when we expect it. c) Prepare a similar list of expected outflows - payroll, payments on accounts payable, and taxes payable, monthly overhead, equipment purchases, advertising expenses, or set aside for future payment. These information will all be put it into a monthly cash flow projection excel sheet in a chronological order (Excel sheet is attached separately). The excel sheet is a three part analysis of Cash Flow Forecast. The first part details our Cash Revenues. The second part is our Cash Disbursements, which details various expense categories from the cash expenditures we actually expect to pay every month. The last part of the Cash Flow Forecast is the reconciliation of our Cash Revenues with Cash Disbursements. As the name "reconciliation" advocates, this section commence with an opening balance that is the carryover of the preceding months operations. The revenue of the present month is added to this balance; the present months Disbursements are deducted, and new cash flow balance is taken forward to the next month. (Refer to the excel sheet). 1.3 Risk Analysis and Response Classic risk management procedure goes through three major stages: Risk Identification, Analysis, and Response. We will also go through these three processes while using risk assessment techniques such probability contours and sensitivity analysis. Risk identification Construction industry is a typical example of a sector, where the proposed project outcome may be delivered in an exceptionally complex risk network. As such, we have identified the risks which might result in our case regarding the site we intend to construct the new residential housing. These identified risks shall constitute the project Value at Risk (VaR) as they consume the value of the project in terms of the cost that will be incurred in mitigating them. These risks include: Existing Building and Wall The Site and Housing Plan states the existing barracks and stone boundary wall on the site must be retained as they are of local interest. So as to alleviate this risk we have incorporated both elements into our appraisal, retaining the wall as a ‘feature of the site’ and converting the unused barracks into both residential and commercial space. Surface Water As a result of location of the site in Lye Valley SSSI, policy SP6 in the Sites and Housing Development plan requires any development on the site to take special consideration to reduce surface water run-off in the area. Our appraisal in fact reduces the surface area covered by hardcore by introducing areas of grass and bark. Tree Preservation Orders There are three trees on the site which are protected by a tree preservation order. These trees are identified on the map. We will ensure that these trees are retained and can be seen on our proposed development model. Contamination It is assumed that, due the previous re-development of the larger barrack site in the past, there is no contamination on the existing site. Noise and pollution mitigation Given the proximity of a main road, our site will suffer from some traffic noise. We have set back all residential units from the main road in order to mitigate this. The site also offers the potential to develop green areas for public space to mitigate pollution. This has been incorporated into our proposals. Environmental Concerns The below map shows that our site lies outside of any flood risk zone so we our proposals do not incorporate any flood mitigating measures. These risks are connected to the external environment, meaning that to manage these risks we need to allocate some cash, as part of the project cost, to alleviate and cope with these project uncertainties from external environment. Anytime risk concern rises during the project execution, actions usually is taken by the project managers or some other worker using her or his own experience. It is typically very time-consuming, complicating and makes the proposed project very costly if risks are not identified and evaluated in construction industry. As such, the process of rendering the project almost impossible is so high particularly where there are insufficient amount of time and information. Hence, a risk analysis is inevitable in our case. Risk Analysis Mathematical models will be used to approximate the level occurrence of various highly probable construction risk phenomena. Model development involves several logical stages, one of which is to determine the parameters that are most influential regarding the model results (Götze, Northcott & Schuster, 2008: 98). To analyze these risks, we will use sensitivity analysis technique to do an evaluation of these parameters which is not only critical to us but will also serve to direct future research efforts. We shall conduct the sensitivity analysis for various reasons including need to ascertain: a) which parameters need additional research to strengthen the knowledge base, thus reducing the output uncertainty; b) which inputs contribute the most to output variability; c) which parameters are unimportant and can be removed from the final model; d) which variables are highly correlated with output; and e) what consequence results from altering a given input parameter. There are various different ways of performing sensitivity analyses; nonetheless, in answering these important questions the different analyses might not produce similar results. As such, we will do a sensitivity analysis by: defining a model and its dependent and independent variables assigning a probability density functions to every input parameter, assessing the influences as well as the relative importance of every input/output relationship. For the sake of our Value at Risk (VaR), we will consider, in constructing the model, n site related sources of risks whose costs, given in terms of prices, at any given time t to be denoted by Pi,t=1,……,n. The value at time t of the project`s portfolio with allocations ai, where i=1,……,n will therefore be: Wf(a)=summation ai(Pi, t)=d Pt. When the portfolio structure is kept constant between the current time t and t +1, the change in market value will be given by: Wt+1(a)-Wt(a)=d (Pt+1-Pt). The main purpose of VaR evaluation is to offer quantitative guidelines so as to set reserve amounts of cash or capital requirements to cater for potential adverse alterations in prices (Uher & Loosemore, 2003: 67). For any loss probability level q our Value at Risk, VaRt (a, q) will be express as: Pt [Wt + 1(a)- Wt(a) + VaRt (a, q) VaRt (a, q)] = q Where, Yt +1= Pt +1 -Pt At any time t, the VaR will always be a function of the past information, of portfolio structure and also of loss probability level q Consider the specification for VaRt (a, q) = Y1 that all results < £ 260 thousands (cost of mitigating the risks) are acceptable; combinations of risk factors X1 and X2 (X1 and X2 are input matrix of the identified risks) which give predictions near to the contour line 260 raise the probability to obtain a value > 260. The Risk of not fulfilling the specification (failure) Y1 < £ 260 with the site settings near the border increases. So as to help us understand and assess these risks the corresponding plot may be made as the probability of success (meeting the specification). The resulting plot is called Probability Contour Plot (refer to figure 2). The contour lines, in the plot, represent the risk of failure (not meeting the given specification with different settings of X1 and X2). Figure 2. Risk response From the contour it`s evident that the risk of not meeting the specification is a bit low as depicted by the red parts in the contours. This implies that these risks are likely to occur but the cost of mitigating them will be lower than £ 260,000. The probability that the cost of mitigation of risk might be less than the specified amount is 0.124. Reference List ASIAN DEVELOPMENT BANK. (1978). Economic and financial appraisal of bank-assisted projects. [S.l.], Asian Development Bank. CAMPBELL, H. F., & BROWN, R. P. C. (2003). Benefit-cost analysis: financial and economic appraisal using spreadsheets. Cambridge [u.a.], Cambridge Univ. Press. COLLIER, N. S., COLLIER, C. A., & HALPERIN, D. A. (2007). Construction funding: the process of real estate development, appraisal, and finance. Hoboken, N.J., John Wiley. DAYANANDA, D. 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