Economic Analysis for Construction Project - Case Study Example

Name Date Tutor Task Investing in any major construction is a representation of a major commitment of resources and could accrue serious consequences on the profitability and financial stability of any entity either public or private sector. This therefore determines the decisions made as well as the agency that will be given the mandate to mange a construction project this is because the decisions will affect the financial viability, there is a need therefore to evaluate facilities rationally this is in regard to economic feasibility of the projects . HISTORY OF CONSTRUCTION ECONOMIC ANALYSIS. The history of construction economic analysis can be associated with the cordwood structures that can be dated to around one thousand years back in northern Greece and Serbia, more of the contemporary ones can be located in Europe, America and Asia. The cord wood structures involved the erection of a basic shelter between a fire and stacked wood pile. It was found to be very economical method of construction whereby logs ends or fallen trees are used, the trees are usually debarked then used for construction. In 1988 comparative analysis of the whole stud frame, cob and straw bale cordwood appeared to be an economically viable alternative e.g. a two storey house in Cherokee, North California which was fitted with tongue and grove pine, good quality tile, live earth roof, raised panel cabinets exclusive of the lab our cost the owner then about $ 52,000 while in the same year it would cost the owner around $75,000-$120,000 this is an example of how the cord wood put in place ways in reduction of construction cost. Over the years there has developed the need to assess both the economic feasibility of individual projects as well as the net benefit of the construction projects to be started. The economic analysis of a project thus goes through the whole construction process looking at it as cycle right from the initial conception of the project, through planning, procurement to the actual start of the construction the major economic assessment that would be considered are basic concept of the facility investment which looked at time preference, minimum attractive rate of return, profit measures, opportunity cost and cash flow over the planning period. Methods of economic evaluation for the project including equivalent annual value benefit cost ratio and net present value. In setting out an engineering economic analysis of constructions has been difficult though due to fact that not all facility impacts of construction facilities can be easily estimated in dollar amounts some firms may choose to minimize environmental impacts of constructions this in a bid to gain popularity for environmental protection and not directly related to monetary benefits. An important principle that has been put to use is the evaluation of economic cost and benefits of a construction this is by finding the individual changes in welfare of the parties affected by the project, this should be measured in monetary terms e.g. safety improvements or cost of environmental degradation. CASE STUDY OF PROJECT S ECONOMIC ANALYSIS The purpose of project based economic analysis e.g. a construction project is so as to help design as well as a viable project that contributes to the welfare of a country and its citizens thus cost benefit coupled with other economic approaches are put in place so as to determine the highest investment return in a project this goes a long way in ensuring rational comparison of the available options to encourage accountable investment decisions. Economic analysis is also useful in identifying and clarifying the involved issues that surround decision making and project selection. A case example where a working cost benefit analysis where a variety of methods were used to estimate loss probability functions as related to benefits of disaster risk reduction initiatives this was based on quantitative information for example a cost benefit integrated water management and flood protection scheme in a town called Semarang in Indonesia by (GTZ) a German non governmental organization the project somewhat exceeded probability curves. An analysis of the NGO’s intervention to reduce the impact of flooding was thus based on assumptions that flood related losses in the absence of intervention would be the same (Cabot and venton, 54) thus the project is assessed on the basis of whether it will generate sufficient net benefits over a specified relatively short time this could be as little as two to three years, the cost and benefit that goes beyond the cut-off period are ignored. In a different out look the discount rate adjustment approach less weight is placed on increasingly uncertain future benefits and cost this is by adding risk premium to the discount rate. Indirect benefits which is where economic analysis on a project should take into account changes in indirect losses that can only be attributed to the project. Case two: cost effectiveness analysis on seismic retrofitting project in Romania: cost effectiveness analysis was undertaken to determine the selection of possible seismic retrofitting options for sub projects by world bank which was aimed at risk mitigation and emergency preparedness in Romania the selection of the project in turn was based on the functional importance of different public facilities that are situated within the emergency response system the implementation and cost of the retrofitting project would have to be under 60 percent of replacement cost for its selection.(world bank, environmental and socially sustainable development unit, Europe and central Asia region,87). For larger projects and those with net present values close to zero a more rigorous sensitivity analysis is done varying the values of all key variable simultaneously in order to generate probability distribution function of a project expected economic net present value, in the examination of the extent to which the intended beneficiaries will reap the benefits of the project the implemented projects in this two towns therefore took into account the both the cost efficiency as well as taking into account rights to safety and protection of the beneficiaries. Economic analysis in this case helped in making informed decisions on project alternatives thus on the economic perspective project alternatives can be compared on various bases such as their mean net resent values using of the mean variance analysis takes into account the degree of dispersion around the mean while safety first analysis seeks to maximize the expected net present value depending on the risk of benefits falling below a critical level being a small as possible. In both of the projects the construction of the project had economic views n the to ensure that not only is the project beneficial to the beneficiaries but also looks at the cost return of the project all the project where deemed beneficial in that they would give good financial returns to the communities involved as well as the implementing partners. TYPES AND METHODS USED FOR ECONOMIC ANALYSIS: There are two types of economic analysis mainly primary and secondary economic analysis. A secondary economic is when a new requirement is to be met or in a case where the current method of economic analysis is no longer suitable to meet the requirements of either a project or otherwise. A primary economic analysis on the other hand is carried out when a better and less costly way to meet the stipulated needs is put forward i.e. although the current project requirement is being met there is still a better method to carry out the analysis but it is opted for because of its cost efficiency. In the secondary economic analysis the most economical option is usually selected from among the existing options this selected option should be able to perform a function it has been selected to cater for, the chosen option however does not usually guarantee absolute savings but it represents the least costly alternative as compared to the other presented options. In primary economic analysis there is the need for comparing provided alternatives with the present method of operation in order to meet requirements and minimize costs, investments that are supported by the primary economic analysis should predict absolute cost savings over the present method. METHODS OF ECONOMIC ANALYSIS: 1. Net present value: this method is used when all alternatives meet the requirements over the same stipulated period of time, the net present value is calculated for each alternative and they are consequently ranked and the one with the lowest net present value is the ultimate option, this is achieved through discounting the value of the cost minus the benefit for each year summing the years for a total or net value. It should be taken into account that cumulative factors are used for a cost that occurs every year while single amount factors for a one time cost in case of a construction; the net present value calculated for each alternative include (I ) new construction cost (ii) renovation costs. 2. Discounted payback period: this method of economic analysis payback period is the termed as the time required for the total accumulated savings or the benefits of a project to offset investment cost. e.g. if a project costs $ 100 and yielded an annual savings of $ 25 its undiscounted payback period is thus 4 years its is recommended that the discounted payback period should be ten years or less. The duration of a project though has no effect e.g. a payback period of 10 years has no difference whether the economic life 15 or 25 years. 3. Equivalent uniform annual cost (EUAC):all the presented methods above have assumed that all alternative economic analysis have equal duration or greater than the period of analysis the EUAC methods allows the analysis comparison between alternatives with unequal economic durations that are less than the minimum requirement time period this method hence places all life cycles costs and benefits for each alternative in terms of an average annual expenditure this method of economic analysis is found to be very economical. 4. Benefit ratio (BRC):A complete economic analysis identifies all relevant costs and benefits of every provided alternative, the cost and benefit expected is each is considered benefits in this case referring to (outputs, savings, yield or products) the benefits expected from each alternative is expressed so as the decision maker can be in a position to make valid comparisons. BRC= (NPV of benefits) divided by (NPV of costs). Interest rates and capital cost: owing the fact that constructed facilities are long-term investments with a different pay off the cost of their capital is highly dependant on the real interest rate over the period of investment with rising capital rates it becomes less attractive to invest in a large facility due to forgone opportunities. Investment profit measures: this is an indicator of the desirability of a project under construction from a decision maker’s point of view. There is several profit measures that are usually used in both private sectors and public agencies, each of the measures ought to be an indicator of profit or net benefit for the project. Some of these measures indicates the size of the profit at a specified time, yet others give the rate of return per period when the capital is in use or when reinvestment of early profits are included. Internal rate of return: the internal rate of return is the discount rate which sets the net present value of series of cash flows over the planning horizon which equals zero. This is used as a measure of profit since it is identified as the marginal efficiency of capital, this method of analysis that gives the return of an investment when the capital is in use, this method does not take into account the reinvestment opportunities related to the timing and intensity of the outlays and returns. Adjusted internal rate of return: in case where financing and reinvestment policies are incorporated into the evaluation of a construction project an internal rate of return which reflects such policies which serves as a useful indicator of probability under restricted circumstances. Pay back period of the construction project is also important where the benefits received from the investment can repay the cost incurred during the stipulated time of the construction. Methods of economic analysis used in the UAE and why: The united Arab emirates (UAE) is a confederation of seven emirates which was formed in 1971 this states include Dubai, Ajman, Abu Dhabi, Ras al khaimah, ummul al qaiwain, Fujairah, shariah.The discovery of oil in the region has since expanded to a greater level influx of foreign workers, expatriates thus causing a growth in the economy, with a lot of money being channeled towards construction, this makes the UAE the middle east second largest economy after Saudi Arabia. The UAE construction industry represents a close correlation among four major forms of capital which includes industrial, financial, property and commercial, the industry structure of the UAE is formed of joint ventures between foreign and local organizations, with local stakeholders accounting for up to 51% of share capital while 49% is on foreign ownership restricted to companies that are registered in the UAE. The statistics of market share in the construction industry that was prepared by Oryx middle east in December 2007 gives a clear outline of firms involved in contracting activity, top five companies in this field account for 25% of the market. The government of which is the dominant decision maker in the united Arabs emirates has set out long term strategic economic development program in a document (Abu Dhabi Economic vision, 109) the reason for putting such an economic program is so as to diversify the economy so that non-oil growth outstrips and oil sector growth within the next 20 years, this all in a bid to establish a sustainable, globally integrated economy by the year 2030 by the government. The emirates states are also seeking to diversify their economy by moving their economies from total dependence on oil this is to assist to offset the impact of the global financial crisis and collapse in oil prices. In March 2009 the international monetary fund said that the UAE plans to invest more on the real estate industry. Countries like Dubai in the UAE began to embrace the real estate market in 2008 due to the deepened credit crisis that faced the country this made it even difficult for the potential buyers to pay for mortgages leading to funding problems for development construction, paying of most workers was difficult causing them to loss their jobs. The monetary authorities in the UAE decided to authorize the central bank to slash interest rates to offset the effects of the credit crunch. The government also in order to increase the economic performance decided to encourage private investments for both local and foreign investors this is to be achieved through reduction of bureaucracy and streamlining administrative procedures and updating commercial laws to meet international obligation. As a member of the of the world trade organization the UAE’s tariffs are based on the gulf cooperation this ensures low common external tariffs as low as 5% the customs procedures are very simple so as to facilitate trade in the region. The government also has strategies to invest massively to help insulate the UEA from the global economic slow down in March 2009, officials in Abu Dhabi projected that the emirates economy will grow by 4.5% in 2009 and by 6% a year after although there are pessimistic ones see otherwise. In conclusion the construction industry in UAE faces a number of strengths which include political stability, international business and investment from overseas countries, attractive salaries, tax free environment and oil rich reservoirs although this is subject to the falling oil prices world wide. The weaknesses faced by this industry include growth of inflation; oil production spending has increased, disparities between emirates and currency value instability. The opportunities available for them could be looked at in terms of rise in oil income as well as progress towards diversified services e.g. tourism, financial services e.t.c and global increase in oil consumption. The threat to this sector’s development in the UAE could be the restart of Iran’s nuclear weapons programs me, down side risks from global economy as well as worsening international financial market conditions. with these in mind it is clear that the UAE construction industry stands a chance of great development in support of the working economic strategies that have been put in place by the government, the local construction companies especially will probably withstand the storm of economic crisis due to the strong clientele base they continue to capture as well as the government support foreign companies on the other hand may consider an option of establishing strong and stable local relations thus giving them a guarantee of surviving in the UAE even in the tough economic times. References: 1. Bierman H Jr and S. Smidt, The capital budgeting decisions,5th ed, Macmillan, New York,1984. 2. Edwards, W.C and J.F. Wong. A computer model to estimate capital and operating cost, cost engineering,vol.29,No.10,1987,pg[15-21] 3. Belli, P et al. Handbook on economic analysis of investment operations. Washington, DC: World bank operational core services. 4. Au,T and T.P Au, engineering economics for capital investment analysis, Allyn and Bacon,Newton,MA,1993 Read More