ECONOMIC

DECISION IN
CONSTRUCTION
PROJECTS

By
Azhan Umer
Lecturer
Civil Engineering Department
University of Management and
Technology ,Lahore 1
Session 1

TERMINOLOGY &
INTRODUCTION

Session 1
TERMS INVOLVED IN LIFE CYCLE
COSTING
1. Capital
The term “capital” refers to wealth in the form of
money or property that can be used to produce more
wealth. The majority of engineering economy studies
involve commitment of capital for extended period of
time, so the effect of time is important as that
dollar is worth today more than it was five years
back because of the interest or profit it can earn.
Therefore, money has a time value.
2. Interest
Incentive to accumulated Capital
3. O & M Expenses (E)
Salaries of engineering and administrative staff,
routine repair and maintenance, special repair and
maintenance, insurances and taxes, and other
3

operational expenses.
 TERMS INVOLVED IN LIFE CYCLE
COSTING
4. Revenue (R)
Earning from the project in the form of return, revenues,
receipt etc.
5. Salvage
Value of project after its useful/productive or design life.
Net Revenue
=R-E
6. Study Period (N)
Project Life

4
EXAMPLE
An engineer is performing an analysis of warranty costs
for repairs within the first year of ownership of luxury cars
purchased in the United States. He found the average
cost (to the nearest dollar) to be $570 per repair from
data taken over a 5-year period. What range of repair
costs should the engineer use to ensure that the analysis
is sensitive to changing warranty costs?

Solution:
At first glance the range should be approximately –25% to 15%
of the $570 average cost to include the low of $430 and high of
$650. However, the last 3 years of costs are higher and more
consistent with an average of $631. The observed values are
approximately 3% of this more recent average.
If the analysis is to use the most recent data and trends, a
range of, say, 5% of $630 is recommended. If, however, the
analysis is to be more inclusive of historical data and trends, a
 CLASSIFICATION OF
CAPITAL
• Equity Capital
Equity Capital is that owned by the individuals
who have invested their money or property in a
business project or venture.
• Debt Capital
Debt Capital usually termed as borrowed capital
is obtained from lenders for investment. In return
the lenders receive interest from the borrowers.

Capita
l

Equity Debt
Capita Capit
l al
6
INTERE
ST
Origin of interest
• Like taxes, interest had existed from earliest
recorded human history. Records reveal its
existence in Babylon in 2000 B.C. In earliest, it was
paid in the form of money for the use of grain or
other commodities that was borrowed. It was also
paid in the form of grain or other commodities.
•The reason for taking interest on the capital is;

-That investor takes it as incentive to accumulated

capital.
-Interest and profit are the payments for the risk
the investor takes in permitting another person or
party to use his/her money.

7
INTERE
ST interest
Currently has become the essential part
of world trade, finance and banking. Consequently,
interest taking is viewed as an essential and legal
part of doing business. Eventually, interest rates
become available to the public in press, financial
magazines, radio, TV and at various public places.
The rate of interest on capital is different in
countries or even different in same country offered
by different financial institution. Five years back the
interest rate was as low as 9 % per annum but it
has considerably lowered down by Government for
avoiding over burden on National’s Economy.
Currently interest range ranges from 19-20%. The
rate of interest commonly used in the world is 6 to
25 percent. It depends upon Government policy, 8
 TYPES OF
INTEREST
(a) Simple Interest
When the total interest earned or charged is linearly
proportional to the initial amount of the loan
(principal), the interest rate and the number of
interest periods for which the principal is committed,
the interest and interest and interest rate is termed
as Simple Interest.
It may be computed by the formula
I = (P) (N) (i)
where
P = principal amount lent or borrowed
N = number of interest periods (e.g.
years or months)
i = effective interest rate per interest
period. 9
TYPES OF
INTEREST
EXAMPLE

An employee at LaserKinetics.com borrows

$10,000 on May 1 and must repay a total of
$10,700 exactly 1 year later. Determine the
interest amount and the interest rate paid.
TYPES OF INTEREST

EXAMPLE

if Rs. 100,000/- (P) is loaned for five years at a simple

interest rate of 10%, what will the interest earned by
the institution?

I = Rs. 100,000 x 5 x 0.10 = Rs.

50,000/-

Total amount owed at the end of five year would be P+I = Rs.
150,000/-

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 TYPES OF
INTEREST
(b) Compound
Interest
Simple versus Compoud Interest
Whenever the interest
charge for any interest 1350 1331
simple
period is based on the 1300
1300 interest

Amount Owned
1250
remaining principal 1200
1210
1200
compound
interest
amount plus any 1150 1100

accumulated interest 1100

1050
1100

charges up to the 1000

beginning of that period,

1 2 3

End of Interest Period

the interest is said to be
compound. A graphical
comparison of simple
interest and compound
interest in given in figure
below. 12
 Explanation of Compound Interest
• Interestrate is the rental value of money. It represents the growth of
capital per unit period. The period may be a month, a quarter,
semiannual or a year. A interest rate 15% compounded annually
means that for every hundred rupees invested now, an amount of Rs.
15 will be added to the account at the end of the first year. So, the
total amount at the end of the first year will be Rs. 115. At the end of
the second year, again 15% of Rs. 115, i.e. Rs. 17.25 will be added to
the account. Hence the total amount at the end of the second year will
be Rs. 132.25. The process will continue thus till the specified number
of years.
• If an investor invests a sum of
Rs. 100 in a fixed deposit for
five years with an interest rate
of 15% compounded annually,
the accumulated amount at
the end of every year will be
as shown in Table;
DISCOUNT RATE
• The discount rate is the interest rate charged to
commercial banks and other depository
institutions on loans they receive from Federal
Reserve Bank's lending facility-i.e. State bank of
Pakistan, the discount window. The Federal
Reserve Banks offer three discount window
programs to depository institutions: primary
credit, secondary credit, and seasonal credit,
each with its own interest rate. Discount rate
policy is same for all the banks.
• If low discount rate ? Business Activity will grow
or decline?

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 CONCEPT
Session 2 OF
EQUIVALENCE AND
MONEY TIME
RELATIONSHIP

Session 2
THE CONCEPT OF
EQUIVALENCE
 Alternatives should be compared when they produce
similar results, serve the same purpose or
accomplish the same function. Thus comparison of
alternative option or proposal is done by reducing
them to an equivalent basis, that depends on;
 The interest rate
 The amount of money involved
 The timing of monetary receipts or expenses
 The manner in which the interest or profit on invested
capital is paid and the initial capital recovered
e.g. plan of repayment may be
 Pay end of term Principal/N plus Interest due
 Pay interest due at end of term and Principal at
end of N periods
 Pay in N equal end of term payments
16

 Pay Principal and Interest in one payment at end

NOTATION AND CASH FLOW
DIAGRAMS
The following terms are used mainly in formulas
i = effective interest rate per period
N = number of compounding periods
P = Present sum of money the equivalent
value of one or more cash flows at
a reference point in time called
present.
F = Future sum of money, the equivalent
value of one or more cash
flows at the reference time
called future.
A = End of period cash flows in uniform
series continuing for a 17

specified number of periods,

NOTATION AND CASH FLOW
DIAGRAMS
- Horizontal line is the time scale
- The arrows signify cash flows
- Upward arrows represent receipts (positive cash
flows)
- Downward ward arrows represent expenses
(negative cash low)
- Cash flow diagram depends on the view point e.g.
cash flow diagram will be reversed for same cash
flows from borrowers view point instead of lender.

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COMPOUNDING METHOD

1. Discrete Compounding and Discrete Cash

Flows
2. Continuous Compounding and Discrete Cash
Flows
3. Continuous Compounding and Continuous
Cash Flows

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DISCRETE COMPOUNDING AND DISCRETE CASH FLOWS (DD)

• Finding F when P given

Factor is called Single Payment Compound

Amount factor. In functional symbol it may be represented
by
F = P (F/P, i%, N)
• Finding P when F given

Factor is called Single Payment Present Worth

factor. In functional symbol it may be represented by
P = F (P/F, i%, N)
• Find F when A given

Factor is called Uniform Series Compound

Amount factor. In functional symbol it may be represented
by
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F = A (F/A, i%, N)
DISCRETE COMPOUNDING AND DISCRETE CASH
FLOWS
• Finding P when given A

Factor is called Uniform Series Present

Worth factor. In functional symbol it may be
represented by
P = A (P/A, i%, N)
• Finding A when given F

Factor is called Sinking Fund factor. In

functional symbol it may be represented by
A = F (A/F, i%, N)
• Finding A when given P

Factor is called Capital Recovery factor.

In functional symbol it may be represented by
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A = P (A/P, i%, N)
DISCRETE COMPOUNDING AND DISCRETE CASH
FLOWS (DD)

Example-1 (Finding “F” when

“P “ is given)
A person takes a loan of Rs 100,000/- from a bank on
13% interest rate. How much amount he has to pay
after 5 years.

or F = P (F/P, i%, N)
F = 100,000 (1+.13) 5

= 100,000 (1.842)
= Rs.184244/-

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DISCRETE COMPOUNDING AND DISCRETE CASH
FLOWS (DD)

Example-2 (Finding “P” when

“F” is given)
A limited company intend to invest now a certain
amount which will an equivalent worth of Rs
30,000,000/- after 5 years. If the effective interest
rate in the market is 10% what amount they should
invest now?

or P = F (P/ F, i%, N)
P = 30,000,000 (1+.10)-5
= Rs. 1862764/-
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DISCRETE COMPOUNDING AND DISCRETE CASH
FLOWS (DD)

Example-3 (Finding “F” when

“A” is given)
If 10 annual deposit of Rs 36,000/- are placed in a
bank account giving 14% interest. How much money
will be accumulated after the last deposit?

F = A (F/A, i%, N)
F = 36000 {(1+0.14)10 –
1/0.14}
F = Rs. 696, 143/-

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DISCRETE COMPOUNDING AND DISCRETE CASH
FLOWS (DD)
Example-4 (Finding “P” when
“A” is given)
How much money should be deposit now to get 10
end of year withdrawals or Rs. 36000/- ( i =14% )

P = 36,000 {(1+0.14)10
–1/(1+0.14)10 0.14}
= Rs. 187780/-

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DISCRETE COMPOUNDING AND DISCRETE CASH
FLOWS (DD)
Example-5 (Finding “A” when
“F” is given)
Mr. X wants to send his son for higher studies
abroad for which the expected expenditure after
20 years is Rs.20,000,000/-. What uniform annual
amount should be deposited by Mr. X in a bank
giving interest @ 12% per year. The first deposit is
made just at first birthday anniversary of his son.

• A = 20, 000,000 { 0.12

/(1+0.12)20 -1}
• A = F (A/F, i%, N) 26

• = 277,575
DISCRETE COMPOUNDING AND DISCRETE CASH
FLOWS (DD) (Finding “A” when
Example-6
“P” is given)
Mr. Nadir takes a new car on lease from BANK on 25%
down payment. The bank leases new care for the
period of 5 years at 17% interest rate. The market
price of the car is 2535000/-, what installment he has
to pay at the end of each year?

P = Rs.1,535,000/-
A = ?
i = 8.28%/12
N = 5 years =60
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 EXERCISE
Question-1
If Laurel made a $30,000 investment in a friend’s
business and received $50,000 after 5 years,
determine the rate of return.
Question-2

Question-3

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THANK YOU!