Civil Engineering Reference
In-Depth Information
option can be directly compared to other alternatives to ascertain the one with the
lowest net present value or cost. More sophisticated LCC techniques can involve sim-
ulation of effects of maintenance levels on equipment reliability, useful life, and overall
maintenance costs over time.
If the alternative projects have differing service capacities, the analyst can divide
the annualized cost by the equipment capacity to yield a unit cost of service (cost per
gallon, cost per MGD, etc.) for any given year. Then the annual unit costs can be
converted to present value terms and summed across the years to a net present value
total that can be compared with similar statistics for the other alternatives.
Pro Forma Analysis
A financial pro forma analysis is appropriate if the alternative
projects being contemplated can be considered investment options where a return
(earnings, revenue, income, etc.) is garnered over time in return for the investment of
up-front capital and / or ongoing O&M costs. A pro forma analysis may encompass a
more brief period of time than the life cycle cost method, but essentially extends the
annualized cost concepts related above in the LCC method with the additional con-
sideration of projected revenue or income stream and the calculation of a net income
after expenses.
The analyst should first determine the appropriate planning period for the invest-
ment. Once determined, the expense aspects of the investment should be delineated as
previously described for calculating annualized capital and operating costs. Then the
potential revenue associated with the investment should be forecast on an annual basis
over the planning period, in most cases using an assumed price level (utility rate, fee
level, etc.) and the same assumed service levels utilized in forecasting annual O&M
expenses. In some cases, the positive cash flow may include more than pure service-
related revenues, such as property tax revenues (in special water districts), fee receipts,
grant proceeds, or interest earnings.
Once annual service revenues or other income are forecast on an annual basis, these
should be summed to arrive at total annual revenue. Then annualized total expenses
are subtracted from annual total revenues to determine the net annual income. The net
annual income can then be converted to present value terms and summed to arrive at
the net present value (NPV) for that alternative or the value of that investment in
today's dollars.
However, it is unlikely that any two alternatives will involve the same level of
investment and the NPV statistic may not be useful for comparing among alternatives.
In this case, another related statistic, the
internal rate of return
(IRR), provides a more
consistent basis for comparison. The IRR is the discount rate at which the NPV is
equal to zero. The calculations to determine the IRR are very tedious and involve an
iterative process of testing various discount rates for their effect on producing an NPV
equal to zero. Use of an electronic spreadsheet or financial calculator, with such built-
in functions, is highly recommended. Once the IRR is determined for an alternative,
this percentage value can be contrasted to various other alternatives, including the no
action future. For example, a manager has the option of not funding a new project
and instead continuing to earn 6 percent interest on invested funds. If the IRR of the
new project is less than the current rate of return—say, 3 percent instead of 6 percent
currently being realized—then the new investment is not financially attractive. If the
IRR is equal to the desired rate of return, then the investor is indifferent from a
financial perspective. If the IRR of the new project is greater, the investment is more
