Time Value of Money in Project Cost Estimating Process Term Paper

Excerpt from Term Paper :

Value of Money

That the value of money changes with time is a matter of simple understanding. For example, the value of a dollar in 1920 is not the same at the value of a dollar today. In 1920 the dollar bought many more goods and services compared to what it does today. While the time value of money is very important to an investor, whether individual or broker, it is even more important to companies and organizations in the present environment of cost saving and profit generation.

Project financing and cost planning are important factors when finance planning for long-term projects, industrial projects and government projects.

Long-term projects can be financed using a number of options such as commercial debt (bank loans) or bonds. (Investopedia, 2003) For the company receiving payments for long-term projects factoring in the increased cost of labor (increments and salary raises), the cost of utilities (rising cost of rent, electricity, water), the cost of licenses and fees (commercial site license, construction license) and other consumables such as transportation and fuel cost.

Advantages of using the Time value of money in project costing:

When project are of long duration and expense, adjusting the request for proposals (RFP) to incorporate the time value of money is very sensible and smart. In this manner, the services that are performed are always valued at the current rate. The company performing the services does not face financial difficulties as the project progresses. An example of a long-term project would be the construction of a new airport or highway. In this case, it is safe to assume that the construction would go on for at least 5 years or may be more. The contractors undertaking the work will have to be paid at constant intervals during the time or the payment may be made on a one time basis or turnkey basis. When the payment is made during the project, the payments are structured in a manner similar to annuities and a fixed amount is paid at the end of a given period for the entire duration of time. This implies that for the airport project For example, if one contractor gets $10,000 every month for the next five years, the value of the $10,000 today is more than the value of the same amount in 5 years. In the case where the payments are made on a one-time basis or a turnkey basis, the contractor has to financially capable of sustaining the task over the period of time.

It is therefore important that the organization dealing with projects that run over long durations of time factor in the value of the money that they may have to spend (if they are requesting the services) or the money that they may have to get (if they are performing the services) for any task. The duration of the project is often used as a benchmark for evaluating the present value (PV). PV is defined as "the calculation in current dollars of a regular stream of payments or income over a given period by adjusting for some value of annual interest or inflation." (ProjectFinance, 2003)

Adjusting for the present value of money also is helpful when contracting is done in foreign currency and the market risks encountered are high. Investors who lend organizations the money for long-term projects also expect payment at a predetermined rate at the end of the project and sometimes during the operation period. Determining the value of the investment at the end of the operation period and the investment opportunity that the project can generate also are areas where time value of money consideration is helpful. If the project is "crashed" (the shortest length of time required if capital is no barrier) then the cost of the project will escalate, but the project will also get into operations and generate revenue faster. (Gido and Clements, 2003) By modeling different scenarios, financial decision makers can identify the best option that the organization can use in dealing with long-term projects and the approximate bid-ranges from contractors replying to the request for proposals can be considered.

Another advantage of using the present value of money is that it forces both the contractor and the organization requesting RFP's to evaluate all the risks and make decisions based on the ability of all parties to sustain any foreseeable issues during the life of the project. It may not be sensible to accept a bid from a contractor who is unable to fund the cost of his share of the contract due to poor finance or planning. Planning and risk-evaluation also allow for appropriate inflation consideration. In the past, "padding" of estimates was generally done to compensate for any unforeseeable situation. This resulted in sometime the contractor obtaining unrealistic profits from the job -- while at the same time making it difficult for the company to identify areas of additional cost. The dilemma of "bidding high in order to make sure that the project can be completed on time and at a profit vs. bid low in order to get the bid" always exist. (Newbold, 1998)

Disadvantages of using the time value of money for project costing:

Time value of money, rates the net present value of money only and it therefore measures only cash flow for the project. (Anthes, 2003) In a project, the focus should be more holistic. It should measure all aspects of the outcome. The percentage used to rate the money, the discount rate and the number of years that the project will require can change the PV of the money. For example, if a project was supposed to be completed in 3 years, but due to unforeseen conditions could not be completed in 6 years, then the initial project bid price will not be applicable.

The PV of money and the benefits of using this financial model for analysis of all types of organizations are not ideal. The time value of money is not appropriate for more IT projects and projects with short life spans where the product becomes obsolete very fast. In addition, the initial cost of the investment is also important. When the project cost is smaller the different in the PV of the investment and the actual investment made is not very large however as the cost of the project increases the difference also becomes more pronounced and larger.

NPV is also dependent on the period when payback is expected and if the organization cannot determine the appropriate time frame for the returns that can be got the PV cannot be used with good results. In the case where projects are publicly funded programs, the ability to convince the public about spending the money for the desired outcome may have to be provided in addition to justifying the cost of the project over the operational period. (Powell, 2002)

Project financing efforts also have to be able to quantity the results or benefits of performing the task. If NPV is used to justify the spending of the funds, then the monetary values at a range of discount rates and years may help convince the financial managers that the investment can help return a better profit and generate revenue. Evaluating the return on Investment (ROI) for the project over the product or project life cycle is also important. Projects that have higher return on investments are viewed as better and are more likely to be funded.

Project planning and financial oversight are need to be synchronized to achieve the best cash flow and profits for the organization. In recent time, in the aftermath of scandals like Enron and WorldCom, the ability of financial individuals to identify correct metrics and variables has become very critical. The risks also change over the period of construction or operation and the…

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