DCF is a useful method in valuation practice for the determination of the expected cost to build in the future. The expected cost to build is the net present value of the expected progress payments.
EXAMPLE
The contract price to build a house is $59 890. The builder is paid by the bank or building society by way of progress payments during the building period. That is, the builder does not receive a cheque for $59 890 but instead, is paid for the value of the work completed during the building period.
The stages of construction that attract progress payments are stated in the building contract. Since the loan monies do not attract interest until actually drawn down, the real cost to build the house (today) is less than the contract price of $59 890 or the cost on completion.
THE "S" CURVE
Progress payments follow the "S" curve over the construction period which basically, means that most money is paid during the middle of the building period with smaller amounts at the beginning and final stages. The actual curve varies with the building type and specific S Curves are available for those types.
To determine the real cost to build, the progress payments are discounted at the cost of money (or opportunity cost) over the building period. If typical interest rates on borrowed funds are 10% per annum or 2.5% per quarter, the discounted cash flow is shown in the following diagram.
The NPV of the discounted cash flow is $63 357 and is the "real cost" to build the house at the start of the construction period. This is an important figure in valuation practice particularly for the valuation of in globo or development land and feasibility studies which require the determination of the present value of the cost to develop. The real cost to build a future building is used in preference to the contract price which is the nominal cost only.
PRELIMINARIES AND FEES
To construct a building, fees have to be paid for necessary services in the building system. Typically, these are:
Architect
Structural engineer
Council and statutory bodies
Builders' licensing body.
COST ON COMPLETION
A cottage after completion is worth more than the contract price with the builder. This is because the building requires supervision and loss of interest on payments and holding charges. The best method for determining the cost on completion is by way of an Accumulated Cash Flow (ACF). This is shown in the diagram below:
DIAGRAM ACCUMULATED CASH FLOW (ACF)
quarters
| PERIOD: |
0 |
1 |
2 |
3 |
4 |
TOTALS |
| Building
cost: |
4000 |
12890 |
20000 |
18000 |
5000 |
59890 |
| Preliminaries: |
3000 |
3000 | ||||
| Architect
@ 5%: |
645 | 1000 | 900 | 250 | 2795 | |
| Holding
charges: |
300 |
300 |
300 |
900 | ||
|
TOTALS: |
7300 |
13535 |
21300 |
18900 |
5550 |
66585 |
| FV
factors
@
10% pa |
1 |
1.0250 |
1.0506 |
1.0769 |
1.1038 | |
| Net Future Value (NFV) | 7300 |
13873 |
22378 |
20353 |
6126 | |
| Accumulated cash flow (ACF): | 70031 |
Therefore, the real cost of building (on completion) is much more than the contract price. This price can be analyzed in the market place using the sale price of new buildings.