How can contractors deploy limited resources in a way that maximizes return? An introduction to capital budgeting, Part 1.

This series of articles explores modern capital budgeting techniques that give contractors tools to efficiently deploy limited resources and generate superior returns.

Contractors use a variety of criteria to choose which projects to bid:

• Is the project in our “wheelhouse”? 
• Can we win the bid and still make margin? If so, how much margin? 
• If we win the bid, how much of our labor will be tied up on this project for how long?
• Are there other projects we expect to come up for bid that we might prefer (so let’s skip this one and keep our labor available)? 
• Are there no better projects expected, so we should take what we can get right now?

These questions are attempting to classify three characteristics of the project:

1. How much profit can we make on this project?
2. How much risk is involved in making that profit?
3. What is the opportunity cost of this project (e.g. How long will our resources be tied up, causing us to forgo other projects? What other investment opportunities do we have - deposit funds in a money market account, pay off debt, etc.?)

The combination of skilled labor scarcity and the growing economy mean that many contractors are in a position to choose which projects to pursue and which to let go. What can you do if there are multiple projects available to bid that all look attractive for different reasons? How do you identify the projects that offer the best return on your scarce labor resources?

Capital budgeting techniques, widely used in other industries, offer sound and actionable information. They allow contractors to rank projects in order of attractiveness and deploy limited resources in a way that generates the best return. This article will explore the basic concepts used in capital budgeting. Later articles will demonstrate with more realistic numerical examples.

First, let’s define some terms. We will define the value of a project in general terms as:

Value = Benefits – Costs, where

Benefits = cash coming in, and

Costs = cash going out.

This is not far removed from how most firms budget a project. We first estimate the cost of performing the job (the “Costs”), then we submit a bid number that sets revenue higher than the estimated costs (revenue is the “Benefit”). The “Value” is what the contractor (hopefully!) gets to keep after completing the project. We are used to thinking of this in percentage terms when we talk about “Margin”. Note that we could re-write the value relationship in terms of margin like this:

Margin = (Benefits – Costs) / Costs

Margin = Value / Costs

This basic value/margin relationship above helps answer the question of how much profit a project offers, but it does not address the other characteristics of a project that a contractor cares about: risk and the length of time it ties up resources. Capital budgeting tools allow us to formally account for the profit, riskiness, and timing of a project in a single number: Net Present Value - often abbreviated NPV.

Before we go too far down the NPV road, let’s build a case on how we can formally account for the timing of cash flows. In general, the same amount of cash received at different times is not equal in value. Let’s look at an extreme example to see this idea at work. Suppose we have two projects to choose from where the only difference between them is timing. Each project starts at nearly the same time and fully commits labor resources. You can only choose one.

Project 1: Generates $11 million in revenue on $10 million in costs.

• The Value is then $1 million (Benefits – Costs = $11 - $10 = $1 million) 
• The Margin is 10% (Value / Costs = $1 / $10 = 10%)
• All costs will be paid and all revenues received in four months. That is, you will receive $1 million in profit four months from beginning the project. 

Project 2: Generates $11 million in revenue on $10 million in costs.

• The Value is then $1 million (Benefits – Costs = $11 - $10 = $1 million)
• The Margin is 10% (Value / Costs = $1 / $10 = 10%).
• All costs will be paid and all revenues received in fifteen months. That is, you will receive $1 million in profit fifteen months from beginning the project. 

All other things being equal, would you rather have $1 million in four months, or $1 million in fifteen months? Most would prefer to receive cash sooner. The sooner we receive cash, the sooner we can redeploy it for another opportunity. Even if there is not another project forthcoming, we could still deposit the cash in an interest-bearing account and earn interest.

This is a non-trivial concern even in today’s low interest rate environment. Let’s consider the difference 11 months makes on a deposit of $1 million in a money market account yielding 1% APR (annual percentage rate), where 11 months is the timing difference between taking the first project and taking the second project. If you take the first project, you will receive $1 million four months from today. If you take the second project, you will receive $1 million 15 months from today. Let’s assume you take the first project, receive the $1 million, and deposit into the money market account yielding 1% APR. Over the next 11 months you would earn $9,204.96 in nearly risk-free interest on your deposit. Your account balance 15 months from today would be $1,009,204.96. This is Future Value (or FV), where future value refers to cash flows expressed in terms of what they worth in the future. The formal relationship between future value and the nominal value of the initial cash flow is:

FV = PV x (1 + r)^n, where

FV = Future Value

PV = Present Value, or the nominal value of the initial cash flow

r = Periodic effective interest rate*

n = Number of compounding periods where interest is earned

Applying this formula to the above example yields:

FV = $1,000,000 x (1 + 0.01/12)^11 = $1,009,204.96

The equation may be little dense, but the interpretation is straightforward: If you take Project 1, you will have $1,009,204.96 in the bank 15 months from today. If you take Project 2, you will have $1,000,000 in the bank 15 months from today. That’s the worst-case scenario. It is more likely that another project comes along in the 11-month interim, which would further increase the value of accepting the short-term project.

The idea that cash received sooner is more valuable than cash relieved later is not revolutionary, but the example illustrates an important point: In order to compare the value of different projects, we must express the cash flows in the same time period’s dollars. We can adjust the timing of the cash flows using the interest rate of the firm’s next best opportunity. This is exactly what we did above. We expressed the value of both projects in “month 15” dollars. Expressed in “month 15” dollars, Project 1 is worth $1,009,204,96 and Project 2 is worth $1,000,000.00. Since $1,009,204,96 > $1,000,000.00, we would prefer Project 1 to Project 2. Despite both offering the same nominal profit and margin, these projects are not equal in value. Project 1 is clearly superior.

Widely used capital budgeting techniques Net Present Value (NPV), Profitability Index (PI), Internal Rate of Return (IRR), and Modified Internal Rate of Return (MIRR) provide more rigorous methods for comparing projects with different risk and timing characteristics. In the next articles we will formally introduce NPV and consider some more realistic examples.

Next articles in this series:

How can contractors deploy limited resources in a way that maximizes return? An introduction to capital budgeting, Part 2.

Using agile project management to increase a construction project’s financial utility

*In this example, our money market account earns 1% APR (annual percentage rate) and pays interest monthly. The “periodic effective rate” in this example is the monthly effective rate. The monthly effective rate is equal to the APR (expressed as a decimal) / 12, or 0.01 / 12.

-Steven Stelk, PhD, FP&A; Financial Strategist, Cycle Rate Performance