Discounting for construction projects
Cost-benefit analyses can be used not only to examine the current benefits and costs of a project, but also the future benefits and costs.
Discounting is a way of comparing the value of costs and benefits over different time periods to their present values. It provides a means for accurately assessing the economic impact of a project over time and helps to calculate net present value (NPV - the difference between the present value of cash inflows and the present value of cash outflows for a long-term investment that can be used to assess the likely profitability of investments).
The principle of discounting is based around the time value of money. This is the concept that money is worth less in the future than it is in the present because of its reduced capacity for generating a return, such as interest, and because of inflation. Discounting is a means of assessing how much less an amount is worth in the future than it is now.
This is the opposite of the concept of ‘compounding’, which describes the rate at with an amount will grow over time due to the accumulation of returns such as interest.
A construction project has initial costs of £1.7m. It is expected to generate the following cash inflow:
- End of year 1 = £120,000.
- End of year 2 = £250,000.
- End of year 3 = £550,000.
- End of year 4 = £1.3m.
To calculate the discount value at a rate of 5% you use the following equation:
120,000/1.05¹ = £114,285.70 (Year 1).
250,000/1.05² = £226,757.37 (Year 2).
550,000/1.05³ = £475,110.68 (Year 3).
1,069,512.22/1.05^4 = £1,069,513.22 (Year 4).
NPV = £1,885,666.97
NPV = £1,885,666.97 – £1.7m
NPV = £185,666.97
So there is still economic justification for the project to go ahead. However, if the discount rate is increased to 10% the result is:
120,000/1.1¹ = £109,090.91 (Year 1).
250,000/1.1² = £206,611.57 (Year 2).
550,000/1.1³ = £413,223.14 (Year 3).
1,069,513.22/1.1^4 = £887,917.49 (Year 4).
NPV = £1,616,843.11
NPV = £1,616,843.11 – £1.7m
NPV = -£83,156.89
In this scenario there does not appear to be economic justification for the project to go ahead.
 Related articles on Designing Buildings Wiki
- Base year.
- Cash flow.
- Compound Annual Growth Rate (CAGR).
- Discounted cash flow.
- Gross value added (GVA).
- Internal rate of return for property development.
- Life cycle assessment.
- Life Cycle Costing BG67 2016.
- Net present value.
- Whole life costs.
 External references
Featured articles and news
Eleven Magazine announce the winner and runners-up in their Moontopia competition.
As January is the time for hitting the gym, Designing Buildings Wiki lists the best gym architecture in the world.
London is at the top of the list of global construction megacities, beating Dubai and Abu Dhabi.
What are the innovative business models of the future, and how to incentivise supply chains to work on a whole life basis?
One of the largest churches in the world, the monumental St. Peter's Basilica.
How thermal comfort is quantified and how it can affect wellbeing.
Snøhetta complete a treehouse cabin that allows guests to lie beneath the Northern Lights.
Christiania is an anarchist 'freetown' in Copenhagen where strange and experimental architecture has flourished.
“UK waste data needs improving” say BRE specialists, in this summary of their report into construction waste.
UandI announce new joint venture with US developer to work on office refurbishment projects.
Why buildings crack, how cracks are categorised and what can be done.