Discounting for construction projects
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
- CBA Builder – Discounting and Compounding
- Cost Benefit Knowledge Bank
Featured articles and news
Sir Oliver Letwin to lead an independent review into the delays in the delivery of housing.
As Carillion collapses, read our article explaining insolvency in the construction industry.
43,000 jobs at risk as Carillion goes into administration.
1961 saw the publication of three important books about urban design that remain relevant today.
Next week the planning fee increases by 20% and new fees are introduced.
How the transformative power of BIM and other digital technologies can be used to gain a competitive edge.
Relevant events and relevant matters are terms used in some contracts, but knowing the differences is important.
Government release statistics showing how many people are now on the property ladder due to Help to Buy schemes.
A summary of the Town and Country Planning Association's new Practical Guide on health in garden cities.
We have launched a new adaptive site that makes Designing Buildings Wiki easier to use on tablets and mobile phones.
ICE President highlights the construction sector deal's potential to boost the UK's economy and productivity.