3. Step 3: Estimate investment costs

Steps

3.1 Develop a time line for tasks from planning to completion.

3.2 Estimate costs for each year.

3.3 Estimate a residual value (if applicable).

3.4 Estimate land costs (if applicable).

3.1 Develop a time line for tasks from planning to completion

Investment costs are costs that:

  • Are essential for the initiative to proceed
  • Will be avoided if the initiative does not proceed[1]
  • Will be incurred before the initiative commences operation
  • Are paid for by the investors.[2]

Investment costs include:

  • Planning and design
  • Site surveying
  • Site preparation
  • Investigation, data collection and analysis (economic, environmental, social, market research, etc)
  • Legal costs
  • Administrative costs
  • Land acquisition
  • Construction costs (labour, materials, insurance, etc)
  • Consequential works.

3.2 Estimate costs for each year

Value all costs in a CBA at social cost. See Boxes 1 and 2 for an explanation. For most investment costs, the social cost will be the same as the market price. For financial analysis, use financial costs.

Include land costs where appropriate. See Section 4.4 for further detail.

Buildings or houses that have to be demolished to make way for the initiative should be valued at market prices (net of selling costs), plus demolition costs minus scrap value. Include relocation costs for occupants.

Labour costs should generally reflect market rates with an allowance for labour on-costs. Income and payroll taxes should not be deducted. (See Box 2 for details).

‘Construction externalities’ refers to costs imposed on others by the construction process, for example, disruption to traffic, severance, noise and dust. Valuation of environmental externalities is discussed in Chapter 10.

For vehicles used in construction, a rental cost should be included to cover wear and tear and usage of capital tied up in the equipment. Value the fuel they consume at resource cost; that is, exclude fuel excise, goods and services tax (GST) and subsidies.

Estimate the amount of time required for each phase of implementation of the initiative and total the costs for each year.

Be transparent about how the investment costs are estimated by showing them item by item, including physical quantities of inputs and unit costs. The level of detail should differ between rapid and detailed CBAs. If financial and resource investment costs are different, provide both costs. Financial costs are required for financial analysis, funding and budgeting purposes.

For rapid CBA, expect investment costs to be estimated within ±40 per cent of the actual amount. For detailed CBA, the expected level of accuracy is ±10 per cent.

Forecasts of construction costs are notorious for optimism bias. People fail to consider what can go wrong and there is an incentive to keep investment costs down to improve CBA and financial results. Chapter 12 on risk analysis provides a way to minimise optimism bias, but it is unlikely to be applied at the rapid CBA stage.

3.3 Estimate a residual value (if applicable)

There may be some value remaining in infrastructure at the end of its life. It could have value when sold intact or as scrap. One way to estimate the resale or scrap value is to take a proportion of the replacement cost.

There is a variety of ways to calculate a residual value where asset lives extend significantly beyond the end of the appraisal period. Some of these involve extrapolating benefits. The approaches recommended here are based on straight-line depreciation of capital costs.

Under the straight-line depreciation (SLD) method

Residual value (SLD) = Capital cost × Asset life remaining after appraisal period Asset life

All capital costs incurred are depreciated at a constant rate during the estimated asset life for the whole road initiative without discounting such that the RV at the end of the appraisal period is simply a fraction of the capital costs.

The component SLD method distinguishes between components of capital costs with different asset lives (n components, subscript i).

Residual value (component SLD) = i = 1 n Capital cost i × Asset life remaining after appraisal period i Asset life i

Benefit-based methods include estimating post appraisal period benefits for the remaining asset life

  • In the same way as for benefits during the appraisal period (for example from a model)
  • Final year benefits projected to grow at the same rate as for forecast traffic
  • Final year benefits assumed to remain constant
  • Final year benefits projected to decline linearly to zero.

These benefit-based methods are not recommended for the main CBA result, but as possible sensitivity tests to use where the residual value amounts to a substantial proportion of the present value of total benefits. Because SLD residual values are independent of benefit levels, residual values calculated under SLD and benefit methods will diverge more where benefit–cost ratios are significantly different from one.

Count the residual value of an initiative as a benefit at the end of the final year of the appraisal period.

3.4 Estimate land costs (if applicable)

Determine whether the land required for an initiative has an opportunity cost. Examples of land having no opportunity cost include land required for access purposes and land that is too narrow to have an alternative use.

Value land at its market price at the time of commencement of the initiative, even if it has been acquired in the past at a lower or higher price, because this represents its opportunity cost. If the land has already been acquired, use the market price net of selling costs. If the land is yet to be purchased, include all acquisition costs.

Be wary about the possible effects on land prices of expectations about the initiative proceeding.

Unlike built-assets, the value of land does not depreciate over time. If land costs are included with investment costs, and the land is likely to have an alternative use at the end of the initiative’s life, it may be appropriate to include the value of the land as a residual at the end of the appraisal period. The difference between the present value of the land costs at the start and end of the appraisal period represents the present value of the rental cost of occupying the land for the duration of the appraisal period. If land values are expected to rise over the appraisal period, adjust the end-of-appraisal-period land value accordingly. The forecast increase in land value should be that for the base case, so there is no increase in land value caused by the initiative. The forecast growth rate in land value should never exceed the discount rate.

Land rental costs in the residual value can be calculated in the same way

  • The present value discounted over the number of years given by asset life minus appraisal period, less
  • The value of land at the end of the appraisal period. Due to the level of uncertainty, do not allow for any increase in land value after the appraisal period.

If using the component SLD method for estimating residual value, take the weighted average asset life using investment costs of as the weights.

If there are land clean-up or infrastructure demolition costs at the end of the asset life, deduct them from the residual value, after discounted them to the end of the appraisal period.

[1] Leave out any planning, design and investigation costs already incurred at the time of undertaking the CBA. The decision about whether or not to proceed with the initiative will have no effect on these costs.

[2] Investment costs form the denominator in the BCR, used to rank initiatives for the purpose of allocating funds from a budget (see Section 10.4). Costs of negative externalities caused by construction should be included in a CBA, but are not relevant for capital budgeting. They should therefore be treated as disbenefits.