Viewpoint:
This is a financial analysis from the point of view of the Department of Administrative
Services – that is, from the federal government's narrow fiscal point of view.
External social costs and benefits such as increasing traffic at a particular site, or
providing a catalyst for development in a particular area [items which accrue to the wider
community rather than to the department] are not considered in this analysis. They would
be considered in an analysis from the local community viewpoint, if there were indications
that they might be significant.
Priority and Objectives/Link to Business Plan:
The Bureau is responsible for the collection, storage and dissemination of information
on the minerals sector in Canada. Their present building was originally designed for
offices but had been converted over time to house laboratories and specimen collections.
These modifications however did not meet modern health and safety requirements. As well,
there was a risk of fire or water damage to the extensive database and valuable
collections. These considerations were the highest priorities, but possible co-location
benefits [reduced overhead expenses and increased contact among staff] were also
potentially important.
Costs and Risks:
Option 1: Renovate 40 Pond, hold 151 Pond in use in its present configuration, and rent
swing space for one year while 40 Pond is being renovated (space is available in 243
Scotch St. and 380 Wills St).
This is the "status quo" option. 40 Pond would be upgraded to make the
laboratory space safe, and to improve the efficiency of the rest of the building. While
this space was being done, staff from 40 Pond would be relocated in rental "swing
space". Disruption would be kept to a minimum; but the end result would be a
compromise. 40 Pond can be upgraded to minimum standards, but will never be first-class
space for the purpose. The general perception of the managers was that 151 Pond is a
better building to meet the department's long-term needs. In this option, both 40
Pond and 151 Pond are held for the full fifteen years of the analysis time frame. There is
some financial advantage to this, since property prices are inflating more rapidly than
the general inflation rate.
The main uncertainty in this option is the cost to renovate 40 Pond, since renovation
costs are more difficult to anticipate than new construction costs. It is doubtful whether
the department can obtain a fixed price contract for the sort of renovation needed.
Option 2: Add a floor to 151 Pond and renovate other floors. Sell 40 Pond as soon as
151 Pond is fully ready. Hold temporary "swing" rental space as needed.
In this option the department consolidated its operations in one building by adding a
floor to 151 Pond. Adding a floor while keeping parts of the building operational seemed
risky. It involved unknown and unstructured risks to personnel safety and
continuity of operations. These factors were not incorporated into the financial analysis
because they were not quantified nor monetized. Perhaps with more research on similar
projects in the past, the analyst might have been able to identify and quantify the risks
involved.
Part of the cost was offset by a "consolidation benefit" from having all
staff in the same building, a state that would be achieved after two years of operations.
The value of this benefit was uncertain, and partly intangible. However, the
department's senior managers set it at $500,000 per year on the basis of obvious
efficiencies such as simpler core services and decreased communication costs.
Option3: Purchase a new building. Hold 151 Pond in use in present condition. Sell 40
Pond.
This option involves no renovations other than the standard fit-up. 40 Pond is held for
a year, while a new building is being purchased, then sold. It is assumed that it would
take a further year to sell 40 pond. This seems a reasonable allowance. However, there was
some uncertainty whether the estimated market value of 40 pond would prove to be correct
since the real estate market was depressed at that time, and some changes and improvements
(uncosted) might have to be made to attract a private sector buyer.
Net Value and Risk:
Table 1-1: Key Numbers for Comparison
Option 1: Renovate 40 Pond
Expected (avg.) value of the net costs:
-$15.8 million
Minimum net cost possible, given assumptions: -$14.6 million
Maximum net cost possible, given assumptions: -$16.9 million
Option 2: Consolidate in 151 Pond
Expected (avg.) value of the net costs:
-$7.9 million
Minimum net cost possible, given assumptions: -$5.1 million
Maximum net cost possible, given assumptions -$9.5 million
Option 3: 151 Pond + New Building
Expected (avg.) value of the net costs:
-$11.8 million
Minimum net cost possible, given assumptions: -$10.4 million
Maximum net cost possible, given assumptions -$13.1 million
Advantage of Option 2 over Option 3
Expected (avg.) NPV for choosing option 2:
$3.9
million
Loss exposure ratio (probability of a negative NPV): Zero
Minimum NPV possible, given assumptions:
$2.4
million
Maximum NPV possible, given assumptions:
$6.3 million
5% probability that NPV will be less than:
$3.1 million
50% probability that NPV will be less than:
$3.8 million
95% probability that NPV will be less than:
$4.8 million
Distribution of Costs and Benefits:
There were no distributional questions of importance in this analysis because of its
narrow fiscal point of view.
Sensitivities:
The choice of option 2 is most sensitive to the discount rate and the inflation rates.
It is also sensitive to the consolidation benefit, as one would expect. Nothing else seems
particularly important to the choice.
Recommendation:
Choose Option 2 because it has the lowest costs under all scenarios. The NPV
probability curves do not intersect, so there is no possibility that Option 2 would be
worse than another option even if option takes its lowest value (highest cost) and the
other option takes its highest value. One can see that the NPV of choosing Option 2 is
distributed more or less normally around a central value of $3.8 million. There is only a
5% chance that the NPV will be below $3.1 million, and the NPV is a little skewed toward
high-end values (the high end tail of the distribution is long, reaching out to about $6.3
million but the probabilities of the NPV actually being above $4.8 million are only 5%).
Based on these numbers, it is an easy decision to make, without much risk.
Unresolved Issues:
We see that the choice is very sensitive to the discount rate so one would have to
consider the range of rates carefully. Even for a financial analysis the discount rate
used seems low. There would need to be a strong rationale for having such a low average
rate over a fifteen-year time horizon. It does not seem plausible that a range of 5.5% to
7.5% adequately captures all the possible variation of average rates over such a long
period of time.
As well, the times allowed for renovation, and the assumption that part of 151 Pond can
be occupied while another floor is added, seem overly optimistic. If they are, then much
more use of temporary "swing" space might be necessary. On the other hand, the
residual values allowed for the owned properties might be too generous. These are not new
buildings. After another 15 years of use, there might be little value left other than
"land minus demolition" costs. If so, this might change the balance of advantage
among the options quite substantially. Lastly, the analyst has not allowed for
de-commissioning costs for space that is taken out of use, and these costs might be
significant.
Table 1: Renovate,
build or lease new accommodation and lab space? |
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Point of view: Department
of Administrative Services [Financial analysis - cost minimization] |
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Investment horizon:
fifteen years |
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Unit: $'000 except where
specified |
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Parameter
Table. |
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Deterministic |
Low |
High |
Risk form |
General inflation rate |
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2.75% |
2.00% |
3.50% |
Normal |
Rental rates inflation rate |
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4.50% |
4.00% |
5.00% |
Uniform |
New construction inflation
rate |
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5% |
4% |
6% |
Normal |
Land price inflation rate |
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6% |
5% |
7% |
Normal |
Swing space rental rate
sq.m. year |
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$600 |
$550 |
$650 |
Normal |
Construction costs per
sq.m. |
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$700 |
$650 |
$750 |
Normal |
O&M of owned space in
use [per sq.m.year] |
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$175 |
$150 |
$200 |
Normal |
O&M of empty space held
[per sq.m.year] |
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$75 |
$65 |
$85 |
Normal |
Consolidation benefit
[$millions 1996, per year] |
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$0.50 |
$0.45 |
$0.55 |
Triangular |
Discount rate |
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5.5% |
3.5% |
7.5% |
Normal |
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Cost 1.
Renovate 40 Pond |
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t0 |
t0-t1 |
t1-t2 |
t2-t3 |
t3-t4 |
PVt4-t15 |
Hold 40 Pond empty for a
year |
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($111) |
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Renovate 40 Pond |
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($1,600) |
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Initial and residual values
40 Pond |
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($2,300) |
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$4,532 |
Maintain 40 Pond for 14
years |
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($271) |
($283) |
($296) |
($3,241) |
Maintain 151 Pond for 14
years |
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($585) |
($611) |
($638) |
($667) |
($7,314) |
Initial and residual values
of 151 Pond |
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($4,600) |
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$9,065 |
Rent at 243 Scotch St. |
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($264) |
($199) |
($207) |
($217) |
($2,378) |
Rent at 380 Wills St. |
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($633) |
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Net cash flow [nominal
$] |
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($6,900) |
($3,193) |
($1,080) |
($1,129) |
($1,179) |
$664 |
NCF [constant 1996$] |
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($6,900) |
($3,107) |
($1,023) |
($1,040) |
($1,058) |
$580 |
Present values [constant
1996$] |
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($6,900) |
($2,945) |
($919) |
($886) |
($854) |
$444 |
Net present
value [costs] |
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($12,061) |
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Cost 2.
Consolidate in 151 Pond |
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Maintain 40 Pond for two
years |
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($259) |
($271) |
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Initial and residual values
of 40 Pond |
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($2,300) |
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$2,536 |
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Maintain 151 Pond during
constuction |
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($877) |
($901) |
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Maintain 151 Pond
consolidated |
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($877) |
($916) |
($10,047) |
Add a floor to 151 Pond |
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($1,132) |
($1,188) |
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Initial and residual values
of 151 Pond |
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($4,600) |
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$10,449 |
Consolidation benefit |
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$500 |
$514 |
$528 |
$542 |
$5,391 |
Rent 1670 sq.m. swing space
for a year |
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($1,002) |
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Net cash flow [nominal
$] |
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($6,900) |
($2,770) |
$689 |
($349) |
($374) |
$5,794 |
NCF [constant 1996$] |
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($6,900) |
($2,696) |
$653 |
($322) |
($335) |
$5,059 |
Present values [constant
1996$] |
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($6,900) |
($2,555) |
$587 |
($274) |
($271) |
$3,871 |
Net present
value [costs] |
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($5,542) |
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Cost 3. 151 Pond+New
Building |
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Maintain 40 Pond in use for
a year |
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($259) |
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Maintain 40 Pond empty for
a year |
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($116) |
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Initial and residual values
of 40 Pond |
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($4,600) |
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$5,072 |
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Maintain 151 Pond in use |
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($585) |
($611) |
($638) |
($667) |
($7,314) |
Initial and residual values
of 151 Pond |
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($4,600) |
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$10,449 |
New building initial and
residual values |
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($1,169) |
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$2,656 |
Maintain new building empty
for one year |
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($125) |
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Maintain new building in
use |
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($292) |
($305) |
($319) |
($3,500) |
Net cash flow [nominal
$] |
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($10,369) |
($969) |
$4,052 |
($944) |
($986) |
$2,291 |
NCF [constant 1996$] |
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($10,369) |
($943) |
$3,838 |
($870) |
($885) |
$2,001 |
Present values [constant
1996$] |
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($10,369) |
($894) |
$3,449 |
($741) |
($714) |
$1,531 |
Net present
value [costs] |
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($7,738) |
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Advantage
of Option 2 over Option 3 |
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Present values [constant
1996$] |
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$3,469 |
($1,661) |
($2,862) |
$467 |
$443 |
$2,340 |
Net benefit
of choosing option 2 |
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$2,196 |
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