Final Feasibility Study Project

Prepared by L A

Course Title: Feasibility Study

Professor Mohammad Omar

MBA, spring 2010-2011

Outline

I. Introduction

II. Case Study

III. Conclusion

IV. References
 I. Introduction

A feasibility study is a study carried out in order to oversee the results of a future course of
action. It includes a detailed analysis of a company and its operations. Feasibility study is
different studies in different fields including marketing, financial, financing, technical and
social. It is useful for making strategic decision. For example, a company might perform a
feasibility study to evaluate a proposed change in location, the acquisition of another company,
a purchase of major equipment or a new computer system, the introduction of a new product or
service, or the hiring of additional employees. In such situations, a feasibility study can help a
small business's managers understand the impact of any major changes they might face. The
feasibility study will help managers accurately anticipate what will and will not work in varied
situations. It makes it easier in determining what resources are essential to complete varied
situations and gain an understanding of how to draw on the company’s strengths.

i. Classifying Feasibility Study

According to the function of the Feasibility study it is classified into four types:
1. Marketing Feasibility Study which determines the market size, the quality of expected
sales, and expected demand and price.
2. Technical Feasibility Study which determines the capacity line of production, best
source to get raw materials, and best location for the project.
3. Financing Feasibility Study which determines the different sources for financing the
proposed project; the cost of each source; and the best financing structure.
4. Financial Feasibility Study which determines if the proposed project is accepted or
rejected and choose the best among accepted alternatives.

ii. Steps in conducting Feasibility study

The study should begin with an evaluation of the entire operation. For example, a good
feasibility study would review a company's strengths and weaknesses, its position in the
marketplace, company's major competitors, primary customers, and its financial situation. This
sort of overview provides owners and managers with an idea about the opportunities of the
company and its current situation. A feasibility study can also lead to new ideas for strategic
changes by providing information on consumer needs and how best to meet them.

A good feasibility study should provide a detailed estimate of the costs and benefits of a
proposed project. It can be used to develop a strategic plan for the project, translating general
ideas into measurable goals. Then the goals can be broken down to create a series of concrete
steps and plan for implementing these steps. Throughout the process, the feasibility study will
show the various consequences and impacts associated with the plan of action.

In order to ensure the accuracy and objectivity of a feasibility study, it should be performed by a
qualified consultant. It is also important that an internal person help in gathering information for
the feasibility study. Moreover, the owner of the business owner must make sure that those
conducting the study have full access to the company and the specific information needed for
the study.

iii. Main Target of Feasibility Study

The main target of feasibility study is to maximize profit and minimize cost of production.
Investors need to know if the project will work and whether it makes economic sense. The
study should provide a thorough analysis of the business opportunity, including a look at all the
possible barriers that may stand in the way of the projects’ success. The outcome of the
feasibility study will indicate whether or not to proceed with the proposed project. If the results
of the feasibility study are positive, then a business plan can be developed in order to implement
the project. If the results show that the project is not a sound business idea, then the project
should not be pursued. Although it is difficult to accept a feasibility study that shows these
results, it is much better to find this out sooner rather than later, when more time and money
would have been invested and lost.

II. Case Study(an Italian Case Study by Nick French and Laura Gabrielli)
Feasibility studies are extensively used in Italy to determine land value. There are two methods
for the valuation of land. First method is to compare similar and recent sales of land with the
same development potential. Second method is to estimate the value from a fundamental
analysis of the income producing qualities of the completed development. This technique is
known as Feasibility study in the continental Europe. In principle, the method of approach is to
find out the present capital value of an estimated future income( The Gross Development Value
- GDV), and then to deduct from that the cost of all works needed to complete the development
to a standard able to command such a future income( represented in the figure below).

GDV - Total Cost = Site Value

Gross development All construction costs Net Residual Value:
Value: including interest payable Maximum bid for site
Value of Completed on short-term funds, including acquisition
development sales/letting fees, fees, taxes and interests
developer’s profit and on money borrowed for
professional fees. site purchase.

Figure 1- The Feasibility Study Model

This method can be used to calculate three outcomes:

1) Maximum value (to the purchaser/developer) of the site
2) Expected profit from the development (the site having been acquired)
3) The maximum outlay for construction

The complexity of the model used to undertake this analysis will vary according to the
developer's/appraiser's requirement. The model can be extremely simplistic and use only
current day figures for cost and values and as such give a broad ballpark indication of the
residual in current day terms or it can be more complex and allow for the time value of money
through a cash flow approach. This cash flow attempts to model the reality of the development
process. The development process can take between 6 months and 4 years to be completed. The
estimates of costs and sale values will change during that time. A static, non cash flow, model
is unable to incorporate these changes as does not project forward expenditure and receipts into
the future. The two approaches can be illustrated by reference to a real life case study of the
sale of development land by a municipal authority in Italy.
The case study for feasibility study discussed in this paper is the sale of an urban regeneration
area located in a medium size city in the north of Italy. The Municipality, as with all small and
medium size cities in Italy, is not a particularly volatile market and is less prone to market
change than cities such as Milan and Rome. The site in question is a disused industrial site left
vacant since 1980.the Italian Municipalities find a significant opportunity in the renovation of
the industrial buildings into other uses to regenerate their town centers. The problem arising
with such opportunity is financing the regeneration project. Therefore the Municipality needs to
implement a process to progress the project that is a balance between the public and private
interests. To achieve the balance between the planning objectives of the Municipality and the
private financial objectives, the Municipality sells the land subject to an Urban Renewal Plan.
The land value is determined by reference to a detailed plan prepared by the Municipality,
defining the preferred mixed use for the site and sets the limits for each property type.
Therefore a feasibility study needs to be undertaken to identify the potential income and costs
of the project.
In this case, the redundant site is a total area of 37,000 square meters, of which the disused
industrial buildings cover about 13,000 square meters. The Urban Renewal Plan indicates that
the existing buildings should be refurbished (redecorated) into small and medium size offices
and that the surrounding land should be new development. It also dictates that the development
should be a mixed used development (as it the norm in Italian Cities) of residential, retail and
offices.

The acceptable mix of uses was determined to be:

52% offices;
35% residential;
13% retail
In addition, the plan provides for substantial public and private parking spaces.

Estimate of Costs and Incomes

In order to start the feasibility study, the appraiser needs to identify all the crucial variables and
use their professional's judgment to estimate values for all the critical variables concerned. On
the other hand, this study is controlled by the accuracy of the variables used. At this point, we
will identify the critical variables and assign appropriate values to them based on an analysis of
the current market. The critical variables identified are listed in Figure 2 below.

In the summer 2003 the case study started. It was at that time that the property market for the
town in question was floating with constant growth for both capital values and rents in all
sectors. Also there was a strong and growing demand for retail and residential. The price of
small shops in the city centre was very high and there was a lack of supply of small and
medium sized, high quality, apartments resulting in high prices for residential buildings.
Similarly, the office rented sector was correspondingly strong. An analysis of the local property
market produced average prices of €3,500 per square meter for Residential; €2,500 per square
meter for Offices and €5,000 per square meter for Retail. These prices reflect the demand for
small commercial spaces and new residential spaces located in the historical city centre, with
all services and parking spaces in their proximity.

A similar market analysis was undertaken to determine the costs of the refurbishment and new
construction. The cost of refurbishment is relatively high, at €1,300 per square meter, as the old
industrial buildings have to be adapted to the new functions (offices). The cost for the new
build (retail in the first floors and residential in the upper levels) is lower at €900 per square
meter. The professional fees of the architects and engineers were 10% of total costs with
marketing costs at a further 2%. A specific and relatively high cost imposed in Italy is the
"building permission cost". This cost consists of two parts; the first is a charge for servicing the
development with appropriate infrastructure and the second is more similar to a local tax. The
level of both payments is firstly determined as a range at a Regional level and then the
Municipality decides upon an appropriate rate within that range for the city. Both payments are
calculated on a percentage basis.
Finally, the Feasibility Study estimates the land value to a potential developer based on the
project being financed by bank borrowing. The standard in Italy is that the bank agrees to lend
money to the developer a "passive" (debit) rate and will apply a lower "active" (credit) rate if
the account is in credit at any point during the construction period. The rates used in this case
study are 3.5% and 2.5% respectively. As we are trying to determine market value, the
hypothesis of the model is that the developer will borrow all the money needed from the bank
regardless of their actual equity position. This is a generally accepted simplification, which
effectively assumes that the opportunity cost for the developer's own funds is equivalent to the
rates charged by the bank.
The 'Ballpark' Approach to Determine Land Value
This is a very simplistic model that determines today's land value by undertaking the analysis
as a single snapshot in time.
Fig 3
All the critical variables used are measured by reference to today's market. Thus the cost of
construction is an average cost based on today's prices and similarly the estimated GDV figure
should be an estimate of how much the development would sell for today if it were already
completed. The residual figure is therefore a quick estimate of land value as an approximate
present value.

Initially, the simple deduction of total costs from GDV produces a Gross Residual Value
(GRV) of €17,795,147. This represents all costs of purchasing the land based on current
assumptions. It is the maximum amount that a developer can afford to pay for the site
including. It is the surplus at the end of the development period. This figure doesn't only
represent the land value, but it must also include the acquisition costs for the land, taxation and
most importantly, the financing of the purchase of the land. The appraiser therefore needs to
determine the Net Residual Value (NRV), which equates to the land value alone. Using a
simple algebraic calculation the NRV can be calculated. The finance cost is 14.75% (3.5%
compounded for the construction period of 4 years) and the land purchase costs are a further
2.5% of the resulting figure. In other words, the GRV is equal to 1.1475 x NRV (before costs)
which is €15,507,402 and NRV (before costs) is equal to 1.025 of the NRV of €15,129,212.
The NRV is the Land Value.

Thus, this approach can be a useful approximation of site value but as a static model it fails to
take into account the time value of money. This is particularly the case, where (as in case
study) the development benefits from a phased completion results in incomes being received
during the development period. The reality of this can have a significant impact upon the
financing of the scheme and thus any resulting savings will be passed through to the residual
land value. Similarly, the ballpark model fails to account for present valuing at the developers
target rate and ignores the perceived risk inherent in the project. Therefore an alternative and
preferred method would be a cash flow approach.

The 'Cash Flow' Approach to Determine Land Value

The ballpark approach can be used effectively as "rough indicator" of a development's
feasibility, but it doesn’t provide a full analysis of the scheme's sensitivity to changes in the
input variables. A better and more accurate valuation method is the one that takes into account
differences in the developer's likely cash flow, such as the capital outstanding at any point in
time is known and an accurate estimation of finance charges may be made. The use of the cash
flow approach also allows the appraiser to accurately reflect the phasing of the development
and any changes in value or building costs over the development period. The cash flow
approach estimates the timings of the expenditure on the construction and the capital receipts
upon completion. This produces a period-by- period net cash flow, which then allows the
appraiser to determine the capital outstanding (or in credit) at the bank for each respective
period. The model can then calculate the accrued interest to each payment/receipt and carry it
forward to the next period. The total accumulation represents the surplus of funds at the end of
the development. To find the GRV today, the future amount needs to be discounted at the debit
rate (as this will allow for the finance on the land purchase) to derive a Present Value sum that
represents the land value plus acquisition costs. This figure is then adjusted (as illustrated in the
ballpark valuation above) to derive the land value.
The only inputs that are required in addition to those used in the ballpark valuation are the
timings that should be applied to the construction costs and, correspondingly, the capital
receipts shown in Figure 4 below.

By introducing a timing of expenditure input table, the appraiser can specify, in percentage
terms, the likely timing of the expenditure. The % of costs better represents the 'S' curve
expenditure profile, which mirrors the normal expenditure profile of a development of this
nature. To produce a more realistic actual expenditure cash flow, this input table is related to
the building costs. Similarly, the phasing of the project has been allowed for within the timing
table. This shows that capital receipts for the various parts of the overall development will be
received prior to the completion of the whole. The total costs and revenues have not been
increased, but the timing of the expenditure/receipts has been altered significantly which may
have an effect on the financing of the project.
The advantage of the cash flow technique is that the appraiser can build in outgoings such as
professional fees and sales fees more realistically; relating them to the construction costs/sales
income as they occur and not to a total figure as with the ballpark method. The cash flow
feasibility study is illustrated in Figure 5.

The cash flow approach calculates the accrued interest to each payment/receipt (from the net cash flow)
and carries it forward to the next period. The total accumulation in the end of the final year (which is
€34,732,075) represents the profit, land value, and the surplus of funds at the end of the development.
This figure need to be adjusted in order to find the maximum amount somebody could afford to pay for
the site today. This is shown in Figure 6.

Surplus at End of Development €34,732,075

Less Profit (20% of GDV) €11,900,000

Fund to Purchase Land €22,832,075

Present value10 of the Land Value Fund €19,873,303
Costs of Land Purchase (2.5% of land value) - €484,715
LAND VALUE €19,388,588
Figure 6: Case Study - The Cash Flow - Calculation of Land Value

The cash flow approach can be developed so that it may be used to calculate the developer's
profit where the site has already been acquired. Since the technique allows for the time value of
money, the appraiser can analyze the profit on a Net Present Value (NPV) and/or an Internal
Rate of Return (IRR) basis. However, in this case study, we are assessing land value on behalf
of the Municipality and thus are not considering profit calculations in this paper.

Thus, in this case, the feasibility study is being used to determine the land value, which
represents the minimum acceptable bid for tender. The Municipality is required to offer the
land to the private sector by stating that they will consider offers in excess of the Land Value
figure calculated. As such, the fact that we have been conservative in our analysis by using only
current day figures and ignoring any advantages of gearing (by the use of the developer's own
equity) means that, in reality, the interested parties who are likely to bid will be able to offer
figures in excess of the land value calculated on behalf of the municipality.
The cash flow approach (Land Value €19,388,588) is preferred to the ballpark approach (Land
Value €15,129,212) as it allows for the phasing of the development over the build period that
must be reflected in the land value.

One of the main problems with feasibility studies is that it is very sensitive to changes in any of
the input variables. A small change in any of the variables (value, cost, time or interest rate) can
disproportionately affect the resultant residual land value. The feasibility study is a single point
analysis based upon a single set of "likely" inputs. Each of the variables is based on the
subjective professional judgment (expertise) of the appraiser and the model does not allow for
the susceptibility to change among the various constituent components through time which
means there is uncertainty.

Allowing for Uncertainty in the 'Cash Flow' Approach

Uncertainty is a real and universal phenomenon in feasibility studies. If the model was adapted
to better reflect the uncertainty of the variables, it would produce a range of possible outcomes
and provide the client, in this case the Municipality, with a better understanding of the likely
outcome as reflected in the tender bids. Uncertainty impacts the feasibility study in two ways;
firstly the cash flows from development are uncertain and secondly the resultant valuation
figure is therefore open to uncertainty. This paper looks at how uncertainty can be accounted
for in the feasibility study and how it can be reported to the client in an effective and
meaningful way. This can be achieved by recognizing that the inputs are not single figures but
are, in fact, a possible range of figures that can be modeled statistically by a probability
distribution. The resulting output will therefore also be a range. Thus to start this new analysis
it is required to adopt a standardized approach and we suggest that the use of a generic
forecasting software package, in this case Crystal Ball, which acts as an overlay to the cash
flow model already developed on Excel (or Lotus 123) and to work with a predetermined set of
probability distributions. The argument for using such a technique is that a single value may not
provide the client with sufficient information to make an informed decision and thus a range of
values might be more meaningful (Brown, 1991).

Risk and Uncertainty

It is important to differentiate between uncertainty and risk. The academic literature has
extensively discussed the distinction between risk and uncertainty. Uncertainty is due to the
lack of knowledge and imperfect information about the inputs required in the model. Moreover,
uncertainty in outputs increases as more analysis is taken into the future. The outcomes of an
analysis are only certain when we can foresee the future. On the other hand, the risk is the
measure of the difference between the actual and the expected outcomes of our analysis.
One of the ways of measuring uncertainty is Probability theory. This way allows the appraiser
to make a range of outcomes for the most important variables and to assign probabilities to
these variables. Monte Carlo simulation, an important component of quantifying risk since the
1960s, is used to further develop this probability analysis. The basis of the analysis is a
continuous process that carries out multiple calculations of the cash flow by randomly selecting
an input figure for each of the critical variables identified. It selects a value from the qualified
probability distribution and uncertain input values are specified as probability distributions.

Probability Distributions
This paper seeks to identify the substance and the characteristics of the uncertainty that applies
to the inputs involved. Thus we need to address the probability and range relating to the inputs.
The outcome can still be described as a single valuation but an understanding of the uncertainty
relating to the inputs used in the model will allow the appraiser to report to the Municipality the
uncertainty related to that specific single valuation figure. This is an investigation approach and
the appraiser's judgment of the uncertainty relevant to the choice of inputs will vary according
to market conditions. If the market is strong, it is likely to have closely aligned observations
and a small range of the observed inputs. Then the appraiser will be more certain about the
estimates for inputs. However, as market conditions deteriorate, the appraiser will be less
certain of the input choices since the amount of direct comparables information falls. The
simulation analysis effectively tests the healthiness of the single point estimates and produced a
range of possible outcomes.

Probability Distributions and Choice of Critical Variables

The normal distribution (bell distribution) is the most well known and its parameters, the mean
and the standard deviation, are the most used. In this case the most likely figure will be
represented by the central figure (the mean) and the uncertainty by the range around that
number. There is equal probability that the observed figure will be above or below the central
assumed figure. The majority (99.74%) of the possible observations will lie within plus or
minus three standard deviations of the mean. The exact standard deviation will vary according
to the uncertainty relating to the average value. Thus the greater the uncertainty the higher the
standard deviation is. In the real world, and particularly in property market, market values,
interest rates and other factors might be skewed and this model allows for the appraiser to
develop the analysis on this basis if required.
Crystal Ball is a method that helps in assigning different probability distributions to each
variable as appropriate. The normal, triangular, uniform or lognormal distributions are the most
used in the simulations. Many factors affect in choosing one or more distributions: 1) depends
on the market analysis, 2) the market information about the inputs considered 3) the ability and
experience of the appraiser in assigning inputs with the proper parameters which describe the
characteristics of the market values, the interest rates, the costs etc.
The purpose of this paper is to use a language that might be readily understood by the client
and a valuation approach accepted in Italy. This is why the expanded model used in this case
study should consider all the inputs to be normally distributed, and the original inputs used in
the cash flow model above spreadsheet are the means (the most likely) of these distributions.
 III. Conclusion:

This paper started by looking at the simple application of a static feasibility study to the
problem of assessing land value for regeneration site in a Northern Italian Municipality. It was
seen, that the ballpark approach could provide a rough estimate of land value. Since this
method failed to account for timing and the possibility of phased receipts, it was argued that a
cash flow model should be preferred. The same calculation was therefore undertaken projecting
forward the most likely timings of expenditure and revenue receipts. In the cash flow model, a
higher land value was estimated. Yet both versions of the feasibility study worked within the
parameter of a fixed, predetermined, set of variable. The appraiser had ascribed a figure to each
of the inputs based on an analysis of the market coupled with his or her expert opinion. But as
with all models of this type, by fixing the input variables the appraiser will produce a single
point answer for the land value. In reality, there will always be uncertainty. The appraiser will
not be absolutely certain of any of the chosen input figures yet the model effectively ignores
uncertainty in the inputs and thus suggests certainty in the output, the land value figure. This
may be misleading. It was therefore suggested that the cash flow model could be adapted, with
the use of a generic computer program called Crystal Ball, to introduce a range for each of the
critical inputs and thus produce a range of outcomes.
The Crystal Ball program allows the appraiser to model this uncertainty by carrying out
multiple calculations (using a Monte Carlo technique) that give a range of outcomes. According
to the case more work will be required to develop these techniques for the real estate profession
but the use of a Monte Carlo model coupled with an analysis that recognizes the difference
between uncertainty and variability will provide the client with a robust and accessible way of
expressing and understanding risk and thus lead to better decision making. Finally any model is
only there to aid the decision maker by providing information in an appropriate form to
support, in this case, the city regeneration process.

IV. References:

✔ http://www.ncbi.nlm.nih.gov/pmc/articles/PMC1349178/pdf/amjph00242-

0065.pdf

✔ http://www.umanitoba.ca/afs/agric_economics/MRAC/feasibility.html

✔ http://www.referenceforbusiness.com/small/Eq-Inc/Feasibility-Study.html

✔ "http://en.wikipedia.org/wiki/Feasibility_study"