Project management chapter 7

Project Management for Construction
Fundamental Concepts for Owners, Engineers, Architects and Builders

Chapter 7
Financing of Constructed Facilities

Financing of Constructed
Facilities
7.1 The Financing Problem

Investment in a constructed facility represents a cost in the
short term that returns benefits only over the long term use of
the facility. Thus, costs occur earlier than the benefits, and
owners of facilities must obtain the capital resources to finance
the costs of construction. A project cannot proceed without
adequate financing, and the cost of providing adequate
financing can be quite large. For these reasons, attention to
project finance is an important aspect of project management.
Finance is also a concern to the other organizations involved in
a project such as the general contractor and material suppliers.
Unless an owner immediately and completely covers the costs
incurred by each participant, these organizations face financing
problems of their own.

At a more general level, project finance is only one aspect of
the general problem of corporate finance. If numerous projects
are considered and financed together, then the net cash flow
requirements constitutes the corporate financing problem for
capital investment. Whether project finance is performed at the
project or at the corporate level does not alter the basic
financing problem.

In essence, the project finance problem is to obtain funds to
bridge the time between making expenditures and obtaining
revenues. Based on the conceptual plan, the cost estimate and
the construction plan, the cash flow of costs and receipts for a
project can be estimated. Normally, this cash flow will involve
expenditures in early periods. Covering this negative cash
balance in the most beneficial or cost effective fashion is the
project finance problem.

During planning and design, expenditures of the owner are
modest, whereas substantial costs are incurred during
construction. Only after the facility is complete do revenues
begin. In contrast, a contractor would receive periodic payments
from the owner as construction proceeds. However, a
contractor also may have a negative cash balance due to
delays in payment and retainage of profits or cost
reimbursements on the part of the owner.

Plans considered by owners for facility financing typically have
both long and short term aspects. In the long term, sources of
revenue include sales, grants, and tax revenues. Borrowed
funds must be eventually paid back from these other sources. In
the short term, a wider variety of financing options exist,
including borrowing, grants, corporate investment funds,
payment delays and others. Many of these financing options
involve the participation of third parties such as banks or bond
underwriters.

For private facilities such as office buildings, it is customary to
have completely different financing arrangements during the
construction period and during the period of facility use. During
the latter period, mortgage or loan funds can be secured by the
value of the facility itself. Thus, different arrangements of
financing options and participants are possible at different
stages of a project, so the practice of financial planning is often
complicated.

On the other hand, the options for borrowing by contractors to
bridge their expenditures and receipts during construction are
relatively limited. For small or medium size projects, overdrafts
from bank accounts are the most common form of construction
financing. Usually, a maximum limit is imposed on an overdraft
account by the bank on the basis of expected expenditures and
receipts for the duration of construction. Contractors who are
engaged in large projects often own substantial assets and can
make use of other forms of financing which have lower interest
charges than overdrafting.

In recent years, there has been growing interest in design-build-
operate projects in which owners prescribe functional
requirements and a contractor handles financing. Contractors
are repaid over a period of time from project revenues or
government payments. Eventually, ownership of the facilities is
transferred to a government entity. An example of this type of
project is the Confederation Bridge to Prince Edward Island in
Canada.

In this chapter, we will first consider facility financing from the
owner's perspective, with due consideration for its interaction
with other organizations involved in a project. Later, we discuss
the problems of construction financing which are crucial to the
profitability and solvency of construction contractors.

Facilities
7.2 Institutional Arrangements for Facility Financing

7.2 Institutional Arrangements
for Facility Financing
Financing arrangements differ sharply by type of owner and by
the type of facility construction. As one example, many
municipal projects are financed in the United States with tax
exempt bonds for which interest payments to a lender are
exempt from income taxes. As a result, tax exempt municipal
bonds are available at lower interest charges. Different
institutional arrangements have evolved for specific types of
facilities and organizations.

A private corporation which plans to undertake large capital
projects may use its retained earnings, seek equity partners in
the project, issue bonds, offer new stocks in the financial
markets, or seek borrowed funds in another fashion. Potential
sources of funds would include pension funds, insurance
companies, investment trusts, commercial banks and others.
Developers who invest in real estate properties for rental
purposes have similar sources, plus quasi-governmental
corporations such as urban development authorities.
Syndicators for investment such as real estate investment trusts
(REITs) as well as domestic and foreign pension funds
represent relatively new entries to the financial market for
building mortgage money.

Public projects may be funded by tax receipts, general revenue
bonds, or special bonds with income dedicated to the specified
facilities. General revenue bonds would be repaid from general
taxes or other revenue sources, while special bonds would be
redeemed either by special taxes or user fees collected for the
project. Grants from higher levels of government are also an
important source of funds for state, county, city or other local
agencies.

Despite the different sources of borrowed funds, there is a
rough equivalence in the actual cost of borrowing money for
particular types of projects. Because lenders can participate in
many different financial markets, they tend to switch towards
loans that return the highest yield for a particular level of risk.
As a result, borrowed funds that can be obtained from different
sources tend to have very similar costs, including interest
charges and issuing costs.

As a general principle, however, the costs of funds for
construction will vary inversely with the risk of a loan. Lenders
usually require security for a loan represented by a tangible
asset. If for some reason the borrower cannot repay a loan,
then the borrower can take possession of the loan security. To
the extent that an asset used as security is of uncertain value,
then the lender will demand a greater return and higher interest
payments. Loans made for projects under construction
represent considerable risk to a financial institution.

If a lender acquires an unfinished facility, then it faces the
difficult task of re-assembling the project team. Moreover, a
default on a facility may result if a problem occurs such as
foundation problems or anticipated unprofitability of the future
facility. As a result of these uncertainties, construction lending
for unfinished facilities commands a premium interest charge of
several percent compared to mortgage lending for completed
facilities.

Financing plans will typically include a reserve amount to cover
unforeseen expenses, cost increases or cash flow problems.
This reserve can be represented by a special reserve or a
contingency amount in the project budget. In the simplest case,
this reserve might represent a borrowing agreement with a
financial institution to establish a line of credit in case of need.
For publicly traded bonds, specific reserve funds administered
by a third party may be established. The cost of these reserve
funds is the difference between the interest paid to bondholders
and the interest received on the reserve funds plus any
administrative costs.

Finally, arranging financing may involve a lengthy period of
negotiation and review. Particularly for publicly traded bond
financing, specific legal requirements in the issue must be met.
A typical seven month schedule to issue revenue bonds would
include the various steps outlined in Table 7-1. [1] In many
cases, the speed in which funds may be obtained will determine
a project's financing mechanism.

Activities Time of Activities
Analysis of financial alternatives
Preparation of legal documents
Preparation of disclosure documents
Forecasts of costs and revenues
Bond Ratings
Bond Marketing
Bond Closing and Receipt of Funds
Weeks 0-4
Weeks 1-17
Weeks 2-20
Weeks 4-20
Weeks 20-23
Weeks 21-24
Weeks 23-26
TABLE 7-1 Illustrative Process and Timing
for Issuing Revenue Bonds

Example 7-1: Example of financing options

Example 7-1: Example of
financing options
Suppose that you represent a private corporation attempting to
arrange financing for a new headquarters building. These are
several options that might be considered:
• Use corporate equity and retained earnings: The building
could be financed by directly committing corporate
resources. In this case, no other institutional parties would be
involved in the finance. However, these corporate funds
might be too limited to support the full cost of construction.

financing options
• Construction loan and long term mortgage: In this plan, a
loan is obtained from a bank or other financial institution to
finance the cost of construction. Once the building is
complete, a variety of institutions may be approached to
supply mortgage or long term funding for the building. This
financing plan would involve both short and long term
borrowing, and the two periods might involve different
lenders. The long term funding would have greater security
since the building would then be complete. As a result, more
organizations might be interested in providing funds
(including pension funds) and the interest charge might be
lower. Also, this basic financing plan might be supplemented
by other sources such as corporate retained earnings or
assistance from a local development agency.

financing options
• Lease the building from a third party: In this option, the
corporation would contract to lease space in a headquarters
building from a developer. This developer would be
responsible for obtaining funding and arranging construction.
This plan has the advantage of minimizing the amount of
funds borrowed by the corporation. Under terms of the lease
contract, the corporation still might have considerable
influence over the design of the headquarters building even
though the developer was responsible for design and
construction.

financing options
• Initiate a Joint Venture with Local Government: In many
areas, local governments will help local companies with
major new ventures such as a new headquarters. This help
might include assistance in assembling property, low interest
loans or proerty tax reductions. In the extreme, local
governments may force sale of land through their power
of eminent domain to assemble necessary plots.

Facilities
7.3 Evaluation of Alternative Financing Plans

7.3 Evaluation of Alternative
Financing Plans
Since there are numerous different sources and arrangements
for obtaining the funds necessary for facility construction,
owners and other project participants require some mechanism
for evaluating the different potential sources. The relative costs
of different financing plans are certainly important in this regard.
In addition, the flexibility of the plan and availability of reserves
may be critical. As a project manager, it is important to assure
adequate financing to complete a project. Alternative financing
plans can be evaluated using the same techniques that are
employed for the evaluation of investment alternatives.

Financing Plans
As described in Chapter 6, the availability of different financing
plans can affect the selection of alternative projects. A general
approach for obtaining the combined effects of operating and
financing cash flows of a project is to determine the adjusted
net present value (APV) which is the sum of the net present
value of the operating cash flow (NPV) and the net present
value of the financial cash flow (FPV), discounted at their
respective minimum attractive rates of return (MARR), i.e.,

Financing Plans
where r is the MARR reflecting the risk of the operating cash
flow and rf is the MARR representing the cost of borrowing for
the financial cash flow. Thus,
where At and are respectively the operating and financial cash
flows in period t.

Financing Plans
For the sake of simplicity, we shall emphasize in this chapter
the evaluation of financing plans, with occasional references to
the combined effects of operating and financing cash flows. In
all discussions, we shall present various financing schemes with
examples limiting to cases of before-tax cash flows discounted
at a before-tax MARR of r = rf for both operating and financial
cash flows. Once the basic concepts of various financing
schemes are clearly understood, their application to more
complicated situations involving depreciation, tax liability and
risk factors can be considered in combination with the principles
for dealing with such topics enunciated in Chapter 6.

Financing Plans
In this section, we shall concentrate on the computational
techniques associated with the most common types of financing
arrangements. More detailed descriptions of various financing
schemes and the comparisons of their advantages and
disadvantages will be discussed in later sections.

Financing Plans
Typically, the interest rate for borrowing is stated in terms
of annual percentage rate (A.P.R.), but the interest is accrued
according to the rate for the interest period specified in the
borrowing agreement. Let ip be the nominal annual percentage
rate, and i be the interest rate for each of the p interest periods
per year. By definition

Financing Plans
If interest is accrued semi-annually, i.e., p = 2, the interest rate
per period is ip/2; similarly if the interest is accrued monthly, i.e.,
p = 12, the interest rate per period is ip/12. On the other hand,
the effective annual interest rate ie is given by:

Financing Plans
Note that the effective annual interest rate, ie, takes into account
compounding within the year. As a result, ie is greater than ip for
the typical case of more than one compounding period per year.

Financing Plans
For a coupon bond, the face value of the bond denotes the
amount borrowed (called principal) which must be repaid in full
at a maturity or due date, while each coupon designates the
interest to be paid periodically for the total number of coupons
covering all periods until maturity. Let Q be the amount
borrowed, and Ip be the interest payment per period which is
often six months for coupon bonds. If the coupon bond is
prescribed to reach maturity in n years from the date of issue,
the total number of interest periods will be pn = 2n. The semi-
annual interest payment is given by:

Financing Plans
In purchasing a coupon bond, a discount from or a premium
above the face value may be paid.

Financing Plans
An alternative loan arrangement is to make a series of uniform
payments including both interest and part of the principal for a
pre-defined number of repayment periods. In the case of
uniform payments at an interest rate i for n repayment periods,
the uniform repayment amount U is given by:

Financing Plans
where (U|P,i,n) is a capital recovery factor which reads: "to find
U, given P=1, for an interest rate i over n periods." Compound
interest factors are as tabulated in Appendix A. The number of
repayment periods n will clearly influence the amounts of
payments in this uniform payment case. Uniform payment
bonds or mortgages are based on this form of repayment.

Financing Plans
Usually, there is an origination fee associated with borrowing for
legal and other professional services which is payable upon the
receipt of the loan. This fee may appear in the form of issuance
charges for revenue bonds or percentage point charges for
mortgages. The borrower must allow for such fees in addition to
the construction cost in determining the required original
amount of borrowing. Suppose that a sum of Po must be
reserved at t=0 for the construction cost, and K is the origination
fee. Then the original loan needed to cover both is:

Financing Plans
If the origination fee is expressed as k percent of the original
loan, i.e., K = kQ0, then:

Financing Plans
Since interest and sometimes parts of the principal must be
repaid periodically in most financing arrangements, an amount
Q considerably larger than Q0 is usually borrowed in the
beginning to provide adequate reserve funds to cover interest
payments, construction cost increases and other unanticipated
shortfalls. The net amount received from borrowing is deposited
in a separate interest bearing account from which funds will be
withdrawn periodically for necessary payments. Let the
borrowing rate per period be denoted by i and the interest for
the running balance accrued to the project reserve account be
denoted by h.

Financing Plans
Let At be the net operating cash flow for - period t (negative for
construction cost in period t) and be the net financial cash flow
in period t (negative for payment of interest or principal or a
combination of both). Then, the running balance Nt of the
project reserve account can be determined by noting that at t=0,

Financing Plans
and at t = 1,2,...,n:

Financing Plans
where the value of At or t may be zero for some period(s).
Equations (7.9) and (7.10) are approximate in that interest
might be earned on intermediate balances based on the pattern
of payments during a period instead of at the end of a period.

Financing Plans
Because the borrowing rate i will generally exceed the
investment rate h for the running balance in the project account
and since the origination fee increases with the amount
borrowed, the financial planner should minimize the amount of
money borrowed under this finance strategy. Thus, there is an
optimal value for Q such that all estimated shortfalls are
covered, interest payments and expenses are minimized, and
adequate reserve funds are available to cover unanticipated
factors such as construction cost increases. This optimal value
of Q can either be identified analytically or by trial and error.

Financing Plans
Finally, variations in ownership arrangements may also be used
to provide at least partial financing. Leasing a facility removes
the need for direct financing of the facility. Sale-leaseback
involves sale of a facility to a third party with a separate
agreement involving use of the facility for a pre-specified period
of time. In one sense, leasing arrangements can be viewed as a
particular form of financing. In return for obtaining the use of a
facility or piece of equipment, the user (lesser) agrees to pay
the owner (lesser) a lease payment every period for a specified
number of periods.

Financing Plans
Usually, the lease payment is at a fixed level due every month,
semi-annually, or annually. Thus, the cash flow associated with
the equipment or facility use is a series of uniform payments.
This cash flow would be identical to a cash flow resulting from
financing the facility or purchase with sufficient borrowed funds
to cover initial construction (or purchase) and with a repayment
schedule of uniform amounts. Of course, at the end of the lease
period, the ownership of the facility or equipment would reside
with the lesser. However, the lease terms may include a
provision for transferring ownership to the lesser after a fixed
period.

Financing Plans
Example 7-2: A coupon bond cash flow and cost

Example 7-2: A coupon bond
cash flow and cost
A private corporation wishes to borrow $10.5 million for the
construction of a new building by issuing a twenty-year coupon
bond at an annual percentage interest rate of 10% to be paid
semi-annually, i.e. 5% per interest period of six months. The
principal will be repaid at the end of 20 years. The amount
borrowed will cover the construction cost of $10.331 million and
an origination fee of $169,000 for issuing the coupon bond.

cash flow and cost
The interest payment per period is (5%) (10.5) = $0.525 million
over a life time of (2) (20) = 40 interest periods. Thus, the cash
flow of financing by the coupon bond consists of a $10.5 million
receipt at period 0, -$0.525 million each for periods 1 through
40, and an additional -$10.5 million for period 40. Assuming a
MARR of 5% per period, the net present value of the financial
cash flow is given by:
[FPV]5%) = 10.5 - (0.525)(P|U, 5%, 40) - (10.5)(P|F, 5%,
40) = 0

cash flow and cost
This result is expected since the corporation will be indifferent
between borrowing and diverting capital from other uses when
the MARR is identical to the borrowing rate. Note that the
effective annual rate of the bond may be computed according to
Eq.(7.4) as follows:
ie = (1 + 0.05)2 - 1 = 0.1025 = 10.25%

cash flow and cost
If the interest payments were made only at the end of each year
over twenty years, the annual payment should be:
0.525(1 + 0.05) + 0.525 = 1.076
where the first term indicates the deferred payment at the mid-
year which would accrue interest at 5% until the end of the year,
then:
[FPV]10.25% = 10.5 - (1.076)(P|U, 10.25%, 20) -
(10.5)(P|F, 10.25%, 20) = 0

cash flow and cost
In other words, if the interest is paid at 10.25% annually over
twenty years of the loan, the result is equivalent to the case of
semi-annual interest payments at 5% over the same lifetime.

Financing Plans
Example 7-3: An example of leasing versus ownership
analysis

Example 7-3: An example of leasing
versus ownership analysis
Suppose that a developer offered a building to a corporation for
an annual lease payment of $10 million over a thirty year
lifetime. For the sake of simplicity, let us assume that the
developer also offers to donate the building to the corporation at
the end of thirty years or, alternatively, the building would then
have no commercial value. Also, suppose that the initial cost of
the building was $65.66 million. For the corporation, the lease is
equivalent to receiving a loan with uniform payments over thirty
years at an interest rate of 15% since the present value of the
lease payments is equal to the initial cost at this interest rate:

If the minimum attractive rate of return of the corporation is
greater than 15%, then this lease arrangement is advantageous
as a financing scheme since the net present value of the
leasing cash flow would be less than the cash flow associated
with construction from retained earnings. For example, with
MARR equal to 20%:
[FPV]20% = $65.66 million - ($10 million)(P|U, 20%, 30) =
$15.871 million

On the other hand, with MARR equal to 10%:
[FPV]10% = $65.66 million - ($10 million)(P|U, 20%, 30) =
$28.609 million
and the lease arrangement is not advantageous.

Example 7-4: Example evaluation of alternative financing
plans.

Example 7-4: Example evaluation of
alternative financing plans
Suppose that a small corporation wishes to build a
headquarters building. The construction will require two years
and cost a total of $12 million, assuming that $5 million is spent
at the end of the first year and $7 million at the end of the
second year. To finance this construction, several options are
possible, including:
• Investment from retained corporate earnings;

• Borrowing from a local bank at an interest rate of 11.2% with
uniform annual payments over twenty years to pay for the
construction costs. The shortfalls for repayments on loans
will come from corporate earnings. An origination fee of
0.75% of the original loan is required to cover engineer's
reports, legal issues, etc; or
• A twenty year coupon bond at an annual interest rate of
10.25% with interest payments annually, repayment of the
principal in year 20, and a $169,000 origination fee to pay for
the construction cost only.

The current corporate MARR is 15%, and short term cash funds
can be deposited in an account having a 10% annual interest
rate.

The first step in evaluation is to calculate the required amounts
and cash flows associated with these three alternative financing
plans. First, investment using retained earnings will require a
commitment of $5 million in year 1 and $7 million in year 2.

Second, borrowing from the local bank must yield sufficient
funds to cover both years of construction plus the issuing fee.
With the unused fund accumulating interest at a rate of 10%,
the amount of dollars needed at the beginning of the first year
for future construction cost payments is:
P0 = ($5 million)/(1.1) + ($7 million)/(1.1)2 = $10.331 million

Discounting at ten percent in this calculation reflects the interest
earned in the intermediate periods. With a 10% annual interest
rate, the accrued interests for the first two years from the project
account of $10.331 at t=0 will be:
Year 1: I1 = (10%)(10.331 million) = $1.033 million
Year 2: I2 = (10%)(10.331 million + $1.033 million - $5.0
million) = 0.636 million

Since the issuance charge is 0.75% of the loan, the amount
borrowed from the bank at t=0 to cover both the construction
cost and the issuance charge is
Q0 = ($10.331 million)/(1 - 0.0075) = $ 10.409 million

The issuance charge is 10.409 - 10.331 = $ 0.078 million or
$78,000. If this loan is to be repaid by annual uniform payments
from corporate earnings, the amount of each payment over the
twenty year life time of the loan can be calculated by Eq. (7.6)
as follows:
U = ($10.409 million)[(0.112)(1.112)20]/[(1.112)20 - 1] = $1.324
million

Finally, the twenty-year coupon bond would have to be issued
in the amount of $10.5 million which will reflect a higher
origination fee of $169,000. Thus, the amount for financing is:
Q0 = $10.331 million + $0.169 million = $10.5 million

With an annual interest charge of 10.25% over a twenty year life
time, the annual payment would be $1.076 million except in
year 20 when the sum of principal and interest would be 10.5 +
1.076 = $11.576 million. The computation for this case of
borrowing has been given in Example 7-2.

Table 7-2 summarizes the cash flows associated with the three
alternative financing plans. Note that annual incomes generated
from the use of this building have not been included in the
computation. The adjusted net present value of the combined
operating and financial cash flows for each of the three plans
discounted at the corporate MARR of 15% is also shown in the
table. In this case, the coupon bond is the least expensive
financing plan. Since the borrowing rates for both the bank loan
and the coupon bond are lower than the corporate MARR,
these results are expected.

Year Source
Retained
Earnings Bank Loan Coupon Bond
0
0
1
1
1
2
2
2
3-19
20
[APV]15%
Principal
Issuing Cost
Earned Interest
Contractor
Payment
Loan Repayment
Earned Interest
Contractor
Payment
Loan Repayment
Loan Repayment
Loan Repayment
-
-
-
- 5.000
-
-
- 7.000
-
-
-
- 9.641
$10.409
- 0.078
1.033
- 5.000
- 1.324
0.636
- 7.000
- 1.324
- 1.324
- 1.324
- 6.217
$10.500
- 0.169
1.033
- 5.000
- 1.076
0.636
- 7.000
- 1.076
-1.076
- 11.576
- 5.308
TABLE 7-2 Cash Flow Illustration of Three Alternative Financing Plans (in $
millions)

Facilities
7.4 Secured Loans with Bonds, Notes and Mortgages

7.4 Secured Loans with
Bonds, Notes and Mortgages
Secured lending involves a contract between a borrower and
lender, where the lender can be an individual, a financial
institution or a trust organization. Notes and mortgages
represent formal contracts between financial institutions and
owners. Usually, repayment amounts and timing are specified in
the loan agreement. Public facilities are often financed by bond
issues for either specific projects or for groups of projects.

For publicly issued bonds, a trust company is usually
designated to represent the diverse bond holders in case of any
problems in the repayment. The borrowed funds are usually
secured by granting the lender some rights to the facility or
other assets in case of defaults on required payments. In
contrast, corporate bonds such as debentures can represent
loans secured only by the good faith and credit worthiness of
the borrower.

Under the terms of many bond agreements, the borrower
reserves the right to repurchase the bonds at any time before
the maturity date by repaying the principal and all interest up to
the time of purchase. The required repayment Rc at the end of
period c is the net future value of the borrowed amount Q - less
the payment made at intermediate periods compounded at
the borrowing rate i to period c as follows:

The required repayment Rc at the end of the period c can also
be obtained by noting the net present value of the repayments
in the remaining (n-c) periods discounted at the borrowing rate i
to t = c as follows:

For coupon bonds, the required repayment Rc after the
redemption of the coupon at the end of period c is simply the
original borrowed amount Q. For uniform payment bonds, the
required repayment Rc after the last payment at the end of
period c is:

Many types of bonds can be traded in a secondary market by
the bond holder. As interest rates fluctuate over time, bonds will
gain or lose in value. The actual value of a bond is reflected in
the market discount or premium paid relative to the original
principal amount (the face value). Another indicator of this value
is the yield to maturity or internal rate of return of the bond. This
yield is calculated by finding the interest rate that sets the
(discounted) future cash flow of the bond equal to the current
market price:

where Vc is the current market value after c periods have lapsed
since the - issuance of the bond, is the bond cash flow in
period t, and r is the market yield. Since all the bond cash flows
are positive after the initial issuance, only one value of the yield
to maturity will result from Eq.

Several other factors come into play in evaluation of bond
values from the lenders point of view, however. First, the lender
must adjust for the possibility that the borrower may default on
required interest and principal payments. In the case of publicly
traded bonds, special rating companies divide bonds into
different categories of risk for just this purpose. Obviously,
bonds that are more likely to default will have a lower value.
Secondly, lenders will typically make adjustments to account for
changes in the tax code affecting their after-tax return from a
bond. Finally, expectations of future inflation or deflation as well
as exchange rates will influence market values.

Another common feature in borrowing agreements is to have a
variable interest rate. In this case, interest payments would vary
with the overall market interest rate in some pre-specified
fashion. From the borrower's perspective, this is less desirable
since cash flows are less predictable. However, variable rate
loans are typically available at lower interest rates because the
lenders are protected in some measure from large increases in
the market interest rate and the consequent decrease in value
of their expected repayments. Variable rate loans can have
floors and ceilings on the applicable interest rate or on rate
changes in each year

Example 7-5: Example of a corporate promissory note

Example 7-5: Example of a
corporate promissory note
A corporation wishes to consider the option of financing the
headquarters building in Example 7-4 by issuing a five year
promissory note which requires an origination fee for the note is
$25,000. Then a total borrowed amount needed at the
beginning of the first year to pay for the construction costs and
origination fee is 10.331 + 0.025 = $10.356 million. Interest
payments are made annually at an annual rate of 10.8% with
repayment of the principal at the end of the fifth year. Thus, the
annual interest payment is (10.8%)(10.356) = $1.118 million.
With the data in Example 7-4 for construction costs and accrued
interests for the first two year, the combined operating and and
financial cash flows in million dollars can be obtained:

Year 0, AA0 = 10.356 - 0.025 = 10.331
Year 1, AA1 = 1.033 - 5.0 - 1.118 = -5.085
Year 2, AA2 = 0.636 - 7.0 - 1.118 = -7.482
Year 3, AA3 = -1.118
Year 4, AA4 = -1.118
Year 5, AA5 = -1.118 - 10.356 = -11.474

At the current corporate MARR of 15%,
which is inferior to the 20-year coupon bond analyzed in Table
7-3.

For this problem as well as for the financing arrangements in
Example 7-4, the project account is maintained to pay the
construction costs only, while the interest and principal
payments are repaid from corporate earnings. - Consequently,
the terms in Eq. (7.10) will disappear when the account
balance in each period is computed for this problem:
At t=0, N0 = 10.356 - 0.025 = $10.331 million
At t=1, N1 = (1 + 0.1) (10.331) - 5.0 = $6.364 million
At t=2, N2 = (1 + 0.1) (6.364) - 7.0 = $0

Example 7-6: Bond financing mechanisms.

Example 7-6: Bond financing
mechanisms.
Suppose that the net operating expenditures and receipts of a
facility investment over a five year time horizon are as shown in
column 2 of Table 7-3 in which each period is six months. This
is a hypothetical example with a deliberately short life time
period to reduce the required number of calculations. Consider
two alternative bond financing mechanisms for this project. Both
involve borrowing $2.5 million at an issuing cost of five percent
of the loan with semi-annual repayments at a nominal annual
interest rate of ten percent i.e., 5% per period.

mechanisms.
Any excess funds can earn an interest of four percent each
semi-annual period. The coupon bond involves only interest
payments in intermediate periods, plus the repayment of the
principal at the end, whereas the uniform payment bond
requires ten uniform payments to cover both interests and the
principal. Both bonds are subject to optional redemption by the
borrower before maturity.

mechanisms.
The operating cash flow in column 2 of Table 7-3 represents the
construction expenditures in the early periods and rental
receipts in later periods over the lifetime of the facility. By trial
and error with Eqs. (7.9) and (7.10), it can be found that
Q = $2.5 million (K = $0.125 or 5% of Q) is necessary to insure
a nonnegative balance in the project account for the uniform
payment bond, as shown in Column 6 of Table 7-3. For the
purpose of comparison, the same amount is borrowed for the
coupon bond option even though a smaller loan will be sufficient
for the construction expenditures in this case.

mechanisms.
The financial cash flow of the coupon bond can easily be
derived from Q = $2.5 million and K = $0.125 million. Using Eq.
(7.5), Ip= (5%)(2.5) = $0.125 million, and the repayment in
Period 10 is Q + Ip = $2.625 million as shown in Column 3 of
Table 7-3. The account balance for the coupon bond in Column
4 is obtained from Eqs. (7.9) and (7.10). On the other hand, the
uniform annual payment U = $0.324 million for the financial
cash flow of the uniform payment bond (Column 5) can be
obtained from Eq. (7.6), and the bond account for this type of
balance is computed by Eqs. (7.9) and (7.10).

mechanisms.
Because of the optional redemption provision for both types of
bonds, it is advantageous to gradually redeem both options at
the end of period 3 to avoid interest payments resulting from i =
5% and h = 4% unless the account balance beyond period 3 is
needed to fund other corporate investments. corporate earnings
are available for repurchasing the bonds at end of period 3, the
required repayment for coupon bond after redeeming the last
coupon at the end of period 3 is simply $2.625 million. In the
case of the uniform payment bond, the required payment after
the last uniform payment at the end of period 3 is obtained from
Equation (7-13) as:
R3 = (0.324)(P|U, 5%, 7) = (0.324)(5.7864) = $1.875
million.

mechanisms.
Period
Operating
Cash Flow
Coupon
Cash Flow
Account
Balance
Uniform
Cash Flow
Account
Balance
0
1
2
3
4
5
6
7
8
9
10
-
- $800
-700
-60
400
600
800
1,000
1,000
1,000
1,000
$2,375
- 125
- 125
- 125
- 125
- 125
- 125
- 125
- 125
- 125
- 2,625
$2,375
1,545
782
628
928
1,440
2,173
3,135
4,135
5,176
3,758
$2,375
- 324
- 324
- 324
- 324
- 324
- 324
- 324
- 324
- 324
- 324
$2,375
1,346
376
8
84
364
854
1,565
2,304
3,072
3,871
TABLE 7-3 Example of Two Borrowing Cash Flows (in $ thousands)

Example 7-7: Provision of Reserve Funds

Example 7-7: Provision of
Reserve Funds
Typical borrowing agreements may include various required
reserve funds. [2] Consider an eighteen month project costing
five million dollars. To finance this facility, coupon bonds will be
issued to generate revenues which must be sufficient to pay
interest charges during the eighteen months of construction, to
cover all construction costs, to pay issuance expenses, and to
maintain a debt service reserve fund. The reserve fund is
introduced to assure bondholders of payments in case of
unanticipated construction problems. It is estimated that a total
amount of $7.4 million of bond proceeds is required, including a
two percent discount to underwriters and an issuance expense
of $100,000.

Reserve Funds
Three interest bearing accounts are established with the bond
proceeds to separate various categories of funds:
• A construction fund to provide payments to contractors, with
an initial balance of $4,721,600. Including interest earnings,
this fund will be sufficient to cover the $5,000,000 in
construction expenses.
• A capitalized interest fund to provide interest payments
during the construction period. /li>
• A debt service reserve fund to be used for retiring
outstanding debts after the completion of construction.
The total sources of funds (including interest from account
balances) and uses of funds are summarized in Table 7-4

Reserve Funds
Sources of Funds
Bond Proceeds
Interest Earnings on Construction Fund
Interest Earnings of Capitalized Interest Fund
Interest Earnings on Debt Service Reserve Fund
Total Sources of Funds
$7,400,000
278,400
77,600
287,640
$8,043,640
Uses of Funds
Construction Costs
Interest Payments
Debt Service Reserve Fund
Bond Discount (2.0%)
Issuance Expense
Total Uses of Funds
$5,000,000
904,100
1,891,540
148,000
100,000
$8,043,640
TABLE 7-4 Illustrative Sources and Uses of Funds from Revenue Bonds During
Construction

Example 7-8: Variable rate revenue bonds prospectus

Example 7-8: Variable rate
revenue bonds prospectus
The information in Table 7-5 is abstracted from the Prospectus
for a new issue of revenue bonds for the Atwood City. This
prospectus language is typical for municipal bonds. Notice the
provision for variable rate after the initial interest periods. The
borrower reserves the right to repurchase the bond before the
date for conversion to variable rate takes effect in order to
protect itself from declining market interest rates in the future so
that the borrower can obtain other financing arrangements at
lower rates.

Example 7-8: Variable rate
revenue bonds prospectus

Facilities
7.5 Overdraft Accounts

Overdrafts can be arranged with a banking institution to allow
accounts to have either a positive or a negative balance. With a
positive balance, interest is paid on the account balance,
whereas a negative balance incurs interest charges. Usually, an
overdraft account will have a maximum overdraft limit imposed.
Also, the interest rate h available on positive balances is less
than the interest rate i charged for borrowing.

Clearly, the effects of overdraft financing depends upon the
pattern of cash flows over time. Suppose that the net cash flow
for period t in the account is denoted by At which is the
difference between the receipt Pt and the payment Et in period t.
Hence, At can either be positive or negative. The amount of
overdraft at the end of period t is the cumulative net cash flow
Nt which may also be positive or negative. If Nt is positive, a
surplus is indicated and the subsequent interest would be paid
to the borrower. Most often, Nt is negative during the early time
periods of a project and becomes positive in the later periods
when the borrower has received payments exceeding
expenses.

If the borrower uses overdraft financing and pays the interest
per period on the accumulated overdraft at a borrowing rate i in
each period, then the interest per period for the accumulated
overdraft Nt-1 from the previous period (t-1) is It = iNt-1 where
It would be negative for a negative account balance Nt-1. For a
positive account balance, the interest received is It = hNt-
1 where It would be positive for a positive account balance.

The account balance Nt at each period t is the sum of receipts
Pt, payments Et, interest It and the account balance from the
previous period Nt-1. Thus,

where It = iNt-1 for a negative Nt-1 and It = hNt-1 for a positive Nt-1.
The net cash flow At = Pt - Et is positive for a net receipt and
negative for a net payment. This equation is approximate in that
the interest might be earned on intermediate balances based on
the pattern of payments during the period instead of at the end
of a period. The account balance in each period is of interest
because there will always be a maximum limit on the amount of
overdraft available.

For the purpose of separating project finances with other
receipts and payments in an organization, it is convenient to
establish a credit account into which receipts related to the
project must be deposited when they are received, and all
payments related to the project will be withdrawn from this
account when they are needed.

Since receipts typically lag behind payments for a project, this
credit account will have a negative balance until such time when
the receipts plus accrued interests are equal to or exceed
payments in the period. When that happens, any surplus will not
be deposited in the credit account, and the account is then
closed with a zero balance. In that case, for negative Nt-1, Eq.
(7.15) can be expressed as:
and as soon as Nt reaches a positive value or zero, the account
is closed.

Example 7-9: Overdraft Financing with Grants to a Local
Agency

Example 7-9: Overdraft Financing
with Grants to a Local Agency
A public project which costs $61,525,000 is funded eighty
percent by a federal grant and twenty percent from a state
grant. The anticipated duration of the project is six years with
receipts from grant funds allocated at the end of each year to a
local agency to cover partial payments to contractors for that
year while the remaining payments to contractors will be
allocated at the end of the sixth year. The end-of-year payments
are given in Table 7-6 in which t=0 refers to the beginning of the
project, and each period is one year.

If this project is financed with an overdraft at an annual interest
rate i = 10%, then the account balance are computed by Eq.
(7.15) and the results are shown in Table 7-6.

In this project, the total grant funds to the local agency covered
the cost of construction in the sense that the sum of receipts
equaled the sum of construction payments of $61,525,000.
However, the timing of receipts lagged payments, and the
agency incurred a substantial financing cost, equal in this plan
to the overdraft amount of $1,780,000 at the end of year 6
which must be paid to close the credit account. Clearly, this
financing problem would be a significant concern to the local
agency.

Period t Receipts Pt Payments Et Interest It Account Nt
0
1
2
3
4
5
6
Total
0
$5.826
8.401
12.013
15.149
13.984
6.152
$61.525
0
$6.473
9.334
13.348
16.832
15.538
0
$61.525
0
0
- $0.065
- 0.165
- 0.315
- 0.514
- 0.721
-$1.780
0
-$0.647
- 1.645
- 3.145
- 5.143
- 7.211
- 1.780
TABLE 7-6 Illustrative Payments, Receipts and Overdrafts for a Six
Year Project

Example 7-10: Use of overdraft financing for a facility

Example 7-10: Use of overdraft
financing for a facility
A corporation is contemplating an investment in a facility with
the following before-tax operating net cash flow (in thousands of
dollars) at year ends:
Year 0 1 2 3 4 5 6 7
Cash
Flow
-500 110 112 114 116 118 120 238

The MARR of the corporation before tax is 10%. The
corporation will finance the facility be using $200,000 from
retained earnings and by borrowing the remaining $300,000
through an overdraft credit account which charges 14% interest
for borrowing. Is this proposed project including financing costs
worthwhile?

The results of the analysis of this project is shown in Table 7-7
as follows:
N0 = -500 + 200 = -300
N1 = (1.14)(-300) + 110 = -232
N2 = (1.14)(-232) + 112 = -152.48
N3 = (1.14)(-152.48) + 114 = -59.827
N4 = (1.14)(-59.827) +116 = +47.797

Since N4 is positive, it is revised to exclude the net receipt of
116 for this period. Then, the revised value for the last balance
is
N4' = N4 - 116 = - 68.203

The financial cash flow resulting from using overdrafts and
making repayments from project receipts will be:
A 0= - N0 = 300
A 0 = - A1 = -110
A 0 = - A2 = -112
A 0 = - A3 = -114
A 0 = N4 - A4 = - 68.203

The adjusted net present value of the combined cash flow
discounted at 15% is $27,679 as shown in Table 7-7. Hence,
the project including the financing charges is worthwhile.

End of Year
t
Operating Cash
Flow
At
Overdraft
Balance
Nt
Financing Cash
Flow
Combined
Cash Flow
AAt
0
1
2
3
4
5
6
7
[PV]15%
- $500
110
112
114
116
118
120
122
$21.971
- $300
- 232
- 152.480
-59.827
0
0
0
0
&300
- 110
- 112
- 114
- 68.203
0
0
0
$5.708
- $200
0
0
0
47.797
118
120
122
$27.679
TABLE 7-7 Evaluation of Facility Financing Using Overdraft (in $ thousands)

Facilities
7.6 Refinancing of Debts

Refinancing of debts has two major advantages for an owner.
First, they allow re-financing at intermediate stages to save
interest charges. If a borrowing agreement is made during a
period of relatively high interest charges, then a repurchase
agreement allows the borrower to re-finance at a lower interest
rate. Whenever the borrowing interest rate declines such that
the savings in interest payments will cover any transaction
expenses (for purchasing outstanding notes or bonds and
arranging new financing), then it is advantageous to do so.

Another reason to repurchase bonds is to permit changes in the
operation of a facility or new investments. Under the terms of
many bond agreements, there may be restrictions on the use of
revenues from a particular facility while any bonds are
outstanding. These restrictions are inserted to insure
bondholders that debts will be repaid. By repurchasing bonds,
these restrictions are removed. For example, several bridge
authorities had bonds that restricted any diversion of toll
revenues to other transportation services such as transit.

By repurchasing these bonds, the authority could undertake
new operations. This type of repurchase may occur voluntarily
even without a repurchase agreement in the original bond. The
borrower may give bondholders a premium to retire bonds
early.

Example 7-11: Refinancing a loan.

Example 7-11: Refinancing a
loan.
Suppose that the bank loan shown in Example 7-4 had a
provision permitting the borrower to repay the loan without
penalty at any time. Further, suppose that interest rates for new
loans dropped to nine percent at the end of year six of the loan.
Issuing costs for a new loan would be $50,000. Would it be
advantageous to re-finance the loan at that time?

loan.
To repay the original loan at the end of year six would require a
payment of the remaining principal plus the interest due at the
end of year six. This amount R6 is equal to the present value of
remaining fourteen payments discounted at the loan interest
rate 11.2% to the end of year 6 as given in Equation (7-13) as
follows:

loan.
The new loan would be in the amount of $ 9.152 million plus the
issuing cost of $0.05 million for a total of $ 9.202 million. Based
on the new loan interest rate of 9%, the new uniform annual
payment on this loan from years 7 to 20 would be:

loan.
The net present value of the financial cash flow for the new loan
would be obtained by discounting at the corporate MARR of
15% to the end of year six as follows:

loan.
Since the annual payment on the new loan is less than the
existing loan ($1.182 versus $1.324 million), the new loan is
preferable.

Facilities
7.7 Project versus Corporate Finance

7.7 Project versus Corporate
Finance
We have focused so far on problems and concerns at the
project level. While this is the appropriate viewpoint for project
managers, it is always worth bearing in mind that projects must
fit into broader organizational decisions and structures. This is
particularly true for the problem of project finance, since it is
often the case that financing is planned on a corporate or
agency level, rather than a project level. Accordingly, project
managers should be aware of the concerns at this level of
decision making.

Finance
A construction project is only a portion of the general capital
budgeting problem faced by an owner. Unless the project is
very large in scope relative to the owner, a particular
construction project is only a small portion of the capital
budgeting problem. Numerous construction projects may be
lumped together as a single category in the allocation of
investment funds. Construction projects would compete for
attention with equipment purchases or other investments in a
private corporation.

Finance
Financing is usually performed at the corporate level using a
mixture of long term corporate debt and retained earnings. A
typical set of corporate debt instruments would include the
different bonds and notes discussed in this chapter. Variations
would typically include different maturity dates, different levels
of security interests, different currency denominations, and, of
course, different interest rates.

Finance
Grouping projects together for financing influences the type of
financing that might be obtained. As noted earlier, small and
large projects usually involve different institutional
arrangements and financing arrangements. For small projects,
the fixed costs of undertaking particular kinds of financing may
be prohibitively expensive. For example, municipal bonds
require fixed costs associated with printing and preparation that
do not vary significantly with the size of the issue. By combining
numerous small construction projects, different financing
arrangements become more practical.

Finance
While individual projects may not be considered at the
corporate finance level, the problems and analysis procedures
described earlier are directly relevant to financial planning for
groups of projects and other investments. Thus, the net present
values of different financing arrangements can be computed
and compared. Since the net present values of different sub-
sets of either investments or financing alternatives are additive,
each project or finance alternative can be disaggregated for
closer attention or aggregated to provide information at a higher
decision making level.

Finance
Example 7-12: Basic types of repayment schedules for
loans.

Example 7-12: Basic types of
repayment schedules for loans.
Coupon bonds are used to obtain loans which involve no
payment of principal until the maturity date. By combining loans
of different maturities, however, it is possible to achieve almost
any pattern of principal repayments. However, the interest rates
charged on loans of different maturities will reflect market forces
such as forecasts of how interest rates will vary over time. As
an example, Table 7-8 illustrates the cash flows of debt service
for a series of coupon bonds used to fund a municipal
construction project; for simplicity not all years of payments are
shown in the table.

In this financing plan, a series of coupon bonds were sold with
maturity dates ranging from June 1988 to June 2012. Coupon
interest payments on all outstanding bonds were to be paid
every six months, on December 1 and June 1 of each year. The
interest rate or "coupon rate" was larger on bonds with longer
maturities, reflecting an assumption that inflation would increase
during this period. The total principal obtained for construction
was $26,250,000 from sale of these bonds.

This amount represented the gross sale amount before
subtracting issuing costs or any sales discounts; the amount
available to support construction would be lower. The maturity
dates for bonds were selected to require relative high
repayment amounts until December 1995, with a declining
repayment amount subsequently. By shifting the maturity dates
and amounts of bonds, this pattern of repayments could be
altered. The initial interest payment (of $819,760 on December
1, 1987), reflected a payment for only a portion of a six month
period since the bonds were issued in late June of 1987.

Date Maturing Principal
Corresponding
Interest Rate Interest Due Annual Debt Service
Dec. 1, 1987
June 1, 1988
Dec. 1, 1988
June 1, 1989
Dec. 1, 1989
June 1, 1990
Dec. 1, 1990
June 1, 1991
Dec. 1, 1991
June 1, 1992
Dec. 1, 1992
June 1, 1993
Dec. 1, 1993
.
.
.
June 1, 2011
Dec. 1, 2011
June 1, 2012
Dec. 1, 2012
$1,350,000
1,450,000
1,550,000
1,600,000
1,700,000
1,800,000
.
.
.
880,000
96,000
5.00%
5.25
5.50
5.80
6.00
6.20
.
.
.
8.00
8.00
$819,760
894,429
860,540
860,540
822,480
822,480
779,850
779,850
733,450
733,450
682,450
682,450
626,650
.
.
.
68,000
36,000
36,000
$819,760
3,104,969
3,133,020
3,152,330
3,113,300
3,115,900
3,109,100
.
.
.
984,000
996,000
TABLE 7-8 Illustration of a Twenty-five Year Maturity Schedule for Bonds

Facilities
7.8 Shifting Financial Burdens

7.8 Shifting Financial
Burdens
The different participants in the construction process have quite
distinct perspectives on financing. In the realm of project
finance, the revenues to one participant represent an
expenditure to some other participant. Payment delays from
one participant result in a financial burden and a cash flow
problem to other participants. It is common occurrence in
construction to reduce financing costs by delaying payments in
just this fashion. Shifting payment times does not eliminate
financing costs, however, since the financial burden still exists.

Burdens
Traditionally, many organizations have used payment delays
both to shift financing expenses to others or to overcome
momentary shortfalls in financial resources. From the owner's
perspective, this policy may have short term benefits, but it
certainly has long term costs. Since contractors do not have
large capital assets, they typically do not have large amounts of
credit available to cover payment delays. Contractors are also
perceived as credit risks in many cases, so loans often require
a premium interest charge. Contractors faced with large
financing problems are likely to add premiums to bids or not bid
at all on particular work. For example, A. Maevis noted: [3]

Burdens
...there were days in New York City when city agencies had
trouble attracting bidders; yet contractors were beating on the
door to get work from Consolidated Edison, the local utility.
Why? First, the city was a notoriously slow payer, COs (change
orders) years behind, decision process chaotic, and payments
made 60 days after close of estimate. Con Edison paid on the
20th of the month for work done to the first of the month.
Change orders negotiated and paid within 30 days-60 days. If a
decision was needed, it came in 10 days. The number of bids
you receive on your projects are one measure of your
administrative efficiency. Further, competition is bound to give
you the lowest possible construction price.

Burdens
Even after bids are received and contracts signed, delays in
payments may form the basis for a successful claim against an
agency on the part of the contractor.

Burdens
The owner of a constructed facility usually has a better credit
rating and can secure loans at a lower borrowing rate, but there
are some notable exceptions to this rule, particularly for
construction projects in developing countries. Under certain
circumstances, it is advisable for the owner to advance periodic
payments to the contractor in return for some concession in the
contract price. This is particularly true for large-scale
construction projects with long durations for which financing
costs and capital requirements are high. If the owner is willing to
advance these amounts to the contractor, the gain in lower
financing costs can be shared by both parties through prior
agreement.

Burdens
Unfortunately, the choice of financing during the construction
period is often left to the contractor who cannot take advantage
of all available options alone. The owner is often shielded from
participation through the traditional method of price quotation for
construction contracts. This practice merely exacerbates the
problem by excluding the owner from participating in decisions
which may reduce the cost of the project.

Burdens
Under conditions of economic uncertainty, a premium to hedge
the risk must be added to the estimation of construction cost by
both the owner and the contractor. The larger and longer the
project is, the greater is the risk. For an unsophisticated owner
who tries to avoid all risks and to place the financing burdens of
construction on the contractor, the contract prices for
construction facilities are likely to be increased to reflect the risk
premium charged by the contractors. In dealing with small
projects with short durations, this practice may be acceptable
particularly when the owner lacks any expertise to evaluate the
project financing alternatives or the financial stability to adopt
innovative financing schemes.

Burdens
However, for large scale projects of long duration, the owner
cannot escape the responsibility of participation if it wants to
avoid catastrophes of run-away costs and expensive litigation.
The construction of nuclear power plants in the private sector
and the construction of transportation facilities in the public
sector offer ample examples of such problems. If the
responsibilities of risk sharing among various parties in a
construction project can be clearly defined in the planning
stage, all parties can be benefited to take advantage of cost
saving and early use of the constructed facility.

Burdens
Example 7-13: Effects of payment delays

Example 7-13: Effects of
payment delays
Table 7-9 shows an example of the effects of payment timing on
the general contractor and subcontractors. The total contract
price for this project is $5,100,000 with scheduled payments
from the owner shown in Column 2. The general contractor's
expenses in each period over the lifetime of the project are
given in Column 3 while the subcontractor's expenses are
shown in Column 4. If the general contractor must pay the
subcontractor's expenses as well as its own at the end of each
period, the net cash flow of the general contractor is obtained in
Column 5, and its cumulative cash flow in Column 6.

payment delays
Period
Owner
Payments
General
Contractor'
s
Expenses
Subcontrac
tor's
Expenses
General
Contractor'
s
Net Cash
Flow
Cumulative
Cash Flow
1
2
3
4
5
6
Total
---
$950,000
950,000
950,000
950,000
1,300,000
$5,100,000
$100,000
100,000
100,000
100,000
100,000
-
$500,000
$900,000
900,000
900,000
900,000
900,000
-
$4,500,000
- $1,000,000
- 50,000
- 50,000
- 50,000
- 50,000
1,300,000
$100,000
- $1,000,000
- 1,050,000
- 1,100,000
- 1,150,000
- 1,200,000
100,000
TABLE 7-9 An Example of the Effects of Payment Timing

payment delays
In this example, the owner withholds a five percent retainage on
cost as well as a payment of $100,000 until the completion of
the project. This $100,000 is equal to the expected gross profit
of the contractor without considering financing costs or cash
flow discounting. Processing time and contractual agreements
with the owner result in a delay of one period in receiving
payments. The actual construction expenses from the viewpoint
of the general contractor consist of $100,000 in each
construction period plus payments due to subcontractors of
$900,000 in each period.

payment delays
While the net cash flow without regard to discounting or
financing is equal to a $100,000 profit for the general contractor,
financial costs are likely to be substantial. With immediate
payment to subcontractors, over $1,000,000 must be financed
by the contractor throughout the duration of the project. If the
general contractor uses borrowing to finance its expenses, a
maximum borrowing amount of $1,200,000 in period five is
required even without considering intermediate interest
charges. Financing this amount is likely to be quite expensive
and may easily exceed the expected project profit.

payment delays
By delaying payments to subcontractors, the general contractor
can substantially reduce its financing requirement. For example,
Table 7-10 shows the resulting cash flows from delaying
payments to subcontractors for one period and for two periods,
respectively. With a one period delay, a maximum amount of
$300,000 (plus intermediate interest charges) would have to be
financed by the general contractor. That is, from the data in
Table 7-10, the net cash flow in period 1 is -$100,000, and the
net cash flow for each of the periods 2 through 5 is given by:
$950,000 - $100,000 - $900,000 = -$ 50,000

payment delays
Finally, the net cash flow for period 6 is:
$1,300,000 - $900,000 = $400,000

payment delays
Thus, the cumulative net cash flow from periods 1 through 5 as
shown in Column 2 of Table 7-10 results in maximum shortfall
of $300,000 in period 5 in Column 3. For the case of a two
period payment delay to the subcontractors, the general
contractor even runs a positive balance during construction as
shown in Column 5. The positive balance results from the
receipt of owner payments prior to reimbursing the
subcontractor's expenses. This positive balance can be placed
in an interest bearing account to earn additional revenues for
the general contractor.

payment delays
Needless to say, however, these payment delays mean extra
costs and financing problems to the subcontractors. With a two
period delay in payments from the general contractor, the
subcontractors have an unpaid balance of $1,800,000, which
would represent a considerable financial cost.

payment delays
Period
One Period Payment Delay Two Period Payment Delay
Net Cash
Flow
Cumulative
Cash Flow
Net Cash
Flow
Cumulative
Cash Flow
1
2
3
4
5
6
7
- $100,000
- 50,000
- 50,000
- 50,000
- 50,000
400,000
- $100,000
- 150,000
- 200,000
- 250,000
- 300,000
100,000
- $100,000
850,000
- 50,000
- 50,000
- 50,000
400,000
- 900,000
- $100,000
750,000
700,000
650,000
600,000
1,000,000
100,000
TABLE 7-10 An Example of the Cash Flow Effects of Delayed Payments

Facilities
7.9 Construction Financing for Contractors

7.9 Construction Financing
for Contractors
For a general contractor or subcontractor, the cash flow profile
of expenses and incomes for a construction project typically
follows the work in progress for which the contractor will be paid
periodically. The markup by the contractor above the estimated
expenses is included in the total contract price and the terms of
most contracts generally call for monthly reimbursements of
work completed less retainage. At time period 0, which denotes
the beginning of the construction contract, a considerable sum
may have been spent in preparation.

for Contractors
The contractor's expenses which occur more or less
continuously for the project duration are depicted by a
piecewise continuous curve while the receipts (such as
progress payments from the owner) are represented by a step
function as shown in Fig. 7-1. The owner's payments for the
work completed are assumed to lag one period behind
expenses except that a withholding proportion or remainder is
paid at the end of construction. This method of analysis is
applicable to realistic situations where a time period is
represented by one month and the number of time periods is
extended to cover delayed receipts as a result of retainage.

for Contractors
Figure 7-1 Contractor's Expenses and
Owner's Payments

for Contractors
While the cash flow profiles of expenses and receipts are
expected to vary for different projects, the characteristics of the
curves depicted in Fig. 7-1 are sufficiently general for most
cases. Let Et represent the contractor's expenses in period t,
and Pt represent owner's payments in period t, for t=0,1,2,...,n
for n=5 in this case. The net operating cash flow at the end of
period t for t 0 is given by:

for Contractors
where At is positive for a surplus and negative for a shortfall.
The cumulative operating cash flow at the end of period t just
before receiving payment Pt (for t 1) is:

for Contractors
where Nt-1 is the cumulative net cash flows from period 0 to
period (t-1). Furthermore, the cumulative net operating cash
flow after receiving payment Pt at the end of period t (for t 1) is:

for Contractors
The gross operating profit G for a n-period project is defined as
net operating cash flow at t=n and is given by:
The use of Nn as a measure of the gross operating profit has
the disadvantage that it is not adjusted for the time value of
money.

for Contractors
Since the net cash flow At (for t=0,1,...,n) for a construction
project represents the amount of cash required or accrued after
the owner's payment is plowed back to the project at the end of
period t, the internal rate of return (IRR) of this cash flow is
often cited in the traditional literature in construction as a profit
measure. To compute IRR, let the net present value (NPV) of
At discounted at a discount rate i per period be zero, i.e.,

for Contractors
The resulting i (if it is unique) from the solution of Eq. (7.21) is
the IRR of the net cash flow At. Aside from the complications
that may be involved in the solution of Eq. (7.21), the resulting i
= IRR has a meaning to the contractor only if the firm finances
the entire project from its own equity. This is seldom if ever the
case since most construction firms are highly leveraged, i.e.
they have relatively small equity in fixed assets such as
construction equipment, and depend almost entirely on
borrowing in financing individual construction projects.

for Contractors
The use of the IRR of the net cash flows as a measure of profit
for the contractor is thus misleading. It does not represent even
the IRR of the bank when the contractor finances the project
through overdraft since the gross operating profit would not be
given to the bank.

for Contractors
Since overdraft is the most common form of financing for small
or medium size projects, we shall consider the financing costs
and effects on profit of - the use of overdrafts. Let be the
cumulative cash flow before the owner's payment in period
t including interest and be the cumulative net cash flow in
period t including interest. At t = 0 when there is no accrued
interest, = F0 and = N0. For t in period t can be
obtained by considering the contractor's expensesI Et to be
dispersed uniformly during the period.

for Contractors
The inclusion of enterest on contractor's expenses Et during
period t (for G 1) is based on the rationale that the S-shaped
curve depicting the contractor's expenses in Figure 7-1 is fairly
typical of actual situations, where the owner's payments are
typically made at the end of well defined periods.

for Contractors
Hence, interest on expenses during period t is approximated by
one half of the amount as if the expenses were paid at the
beginning of the period. In fact, Et is the accumulation of all
expenses in period t and is treated - as an expense at the end
of the period. Thus, the interest per period (for t 1) is the
combination of interest charge for Nt-1 in period t and that for
one half of Et in the same period t. If is negative and i is the
borrowing rate for the shortfall,

for Contractors
If is positive and h is the investment rate for the surplus,

for Contractors
Hence, if the cumulative net cash flow is negative, the interest
on the overdraft for each period t is paid by the contractor at the
end of each period. If Nt is positive, a surplus is indicated and
the subsequent interest would be paid to the contractor. Most
often, Nt is negative during the early time periods of a project
and becomes positive in the later periods when the contractor
has received payments exceeding expenses.

for Contractors
Including the interest accrued in period t, the cumulative cash
flow at the end of period t just before receiving payment Pt (for
t ≥1) is:

for Contractors
The gross operating profit at the end of a n-period project
including interest charges is:
where is the cumulative net cash flow for t = n.

for Contractors
Example 7-14: Contractor's gross profit from a project

Example 7-14: Contractor's
gross profit from a project
The contractor's expenses and owner's payments for a multi-
year construction project are given in Columns 2 and 3,
respectively, of Table 7-11. Each time period is represented by
one year, and the annual interest rate i is for borrowing 11%.
The computation has been carried out in Table 7-11, and the
contractor's gross profit G is found to be N5 = $8.025 million in
the last column of the table.

Example 7-14: Contractor's
gross profit from a project
TABLE 7-11 Example of Contractor's Expenses and Owner's
Payments ($ Million)
Period
t
Contractor's
Expenses
Et
Owner's
Payments
Pt
Net Cash
Flow
At
Cumulative
Cash
Before
Payments
Ft
Cumulative
Net Cash
Nt
0
1
2
3
4
5
Total
$3.782
7.458
10.425
14.736
11.420
5.679
$53.500
$0
6.473
9.334
13.348
16.832
15.538
$61.525
-$3.782
-0.985
-1.091
-1.388
+5.412
+9.859
+$8.025
-$3.782
-11.240
-15.192
-20.594
-18.666
-7.513
-$3.782
-4.767
-5.858
-7.246
-1.834
+8.025

for Contractors
Example 7-15: Effects of Construction Financing

Construction Financing
The computation of the cumulative cash flows including interest
charges at i = 11% for Example 7-14 is shown in Table 7-12
with gross profit = = $1.384 million. The results of
computation are also shown in Figure 7-2.

Period
(year)
t
Constructio
n Expenses
Et
Owner's
Payments
Pt
Annual
Interest
Cumulative
Before
Payments
Cumulative
Net Cash
Flow
0
1
2
3
4
5
$3.782
7.458
10.425
14.736
11.420
5.679
0
$6.473
9.334
13.348
16.832
15.538
0
-$0.826
-1.188
-1.676
-1.831
-1.121
-$3.782
-12.066
-17.206
-24.284
-24.187
-14.154
-$3.782
-5.593
-7.872
-10.936
-7.354
+1.384
TABLE 7-12 Example Cumulative Cash Flows Including Interests for a
Contractor ($ Million)

Figure 7-2 Effects of Overdraft Financing

Facilities
7.10 Effects of Other Factors on a Contractor's Profits

7.10 Effects of Other Factors
on a Contractor's Profits
In times of economic uncertainty, the fluctuations in inflation
rates and market interest rates affect profits significantly. The
total contract price is usually a composite of expenses and
payments in then-current dollars at different payment periods. In
this case, estimated expenses are also expressed in then-
current dollars.

During periods of high inflation, the contractor's profits are
particularly vulnerable to delays caused by uncontrollable
events for which the owner will not be responsible. Hence, the
owner's payments will not be changed while the contractor's
expenses will increase with inflation.

Example 7-16: Effects of Inflation

Inflation
Suppose that both expenses and receipts for the construction
project in the Example 7-14 are now expressed in then-current
dollars (with annual inflation rate of 4%) in Table 7-13. The
market interest rate reflecting this inflation is now 15%. In
considering these expenses and receipts in then-current dollars
and using an interest rate of 15% including inflation, we can
recompute the cumulative net cash flow (with interest). Thus,
the gross profit less financing costs becomes = = $0.4
million. There will be a loss rather than a profit after deducting
financing costs and adjusting for the effects of inflation with this
project.

Inflation
TABLE 7-13 Example of Overdraft Financing Based on Inflated
Dollars ($ Million)
Period
(year)
t
Constructi
on
Expenses
Et
Owner's
Payments
Pt
Annual
Interest
Cumulative
Before
Payments
Cumulative
Net Cash
Flow
0
1
2
3
4
5
$3.782
7.756
11.276
16.576
13.360
6.909
0
$6.732
10.096
15.015
16.691
18.904
0
-$1.149
-1.739
-2.574
-2.953
-1.964
-$3.782
-12.687
-18.970
-28.024
-29.322
-18.504
-$3.782
-5.955
-8.874
-13.009
-9.631
+0.400

Example 7-17: Effects of Work Stoppage at Periods of
Inflation

Example 7-17: Effects of Work
Stoppage at Periods of Inflation
Suppose further that besides the inflation rate of 4%, the project
in Example 7-16 is suspended at the end of year 2 due to a
labor strike and resumed after one year. Also, assume that
while the contractor will incur higher interest expenses due to
the work stoppage, the owner will not increase the payments to
the contractor. The cumulative net cash flows for the cases of
operation and financing expenses are recomputed and
tabulated in Table 7-14.

The construction expenses and receipts in then-current dollars
resulting from the work stopping and the corresponding net
cash flow of the project including financing (with annual interest
accumulated in the overdraft to the end of the project) is shown
in Fig. 7-3. It is noteworthy that, with or without the work
stoppage, the gross operating profit declines in value at the end
of the project as a result of inflation, but with the work stoppage
it has eroded - further to a loss of $3.524 million as indicated
by = -3.524 in Table 7-14.

Period
(year)
t
Constructi
on
Expenses
Et
Owner's
Payments
Pt
Annual
Interest
Cumulative
Before
Payments
Cumulative
Net Cash
Flow
0
1
2
3
4
5
6
$3.782
7.756
11.276
0
17.239
13.894
7.185
0
$6.732
10.096
0
15.015
16.691
18.904
0
-$1.149
-1.739
-1.331
-2.824
-3.330
-2.457
-$3.782
-12.687
-18.970
-10.205
-30.268
-32.477
22.428
-$3.782
-5.955
-8.874
-10.205
-15.253
-12.786
-3.524
TABLE 7-14 Example of the Effects of Work Stoppage and Inflation on a
Contractor ($ Million)

Figure 7-3 Effects of Inflation and Work Stoppage

Example 7-18: Exchange Rate Fluctuation

Example 7-18: Exchange
Rate Fluctuation
Contracting firms engaged in international practice also face
financial issues associated with exchange rate fluctuations.
Firms are typically paid in local currencies, and the local
currency may loose value relative to the contractor's home
currency. Moreover, a construction contractor may have to
purchase component parts in the home currency. Various
strategies can be used to reduce this exchange rate risk,
including:

Example 7-18: Exchange
Rate Fluctuation
• Pooling expenses and incomes from multiple projects to
reduce the amount of currency exchanged.
• Purchasing futures contracts to exchange currency at a
future date at a guaranteed rate. If the exchange rate does
not change or changes in a favorable direction, the
contractor may decide not to exercise or use the futures
contract.
• Borrowing funds in local currencies and immediately
exchanging the expected profit, with the borrowing paid by
eventual payments from the owner.

Facilities
7.11 References

7.11 References
1. Au, T., and C. Hendrickson, "Profit Measures for
Construction Projects," ASCE Journal of Construction
Engineering and Management, Vol. 112, No. CO-2, 1986,
pp. 273-286.
2. Brealey, R. and S. Myers, Principles of Corporate
Finance, McGraw-Hill, Sixth Edition, 2002.
3. Collier, C.A. and D.A. Halperin, Construction Funding:
Where the Money Comes From, Second Edition, John Wiley
and Sons, New York, 1984.

7.11 References
4. Dipasquale, D. and C. Hendrickson, "Options for Financing a
Regional Transit Authority," Transportation Research
Record, No. 858, 1982, pp. 29-35.
5. Kapila, Prashant and Chris Hendrickson, "Exchange Rate
Risk Management in International Construction
Ventures," ASCE J. of Construction Eng. and Mgmt, 17(4),
October 2001.
6. Goss, C.A., "Financing: The Contractor's
Perspective," Construction Contracting, Vol. 62, No. 10, pp.
15-17, 1980.

Facilities
7.13 Footnotes

7.13 Footnotes
1. This table is adapted from A.J. Henkel, "The Mechanics of a
Revenue Bond Financing: An Overview," Infrastructure
Financing, Kidder, Peabody & Co., New York, 1984.
2. The calculations for this bond issue are adapted from a
hypothetical example in F. H. Fuller, "Analyzing Cash Flows for
Revenue Bond Financing," Infrastructure Financing, Kidder,
Peabody & Co., Inc., New York, 1984, pp. 37-47.
3. Maevis, Alfred C.,"Construction Cost Control by the
Owner," ASCE Journal of the Construction Division, Vol. 106,
No. 4, December, 1980, pg. 444.

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