1.040/1.401 Project Management Spring 2007 Project Financing & Evaluation

1.040/1.401Project ManagementSpring 2007Project Financing & Evaluation Dr. SangHyun Lee lsh@mit.edu Department of Civil and Environmental Engineering Massachusetts Institute of Technology

Preliminaries • STELLAR access: to be announced • AS1 Survey due by tonight 12 pm • TP1 and AS2 are out

AS 2: Student Presentation • 10 minute presentation followed by 5 minute discussion • 1 or 2 presentations from Feb. 20 to Mar. 19 • Topics • Your past project experience (strongly recommended if you have any) • Size of project is not important! • Project main figures • Main managerial aspects • Project management practices • Problems, strengths, weaknesses, risks • Your learning • Emerging construction technologies (e.g., 4D CAD, Virtual Reality, Sensing, …) • Volunteers for next week?

Preliminaries • STELLAR access: to be announced • AS1 Survey due by tonight 12 pm • TP1 and AS2 are out • Pictures will be taken before you leave • Who we are • Don’t memorize course content. Understand it.

Outline • Session Objective & Context • Project Financing • Owner • Project • Contractor • Additional Issues • Financial Evaluation • Time value of money • Present value • Rates • Interest Formulas • NPV • IRR & payback period • Missing factors

Session Objective • The role of project financing • Mechanisms for project financing • Measures of project profitability

Project Management Phase DESIGN PLANNING DEVELOPMENT OPERATIONS CLOSEOUT FEASIBILITY Financing & Evaluation Risk

Context: Feasibility Phases • Project Concept • Land Purchase & Sale Review • Evaluation (scope, size, etc.) • Constraint survey • Site constraints • Cost models • Site infrastructural issues • Permit requirements • Summary Report • Decision to proceed • Regulatory process (obtain permits, etc) • Design Phase

Lecture 2 - References More details on: • Hendrickson PM for Construction on-line textbook • Chapter 7

Financing – Gross Cashflows Owner investment = contractor revenue

Financing – Gross Cashflows Construction Design/Preliminary Owner investment = contractor revenue

Financing – Gross Cashflows Construction Design/Preliminary Owner investment = contractor revenue • Early expenditure • Takes time to get revenue

Project Financing Aims to bridge this gap in the most beneficial way!

Critical Role of Financing • Makes projects possible • Has major impact on • Riskiness of construction • Claims • Prices offered by contractors (e.g., high bid price for late payment) • Difficulty of Financing is a major driver towards alternate delivery methods (e.g., Build-Operate-Transfer)

How Does Owner Finance a Project? • Public • Private • “Project” financing

Public Financing • Sources of funds • General purpose or special-purpose bonds • Tax revenues • Capital grants subsidies • International subsidized loans • Social benefits important justification • Benefits to region, quality of life, unemployment relief, etc. • Important consideration: exemption from taxes • Public owners face restrictions (e.g. bonding caps) • Major motivation for public/private partnerships • MARR (Minimum Attractive Rate of Return) much lower (e.g. 8-10%), often standardized

Private Financing • Major mechanisms • Equity • Invest corporate equity and retained earnings • Offering equity shares • Stock Issuance (e.g. in capital markets) • Must entice investors with sufficiently high rate of return • May be too limited to support the full investment • May be strategically wrong (e.g., source of money, ownership) • Debt • Borrow money • Bonds • Because higher costs and risks, require higher returns • MARR varies per firm, often high (e.g. 20%)

Private Owners w/Collateral Facility Distinct Financing Periods • Short-term construction loan • Bridge Debt • Risky (and hence expensive!) • Borrowed so owner can pay for construction (cost) • Long-term mortgage • Senior Debt • Typically facility is collateral • Pays for operations and Construction financing debts • Typically much lower interest • Loans often negotiated as a package construction w/o tangible operation w/ tangible time

“Project” Financing • Investment is paid back from the project profit rather than the general assets or creditworthiness of the project owners • For larger projects due to fixed cost to establish • Small projects not much benefit • Investment in project through special purpose corporations • Often joint venture between several parties • Need capacity for independent operation • Benefits • Off balance sheet (liabilities do not belong to parent) • Limits risk • External investors: reduced agency cost (direct investment in project) • Drawback • Tensions among stakeholders

Contractor Financing I • Payment schedule • Break out payments into components • Advance payment • Periodic/monthly progress payment (itemized breakdown structure) • Milestone payments • Often some compromise between contractor and owner • Architect certifies progress • Agreed-upon payments • retention on payments (usually, about 10%) • Often must cover deficit during construction • Can be many months before payment received

S-curve Work Man-hours months

8 100 90 7 80 6 70 5 60 4 50 $K Cumulative costs $K 40 3 30 2 20 1 10 0 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 Working days S-curve Cost Daily cost Cum. costs

Expense & Payment

Contractor Financing II • Owner keeps an eye out for • Front-end loaded bids (discounting) • Unbalanced bids

Contractor Financing II • Owner keeps an eye out for • Front-end loaded bids (discounting) • Unbalanced bids • Contractors frequently borrow from • Banks (Need to demonstrate low risk) • Interaction with owners • Some owners may assist in funding • Help secure lower-priced loan for contractor • Sometimes assist owners in funding! • Big construction company, small municipality • BOT

Contractor Financing III • Agreed upon in contract • Often structure proposed by owner • Should be checked by owner (fair-cost estimate) • Often based on “Masterformat” Cost Breakdown Structure (Owner standard CBS) • Certified by third party (Architect/engineer)

Latent Credit • Many people forced to serve as lenders to owner due to delays in payments • Designers • Contractors • Consultants • CM • Suppliers • Implications • Good in the short-term • Major concern on long run effects

Role of Taxes • Tax deductions for • Depreciation - Link • the process of recognizing the using up of an asset through wear and obsolescence and of subtracting capital expenses from the revenues that the asset generates over time in computing taxable income • Others

Develop or Not Develop • Is any individual project worthwhile? • Given a list of feasible projects, which one is the best? • How does each project rank compared to the others on the list?

Project A Construction=3 years Cost = $1M/year Sale Value=$4M Total Cost? Profit? Project B Construction=6 years Cost=$1M/year Sale Value=$8.5M Total Cost? Profit? Project Evaluation Example:

Quantitative Method • Profitability • Create value for the company

Profit Time factor?

Quantitative Method • Profitability • Create value for the company • Opportunity Cost • Time Value of Money • A dollar today is worth more than a dollar tomorrow • Investment relative to best-case scenario • E.g. Project A - 8% profit, Project B - 10% profit

Money Is Not Everything • Social Benefits • Hospital • School • Highway built into a remote village • Intangible Benefits (E.g, operating and competitive necessity) • New warehouse • New cafeteria

Outline • Session Objective & Context • Project Financing • Owner • Project • Contractor • Additional issues • Financial Evaluation • Time value of money • Present value • Rates • Interest Formulas • NPV • IRR & payback period • Missing factors

Basic Compounding • Suppose we invest $x in a bank offering interest rate i • If interest is compounded annually, asset will be worth • $x(1+i) after 1 year • $x(1+i)2 after 2 years • $x(1+i)3 after 3 years …. • $x(1+i)n after n years 0 1 $x(1+i) 2 $x(1+i)2 … n $x(1+i)n $x

Time Value of Money • If we assume • That money can always be invested in the bank (or some other reliable source) now to gain a return with interest later • That as rational actors, we never make an investment which we know to offer less money than we could get in the bank • Then • Money in the present can be thought as of “equal worth” to a larger amount of money in the future • Money in the future can be thought of as having an equal worth to a lesser “present value” of money

Equivalence of Present Values • Given a source of reliable investments, we are indifferent between any cash flows with the same present value – they have “equal worth” • This indifferences arises because we can convert one to the other with no extra expense

Preliminaries • STELLAR access: http://stellar.mit.edu/S/course/1/sp07/1.040/ • Next Tuesday Recitation: Skyscraper Part I • Please set up an appointment to discuss your AS2 if you choose emerging technologies (MF preferred) • Office: 1-174 • TA (50%) for our class • Send your resume (or brief your experience) by this Sunday

Outline • Session Objective & Context • Project Financing • Owner • Project • Contractor • Additional issues • Financial Evaluation • Time value of money • Present value • Rates • Interest Formulas • NPV • IRR & payback period • Missing factors

Time Value of Money: Revisit • If we assume • That money can always be invested in the bank (or some other reliable source) now to gain a return with interest later • That as rational actors, we never make an investment which we know to offer less money than we could get in the bank • Then • Money in the present can be thought as of “equal worth” to a larger amount of money in the future • Money in the future can be thought of as having an equal worth to a lesser “present value” of money

Present Value (Revenue) • How is it that some future revenue r at time t has a “present value”? • Answer: Given that we are sure that we will be gaining revenue r at time t, we can take and spend an immediate loan from the bank • We choose size of this loan l so that at time t, the total size of the loan (including accrued interest) is r • The loan l is the present value of r • l = PV(r)

Future to Present Revenue If I know this is coming… x t I can borrow this from the bank now PV(x) t I’ll pay this back to the bank later 0 -x The net result is that I can convert a sure x at time t into a (smaller) PV(x) now! PV(x) t

Present Value (Cost) • How is it that some future cost c at time t has a “present value”? • Answer: Given that we are sure that we will bear cost c at time t, we immediately deposit a sum of money x into the bank yielding a known return • We choose size of deposit x so that at time t, the total size of the investment (including accrued interest) is c • We can then pay off c at time t by retrieving this money from the bank • The size of the deposit (immediate cost) x is the present value of c.

1.040/1.401 Project Management Spring 2007 Project Financing & Evaluation