1 Appendix 4: Financial Risk Management: (Inflation) Overview: To develop an understanding of the ways in which financial risk from inflation can be minimized. Summary: A4.1 Inflation A4.2 Risk Management Under Inflation A4.3 Contingency A4.4 Escalation Clauses A4.6 Example of the Index Formula Methods

2 A4.1 Inflation

3 Inflation can have a significant impact on an international contractor’s profits: –erode value of financial assets (cash in bank, bonds) ; –pay more for goods than anticipated (estimate x, pay 1.1x); –make financial liabilities more attractive (although often counteracted by high interest rates accompanying high inflation); –example inflation rates between 1980 and 1985: Argentina: 342.8% per year; Brazil 147.7% per year; Bolivia 569.1% per year; Israel 196.3% per year. What causes inflation?: –too much money chasing too few goods, that is, demand exceeds supply so prices increase to compensate.

4 Problems caused for international contractor by inflation: –depreciation/devaluation of local currency; –import restrictions; –higher borrowing costs; –political chaos and labor unrest. Some approaches to mitigating inflation: –receivables must be collected as soon as possible; –keep idle cash to a minimum; –import materials from countries where prices are stable (although add in additional costs of packaging, shipping, insurance, customs duties..).

5 Inflation occurs in different areas: –general (throughout the economy); –specific to an industry, for example, a very large project can create a shortage in resources and thus inflation in construction costs and prices: Taipei 55 mile MRT, London Docklands Redevelopment. –specific to resources: high fuel prices due to shortage in oil;

6 Three basic types of contract pricing (with implications for international contracts operating in an inflationary environment): –fixed-price: lump-sum: a single sum is agreed in advance; unit-price: paid a rate agreed in advance (multiply by quantity); –cost-plus contract: paid for costs incurred plus a fee (usually stipulated limits). owners, worldwide, prefer the fixed price approach: –if inflation is high, then good to include a a provision for cost escalation (to share inflation risks between parties); –otherwise contractor will include a large contingency to cover inflation; –however, if inflation is high, the cost-plus fee is preferable for a contractor; –even when the risk is passed to the owner, inflation will still impact the contractor elsewhere (overhead, profit).

7 Three basic approaches to managing inflation risk in international contracts: –contracting approaches, for example: cost-plus fee? (as discussed above); advanced payment arrangements; add contingency to bid (as discussed above). –construction management approaches, for example: execute work using inflation prone items as early as possible; careful purchasing; –countertrade approaches: payments received in goods or materials (for example: oil). A4.2 Risk Management Under Inflation

8 NO YES Contracting: risk sharing? Contract on hard currency Cost-plus contract (cost/unit and quantity) Advance payment arrangement Escalation provisions Documentary proof method (cost/unit not quantity) Index formula method Inflation contingency Construction Management Countertrade Reducing Impacts of Inflation

9 Reducing risk through construction management: –Planning: review of cash flows as a defense against surprise; use an appropriate currency; –Maintaining current information: update control information with prices, indices and trends; –Payments: Scrutinize payment schedules (receive early); –Design time (where you offer design as well as construction, or management of both): expedite engineering to reduce project time; –Innovative contracting: for example, design-build and fast-tracking allows construction to start before design completed;

10 DESIGN TIME CONSTRUCT DESIGN TIME CONSTRUCT Design then build (traditional approach): Design-build (eg; turn-key projects): saving TIME Fast-track (where project can be phased): DESIGN CONSTRUCT 2 DESIGN CONSTRUCT 3 DESIGN CONSTRUCT 1 saving

11 –Procure certain long-lead times: identify and purchase items likely to delay the schedule or be in short supply; –Subdivide contracts: subdividing a large risky contract into several small ones spreads the risk;

12 Contingency is specific provision for variable elements of cost. Variable components can be either: –unforeseeable, for example: ground obstructions in piling operations; –foreseeable, for example: a prescribed increase in interest rates on a loan; –partially foreseeable: future inflation rates (note, the further into the future, the more difficult it is to predict). A4.3 Contingency

13 Factors determining the amount of contingency added: –Magnitude of the Firm: where there is uncertainty, a bid near the expected cost could result in either a loss or profit; in such cases, the greater the uncertainty, then the greater the possible loss or profit; over many projects, the uncertainties will balance out; large companies, operating many projects, can afford the risk since they can carry losses and survive for the projects where they will make a large profit; small companies cannot carry a large loss on a project, and so must include a LARGER contingency to minimize this risk; so small companies will either be taking on a larger risk than large companies, or will have to bid higher;

14 –Estimate Accuracy: a contractor will add a larger contingency when they are less sure about the accuracy of their bid; a major determinant of the level of confidence in the accuracy of a bid is the amount of information available for producing the estimate: overseas contracts can be subject to high levels of uncertainty due to lack of prior experience of prices, delivery efficiency, etc.. ;

15 –Form of Financing: Government financed projects are sensitive to cost overruns reimbursement requires a lot of red tape; the incentive for a contractor, therefore, is to avoid this problem by including a large contingency; Joint-ventures (a good approach for international projects) often include lengthy contractual procedures for evaluating cost overruns: the incentive for a contractor, therefore, is to include a large contingency; If a project is financed exclusively by internal sources, there is less pressure to make large short term returns, and so contingency tends to be smaller (one-off financiers want a profit this time); –Previous Experience with Inflation: A contractor working overseas may be working in a high inflation environment: if this is their first contract in that country, it is possible that they will have little experience of working in a high inflation environment; in this case, it is likely that they will include a large contingency to cover the uncertainty.

16 Many long term contracts contain escalation (fluctuation) clauses to counter the effects of inflation. It is a clause in a contract which automatically revises the contract price, note: –not applicable to changes in the type and quantity of work (this can be handled in other ways); A4.4 Escalation Clauses

17 –is applicable to significant changes in the cost of construction (or significant changes in relevant exchange rates): equipment; material; labor; construction services; taxes; import tariffs; –can be used in fixed price contracts (lump-sum and unit price) (no need for this in cost-plus contracts); –The contract should specify whether prices can adjust DOWN as well as UP (if, say, oil prices fell); –usually only included for contracts that are at least 12 to 18 months in duration, though may be less in countries where inflation is very high.

18 Advantages (from owners perspective): –significantly removes the need for contingency sums; –savings to owner if prices turn-down; –at least savings to owner if prices do not go up (compared to contingency approach); Disadvantages (from owners perspective): –price to owner increases with inflation; –little incentive to contractor to keep costs down; –general inflation indices may not reflect increased costs to the contractor; –more owner participation is required to ensure that escalation clauses are appropriate (determination) and to ensure that they properly implemented (verification).

19 Types of escalation clause: –Day-One-Dollar-One Clauses: owner pays the difference in increase in cost between the date of the contract and the time of installation; –Significant Increase Clauses: owner reimburses the difference in cost as before, but only for large increases often expressed as a percentage (risk is shared); –Delay Clauses: owner reimburses the difference in cost (through inflation), but only increases incurred during a period of delay (the types of delay need to be stipulated, and often the contractor is responsible for the earlier part of any delay).

20 Two types of method are used for determining Price Escalation: –Index Formula Method: where refer to some index of inflation: most governments produce a consumer price index (measure of general inflation); however, governments may purposefully understate the true rate; remember, general inflation may not reflect inflation in the type of work you are involved in; –Documentary Proof method: here the actual costs to the owner are used in the calculation: this can be more time consuming to compute since it requires a compilation of evidence of both: the original expected costs of all relevant materials, equipment, labor, etc; and the actual costs of all relevant materials, equipment, labor, etc.

21 Index Formula Method in detail: –The method requires agreement on both: an index to use as a measure of inflation; and a formula for applying the index to costs: –Indices: A price index is a statistical measure of changes in price of goods and services; it is calculated as the ratio of prices at any point in time to prices at a base point in time (and is thus dimensionless); for example, if the base price of a commodity in the following example is time 1, then: time 1 = $532index = 532/532 = time 2 = $530index = 530/532 = (deflation) time 3 = $541index = 541/532 = (inflation) time 4 = $547index = 547/532 = (inflation) time 5 = $546index = 546/532 = (deflation)

22 –Two broad types of indices used in escalation clauses are: price indices (used to revise material costs); and earnings series (used to revise labor costs). –The US Department of Labor’s Bureau of Labor Statistics publishes several indices used in escalation clauses: Consumer Price Index; Producer Price Index; and Gross Average Hourly Earnings Series. –However, these are only relevant to the USA. –Use appropriate indices from the country in which the product/service etc.. is being purchased: –For example, in the UK, indices applied to escalation include: RPI ( general inflation); Building Cost Indices, Tender Price Indices (industry measures); NED02 (specific work categories). –Note, some countries may produce limited set of indices.

23 –The second factor is the formula in which the indices are applied to costs: a typical example: P1 = (P0 / 100) · (a + b·M1/M0 + c ·N1/N0 + d ·W1/W0) P1 = price payable; P0 = initial price stipulated in the contract; note, a, b, c, and d specify the proportions of different components; a is the proportion of the price excluded from adjustment; b is the proportion of an index related to one category of materials; c is the proportion of an index related to another category of materials; d is the proportion of an index related to wages; note: a + b + c + d = 100; M1 = current price of comparable materials to category b; M0 = base price (at contract start) of materials in category b; N1 = current price of comparable materials to category c; N0 = base price (at contract start) of materials in category c; W1 = current price of wages; W0 = base price (at contract start) of wages;

24 Calculate P1 for the following example: P0 = $50,000; a = 10%; b = 30%; c = 30%; d = 30%; M1 = $10,600; M0 = $10,000; N1 = $10,800; N0 = 11,000; W1 = 15,000; W0 = 14,000; Note, if the work is delayed, the contract may stipulate that the indices be calculated before the delay if the delay is the fault of the contractor.