Chapter 2 Project Financing Dr. Nabil I El Sawalhi Associate Professor of Construction Management AEPM 21

Critical Role of Financing Makes projects possible Difficulty of Financing is a major driver towards alternate delivery methods –Flexibility on owner financing –Flexibility for contractor financing Has major impact on –Riskiness of construction –Claims –Types of construction undertaken –Prices offered by Contractors AEPM 22

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. AEPM 23

The project finance problem is to obtain funds to bridge the time between making expenditures and obtaining revenues. 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. AEPM 24

Institutional Arrangements for Facility Financing Financing arrangements differ sharply by type of owner and by the type of facility construction. municipal projects are financed in the United States with tax exempt bonds for which interest payments to a lender are exempt from income taxes. Different institutional arrangements have evolved for specific types of facilities and organizations. AEPM 25

Private finance A private corporation 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. AEPM 26

Public finance 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 Grants from government are also an important source of funds for state, county, city or other local agencies. AEPM 27

Cost of borrowing money 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. AEPM 28

security for 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. AEPM 29

Lending contract 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 AEPM 210

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 available on positive balances is less than the interest rate charged for borrowing. AEPM 211

Project versus Corporate 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. AEPM 212

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. AEPM 213

Construction Financing for Contractors 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. AEPM 214

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. AEPM 215

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. AEPM 216

Project Financing and Evaluation Project Financing Public Private Project Contractor AEPM 217

Public Financing Sources of funds –General purpose or special-purpose bonds –Tax revenues –Capital grants subsidies –International subsidized loans Public owners face restrictions in funding projects and this leads to Major motivation for public/private partnerships Owners tend to group small construction projects to lower the fixed financing costs  Social benefits important justification to encourage financing such as benefits to region, quality of life, unemployment relief The public finance is exempted from taxes MARR (Min Acceptable Rate of Return) much lower (e.g. 10%), often standardized AEPM 218

Private Financing Major mechanisms –Debt Borrow money Retained earnings Bonds –Equity Offering equity shares Must encourage investors with sufficiently high rate of return Because higher costs and risks, require higher returns MARR varies per firm, often high (e.g. 20%) AEPM 219

Contractor Financing I Payment schedule –Break out payments into components –Often some compromise between contractor and owner –Architect certifies progress Contractor applies for agreed -upon payments Often must cover deficit during construction (<<than total cost) –Often schedule may not capture costs (equipment) –Can be many months before payment received –% Retainage standard AEPM 220

AEPM 221

Contractor Financing II Owner keeps eye out for –Front-end loaded bids (discounting) –Unbalanced bids Frequently borrow from –Reserve –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! AEPM 222

Contractor Financing III 3-way agreements sometimes sought between –Contractor –Owner –Bank –Basically, bank pays contractor according to progress Payment request submitted with progress report monthly by contractor Owner then submits “draw request” to bank AEPM 223

Assignment # 1 Define the followings in not more that 5 lines: Equity share Inflation Bond AEPM 224