Project financing evaluation

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1.040/1.401 Project Management Spring 2007 Project 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      Financial Evaluation        Owner Project Contractor Additional Issues 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 FEASIBILITY DESIGN PLANNING DEVELOPMENT Financing & Evaluation Risk CLOSEOUT OPERATIONS 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 Outline  Session Objective & Context  Project Financing      Financial Evaluation        Owner Project Contractor Additional Issues Time value of money Present value Rates Interest Formulas NPV IRR & payback period Missing factors Financing – Gross Cashflows years OWNER investment operation incomes owner cashflow owner cum cashflow 1 2 3 4 5 6 7 8 9 10 ($10,000,000) ($20,000,000) $2,000,000 $4,000,000 $6,000,000 $6,000,000 $0 ($10,000,000) ($20,000,000) $2,000,000 $4,000,000 $6,000,000 $6,000,000 $0 ($10,000,000) ($30,000,000) ($28,000,000) ($24,000,000) ($18,000,000) ($12,000,000) CONTRACTOR costs ($4,000,000) ($7,000,000) ($14,000,000) revenues $0 $10,000,000 $20,000,000 contractor cashflow ($4,000,000) $3,000,000 $6,000,000 contractor cum cashflow ($4,000,000) ($1,000,000) $5,000,000 Owner investment = contractor revenue $0 $0 $0 $5,000,000 $0 $0 $0 $5,000,000 $0 $0 $0 $5,000,000 $0 $0 $0 $5,000,000 $6,000,000 $6,000,000 ($6,000,000) $6,000,000 $6,000,000 $0 $6,000,000 $6,000,000 $6,000,000 $0 $0 $0 $5,000,000 $0 $0 $0 $5,000,000 $0 $0 $0 $5,000,000 Financing – Gross Cashflows Design/Preliminary years OWNER investment operation incomes owner cashflow owner cum cashflow 1 Construction 2 3 4 5 6 7 8 9 10 ($10,000,000) ($20,000,000) $2,000,000 $4,000,000 $6,000,000 $6,000,000 $0 ($10,000,000) ($20,000,000) $2,000,000 $4,000,000 $6,000,000 $6,000,000 $0 ($10,000,000) ($30,000,000) ($28,000,000) ($24,000,000) ($18,000,000) ($12,000,000) CONTRACTOR costs ($4,000,000) ($7,000,000) ($14,000,000) revenues $0 $10,000,000 $20,000,000 contractor cashflow ($4,000,000) $3,000,000 $6,000,000 contractor cum cashflow ($4,000,000) ($1,000,000) $5,000,000 Owner investment = contractor revenue $0 $0 $0 $5,000,000 $0 $0 $0 $5,000,000 $0 $0 $0 $5,000,000 $0 $0 $0 $5,000,000 $6,000,000 $6,000,000 ($6,000,000) $6,000,000 $6,000,000 $0 $6,000,000 $6,000,000 $6,000,000 $0 $0 $0 $5,000,000 $0 $0 $0 $5,000,000 $0 $0 $0 $5,000,000 Financing – Gross Cashflows Design/Preliminary years OWNER investment operation incomes owner cashflow owner cum cashflow 1 Construction 2 3 4 5 6 7 8 9 10 ($10,000,000) ($20,000,000) $2,000,000 $4,000,000 $6,000,000 $6,000,000 $0 ($10,000,000) ($20,000,000) $2,000,000 $4,000,000 $6,000,000 $6,000,000 $0 ($10,000,000) ($30,000,000) ($28,000,000) ($24,000,000) ($18,000,000) ($12,000,000) CONTRACTOR costs ($4,000,000) ($7,000,000) ($14,000,000) revenues $0 $10,000,000 $20,000,000 contractor cashflow ($4,000,000) $3,000,000 $6,000,000 contractor cum cashflow ($4,000,000) ($1,000,000) $5,000,000 $0 $0 $0 $5,000,000 $0 $0 $0 $5,000,000 $0 $0 $0 $5,000,000 $0 $0 $0 $5,000,000 $6,000,000 $6,000,000 ($6,000,000) $6,000,000 $6,000,000 $0 $6,000,000 $6,000,000 $6,000,000 $0 $0 $0 $5,000,000 $0 $0 $0 $5,000,000 $0 $0 $0 $5,000,000 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 Outline  Session Objective & Context  Project Financing      Financial Evaluation        Owner Project Contractor Additional Issues Time value of money Present value Rates Interest Formulas NPV IRR & payback period Missing factors Public Financing  Sources of funds      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)   General purpose or special-purpose bonds Tax revenues Capital grants subsidies International subsidized loans 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        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   Stock Issuance (e.g. in capital markets) 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    Long-term mortgage  Senior Debt     Risky (and hence expensive!) Borrowed so owner can pay for construction (cost) 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 Outline  Session Objective & Context  Project Financing      Financial Evaluation        Owner Project Contractor Additional Issues Time value of money Present value Rates Interest Formulas NPV IRR & payback period Missing factors “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   Investment in project through special purpose corporations    Often joint venture between several parties Need capacity for independent operation Benefits     Small projects not much benefit Off balance sheet (liabilities do not belong to parent) Limits risk External investors: reduced agency cost (direct investment in project) Drawback  Tensions among stakeholders Outline  Session Objective & Context  Project Financing      Financial Evaluation        Owner Project Contractor Additional Issues Time value of money Present value Rates Interest Formulas NPV IRR & payback period Missing factors Contractor Financing I  Payment schedule  Break out payments into components       Often some compromise between contractor and owner Architect certifies progress Agreed-upon payments    Advance payment Periodic/monthly progress payment (itemized breakdown structure) Milestone 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 S-curve Cost 8 100 90 7 80 6 5 60 50 $K 4 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 Cumulative costs $K 70 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    Contractors frequently borrow from   Front-end loaded bids (discounting) Unbalanced bids 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) Outline  Session Objective & Context  Project Financing      Financial Evaluation        Owner Project Contractor Additional Issues Time value of money Present value Rates Interest Formulas NPV IRR & payback period Missing factors 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 Outline  Session Objective & Context  Project Financing      Financial Evaluation        Owner Project Contractor Additional Issues Time value of money Present value Rates Interest Formulas NPV IRR & payback period Missing factors 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 Evaluation Example:  Project A  Project B  Construction=3 years  Construction=6 years  Cost = $1M/year  Cost=$1M/year  Sale Value=$4M  Sale Value=$8.5M  Total Cost?  Total Cost?  Profit?  Profit? Quantitative Method  Profitability  Create value for the company Profit TOTAL EQUIVAL. $ REVENUES 5,500,000.00 COSTS 4,600,000.00 Project management 400,000.00 Engineering 800,000.00 Material & transport 2,200,000.00 Construction/commissioning 1,300,000.00 Contingencies GROSS MARGIN Time factor? 200,000.00 900,000.00 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      Financial Evaluation        Owner Project Contractor Additional issues 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     0 $x $x(1+i) $x(1+i)2 $x(1+i)3 $x(1+i)n after 1 year after 2 years after 3 years …. after n years 1 $x(1+i) 2 $x(1+i)2 … n $x(1+i)n 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      Financial Evaluation        Owner Project Contractor Additional issues 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 0 PV(x) I’ll pay this back to the bank later-x The net result is that I can convert a sure x at time t t into a (smaller) PV(x) now! 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. Future to Present Cost t 0 If I know this cost is coming… -x I retrieve this back from the bank later I can deposit this in the bank now PV(x) x t t PV(x) The net result is that I can convert a sure cost x at time t into a (smaller) cost of PV(x) now! Summary  Because we can flexibly switch from one such value to another without cost, we can view these values as equivalent PV v’ FV 0 v t Summary  Because we can flexibly switch from one such value to another without cost, we can view these values as equivalent 0 PV  v’ = v(1+i)t FV v t Given a reliable source offering annual return i (i.e., interest) we can shift without additional costs between cash v at time 0 and v(1+i)t at time t Outline  Session Objective & Context  Project Financing      Financial Evaluation        Owner Project Contractor Additional issues Time value of money Present value Rates Interest Formulas NPV IRR & payback period Missing factors Rates  Difference between PV (v) and FV ( =v(1+i)t ) depends on i and t. Rates  Difference between PV (v) and FV ( =v(1+i)t ) depends on i and t.  Interest Rate    Contractual arrangement between a borrower and a lender Discount Rate (real change in value to a person or group)  Worth of Money + Risk  Discount Rate > Interest Rate Minimum Attractive Rate of Return (MARR)  Minimum discount rate accepted by the market corresponding to the risks of a project (i.e., minimum standard of desirability) Choice of Discount Rate r = rf + ri + rr Where: r rf ri rr is the discount rate the risk free interest rate. Normally government bond Rate of inflation. It is measured by either by consumer price index or GDP deflator. Risk factor consisting of market risk, industry risk, firm specific risk and project risk Market Risk rr Industry Risk = Firm specific Risk Project Risk GDP = Gross Domestic Product Outline  Session Objective & Context  Project Financing      Financial Evaluation        Owner Project Contractor Additional issues Time value of money Present value Rates Interest Formulas NPV IRR & payback period Missing factors Interest Formulas  i = Effective interest rate per interest period (discount rate or MARR)  n = Number of compounding periods  PV = Present Value  FV = Future Value  A = Annuity (i.e., a series of payments of set size) at end-of-period Interest Formulas: Payment  Single Payment Compound Amount Factor (F=P×Factor)  Factor that will make your present value future value in single payment  (F/P, i, n) = (1 + i )n 0 1 2 … n F P Interest Formulas: Payment  Single Payment Present Value Factor (P=F×Factor)  Factor that will make your future value present value in single payment  (P/F, i, n) = 1/ (1 + i )n = 1/ (F/P, i, n) 0 1 … n-1 n P F Interest Formulas: Payment - Example  If you wish to have $100,000 at the end of five years in an account that pays 12 percent annually, how much would you need to deposit now? Interest Formulas: Payment - Example  If you wish to have $100,000 at the end of five years in an account that pays 12 percent annually, how much would you need to deposit now? 0 P=?  n F=$100,000 (P/F, 0.12, 5) or (F/P, 0.12, 5)? Interest Formulas: Payment - Example  If you wish to have $100,000 at the end of five years in an account that pays 12 percent annually, how much would you need to deposit now?  P = F×(P/F, 0.12, 5)  P = 100,000 × (P/F, 0.12, 5)  P = 100,000 × 0.5674 = $56,740 Interest Formulas: Series  Uniform Series Compound Amount Factor (F=A×Factor)  Factor that will make your annuity value future value in series payment  (F/A, i, n) =[(1+i)n - 1]/ i F 0  1 2 … n A A A A Annuity occurs at the end of the interest period Interest Formulas: Series  Uniform Series Compound Amount Factor (F=A×Factor)  Factor that will make your annuity value future value in series payment  (F/A, i, n) =[(1+i)n - 1]/ i F=A F 0 1 2 … n A A A A Interest Formulas: Series  Uniform Series Compound Amount Factor (F=A×Factor)  Factor that will make your annuity value future value in series payment  (F/A, i, n) =[(1+i)n - 1]/ i F = A+A(1+i) F 0 1 2 … n A A A A Interest Formulas: Series  Uniform Series Compound Amount Factor (F=A×Factor)  Factor that will make your annuity value future value in series payment  (F/A, i, n) =[(1+i)n - 1]/ i F = A + A(1+i) + … + A(1 + i )n-1 0 1 2 … n A A A A Interest Formulas: Series  Uniform Series Sinking Fund Factor (A=F×Factor)  Factor that will make your future value annuity value in series payment  (A/F, i, n) = i / [ (1 + i )n – 1] = 1 / (F/A, i, n) 0 1 2 … n A A A A F Interest Formulas: Series  Uniform Series Present Value Factor (P=A×Factor)  Factor that will make your annuity value present value in series payment  (P/A, i, n) = [ (1 + i )n -1 ] / [ i (1 + i )n ] P 0 1 2 … n A A A A Interest Formulas: Series  Uniform Series Present Value Factor (P=A×Factor)  Factor that will make your annuity value present value in series payment  (P/A, i, n) = [ (1 + i )n -1 ] / [ i (1 + i )n ] P = A/ (1 + i ) 0 1 2 … n A A A A Interest Formulas: Series  Uniform Series Present Value Factor (P=A×Factor)  Factor that will make your annuity value present value in series payment  (P/A, i, n) = [ (1 + i )n -1 ] / [ i (1 + i )n ] P = A/(1 + i ) + A/(1 + i )2 0 1 2 … n A A A A Interest Formulas: Series  Uniform Series Present Value Factor (P=A×Factor)  Factor that will make your annuity value present value in series payment  (P/A, i, n) = [ (1 + i )n -1 ] / [ i (1 + i )n ] P = A/(1 + i ) + A/(1 + i )2 + … + A/(1 + i )n 0 Verify it! 1 2 … n A A A A Interest Formulas: Series  Uniform Series Capital Recovery Factor (A=P×Factor)  Factor that will make your present value annuity value in series payment  (A/P, i, n) = [i (1 + i )n / [(1 + i )n – 1] = 1 / (P/A, i, n) 0 P Verify it! 1 2 … n A A A A Interest Formulas: Series - Example  A ranch is offered for sale in Mexico with a 15 year mortgage rate at 40% compounded annually, and 20% down payment. Annual payments are to be made. The first cost of the ranch is 5 million pesos. What yearly payment is required? Interest Formulas: Series - Example  A ranch is offered for sale in Mexico with a 15 year mortgage rate at 40% compounded annually, and 20% down payment. Annual payments are to be made. The first cost of the ranch is 5 million pesos. What yearly payment is required?  Down Payment = 5,000,000 * 0.2 = 1,000,000  P = 5,000,000 – 1,000,000 = 4,000,000  A = P * (which factor?) Interest Formulas: Series - Example  A ranch is offered for sale in Mexico with a 15 year mortgage rate at 40% compounded annually, and 20% down payment. Annual payments are to be made. The first cost of the ranch is 5 million pesos. What yearly payment is required?  Down Payment = 5,000,000 * 0.2 = 1,000,000  P = 5,000,000 – 1,000,000 = 4,000,000  A = P * (which factor?) = P * (A/P, 0.4, 15)  A = 4,000,000 * 0.40259 = 1,610,400 pesos/year Equipment Example  $ 20,000 equipment expected to last 5 years  $ 4,000 salvage value  Minimum attractive rate of return 15%  What are the?  A - Annual Equivalent  P - Present Equivalent Equipment Example Equipment Example  A = -20,000 * (A/P, 0.15, 5) + 4,000 * (A/F, 0.15, 5) = -20,000 * (0.2983) + 4,000 * (0.1483) = -5,373  P = -20,000 + 4,000 * (P/F, 0.15, 5) = -20,000 + 4,000 * (0.4972) = -18,011 Outline  Session Objective & Context  Project Financing      Financial Evaluation        Owner Project Contractor Additional issues Time value of money Present value Rate Interest Formulas NPV IRR & payback period Missing factors Net Present Value  Suppose we had a collection (or stream, flow) of costs and revenues in the future  The net present value (NPV) is the sum of the present values for all of these costs and revenues  Treat revenues as positive and costs as negative Calculation of Net Present Value Total Revenue (R) (+) Various Costs (C) (-) Calculate Gross Return Tax (-) Calculate Net Return Discount Rate (r) PV of Net Return Initial Invest (-I) NPV of the Project Net Present Value Decision Rule NPV   > = < 0 Accept the project Indifferent to the project Reject the project Accept a project which has 0 or positive NPV Alternatively, Use NPV to choose the best among a set of (mutually exclusive) alternative projects  Mutually exclusive projects: the acceptance of a project precludes the acceptance of one or more alternative projects. Project Evaluation Example Revisit: Which one is better?  Project A  Project B  Construction=3 years  Construction=6 years  Cost = $1M/year  Cost = $1M/year  Sale Value = $4M  Sale Value = $8.5M  Total Cost?  Total Cost?  Profit?  Profit? Drawing out the examples  Project A $4M 1 2 3 $1M $1M $1M 0  Project B 0 $8.5M 6 1 $1M $1M • Assume 10% discount rate • Link $1M $1M $1M $1M Or Using Interest Formulas  Project A   -$1M * (P/A, 0.1, 3) + $4M * (P/F, 0.1, 3) Project B  -$1M * (P/A, 0.1, 6) + $8.5M * (P/F, 0.1, 6) • Assume 10% discount rate Four Independent Projects  The cash flow profiles of four independent projects are shown below. Using a MARR of 20%, determine the acceptability of each of the projects on the basis of the net present value criterion for accepting independent projects. Solution [NPV1]20% = -77 + (235)(P/F, 0.2, 5) = -77 + 94.4 = 17.4 NPV1 – Cash Flow Year 0 1 $235 M 2 3 4 5 4 5 -$77 M [NPV2]20% = -75.3 + (28)(P/A, 0.2, 5) = -75.3 + 83.7 = 8.4 NPV2 – Cash Flow Year 0 -$75.3 M 1 $28 M each year 2 3 Solution [NPV3]20% = -39.9 + (28)(P/A, 20%, 4) - (80)(P/F, 20%, 5) = -39.9 + 72.5 - 32.2 $28 M each year = 0.4 NPV3 – Cash Flow Year 0 1 2 3 4 -$39.9 M -$80 M [NPV4]20% = 18 + (10)(P/F, 20%, 1) - (40)(P/F, 20%, 2)               - (60)(P/F, 20%, 3) + (30)(P/F, 20%, 4) + (50)(P/F, 20%, 5) = 18 + 8.3 - 27.8 - 34.7 + 14.5 + 20.1 = -1.6 NPV4 – Cash Flow $50 M $30 M $18 M $10 M Year 0 5 1 2 -$40 M 3 4 -$60 M 5 Source: Hendrickson and Au, 1989/2003 Solution [NPV1] = 17.4 [NPV2] = 8.4 [NPV3] = 0.4 [NPV4] = -1.6 Source: Hendrickson and Au, 1989/2003 Discount Rate in NPV  NPV (and PV) is relative to a discount rate  In the absence of risk or inflation, this is just the interest rate of the “reliable source” (opportunity cost)  Correct selection of the discount rate is fundamental. If too high, projects that could be profitable can be rejected. If too low, the firm will accept projects that are too risky without proper compensation.  Its choice can easily change the ranking of projects.  Example Selection of Discount Rate: Example  2 pieces of equipment: one needs a human operator (initial cost $10,000, annual $4,200 for labor); the second is fully automated (initial cost $18,000, annual #3,000 for power). n=10years.  Is the additional $8,000 in the initial investment of the second equipment worthy the $1,200 annual savings? (discount rate: 5 or 10%) Link Selection of Discount Rate: Example  2 pieces of equipment: one needs a human operator (initial cost $10,000, annual $4,200 for labor); the second is fully automated (initial cost $18,000, annual #3,000 for power). n=10years.  Is the additional $8,000 in the initial investment of the second equipment worthy the $1,200 annual savings? (discount rate: 5 or 10%)  There is a critical value of i that changes the equipment choice (approximately 8.15%)  Example: The US Federal Highway Administration promulgated a regulation in the early 1970s that the discount rate for all federally funded highways would be zero. This was widely interpreted as a victory for the cement industry over asphalt industry. Roads made of concrete cost significantly more than those of made of asphalt while requiring less maintenance and less replacement [Shtub et al., 1994] - Link Outline  Session Objective & Context  Project Financing      Financial Evaluation        Owner Project Contractor Additional issues Time value of money Present value Rate Interest Formulas NPV IRR & payback period Missing factors Internal Rate of Return (IRR)  Defined as the rate of return that makes the NPV of the project equal to zero  To see whether the project’s rate of return is equal to or higher than the rate of the firm to expect to get from the project IRR Calculation Example  NPV = -20,000 + 5,600 (P/A, i, 5) + 4,000 (P/F, i, 5)  Link Relationship between NPV & IRR IRR IRR Investment Rule r- > = Accept Indifferent Reject r* < - r = IRR, * r = MARR “Accept a project with IRR larger than MARR” Alternatively, “Maximize IRR across mutually exclusive projects.” IRR vs. NPV      Oftentimes, IRR and NPV give the same decision/ranking among projects. IRR only looks at rate of gain – not size of gain IRR does not require you to assume (or compute) a discount rate. IRR ignores capacity to reinvest IRR may not be unique NPV Discount Rate Link IRR vs. NPV        Oftentimes, IRR and NPV give the same decision/ranking among projects. IRR only looks at rate of gain – not size of gain IRR does not require you to assume (or compute) a discount rate. IRR ignores capacity to reinvest IRR may not be unique Use both NPV (size) and IRR together (rate) However, Trust the NPV: It is the only criterion that ensures wealth maximization. It measures how much richer one will become by undertaking the investment opportunity. Payback Period  Payback period (“Time to return”)   Minimal length of time over which benefits repay costs Typically only used as secondary assessment Payback Period  Payback period (“Time to return”)     Minimal length of time over which benefits repay costs Typically only used as secondary assessment Important for selection when the risk is extremely high Drawbacks   Ignores what happens after payback period Does not take into account discounting Comparing Projects  Financing has major impact on project selection   Suppose that one had to choose between 2 investment projects How can one compare them? Comparing Projects  Financing has major impact on project selection   Suppose that one had to choose between 2 investment projects How can one compare them?  Use NPV  Verify IRR  Check payback period Other Methods  Benefit-Cost ratio (benefits/costs)      Discounting still generally applied Accept if >1 (benefits > costs) Common for public projects Does not consider the absolute size of the benefits Cost-effectiveness   Looking at non-economic factors Discounting still often applied for non-economic   $/Life saved $/Life quality Inflation & Deflation  Inflation means that the prices of goods and services increase over time either imperceptibly or in leaps and bounds. Inflation effects need to be included in investment because cost and benefits are measured in money and paid in current dollars, francs or pesos. An inflationary trend makes future dollars have less purchasing power than present dollars.  Deflation means the opposite of inflation. Prices of goods & services decrease as time passes. Inflation & Deflation ' i = i + j + ij If i, A(y=0) will be A*(1+i) after one year. Then, if j, A will be A*(1+i)*(1+j). i → discount rate excluding inflation i' → discount rate including inflation j → annual inflation rate Inflation & Deflation i → discount rate excluding inflation ' i = i + j + ij i' → discount rate including inflation j → annual inflation rate If i, A(y=0) will be A*(1+i) after one year. Then, if j, A will be A*(1+i)*(1+j). When the inflation rate j is small, these relations can be approximated by: i' = i + j or i = i' − j n NPV = A0 + ∑ At / (1 + i ) t t =1 n NPV = A0 + ∑ At' / (1 + i ' ) t t =1 At → cash flow in year t expressed in terms of constant (base year) dollars A't → cash flow in year t expressed in terms of inflated (then-current) dollars Inflation Example  A company plans to invest $55,000 initially in a piece of equipment which is expected to produce a uniform annual constant dollars net revenue before tax of $15,000 over the next five years. The equipment has a salvage value of $5,000 in constant dollars at the end of 5 years and the depreciation allowance is computed on the basis of the straight line depreciation method (i.e., $10,000 during next five years). The marginal income tax rate for this company is 34%. The inflation expectation is 5% per year, and the aftertax MARR specified by the company is 8% excluding inflation. Determine whether the investment is worthwhile. Link Solution Depreciation costs are not inflated to current dollars in conformity with the practice recommended by the U.S. Internal Revenue Service.    With 5% inflation, the investment is no longer worthwhile because the value of the depreciation tax reduction is not increased to match the inflation rate. Verify that the use of MARR including inflation gives the same result (credit by next Monday – send me one-page excel sheet) Whether taking into account inflation or not, NPV could be different. Impact of Inflation: Boston Central Artery Year   t 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 Price Index   1982 $ 100 104 111 118 122 123 130 134 140 144 146 154 165 165 165 175 172 176 181 183 189 195 202 208 Price Index   2002 $ 53 55 59 62 65 65 69 71 74 76 77 82 88 88 87 93 91 94 96 97 100 103 107 110 Project Expenses   ($ K) Project Expenses   (1982 $ k) 33,000 82,000 131,000 164,000 214,000 197,000 246,000 574,000 854,000 852,000 764,000 1,206,000 1,470,000 1,523,000 1,329,000 1,246,000 1,272,000 1,115,000 779,000 441,000 27,000 67,000 101,000 122,000 153,000 137,000 169,000 372,000 517,000 515,000 464,000 687,000 853,000 863,000 735,000 682,000 674,000 572,000 386,000 212,000 Project Expenses   (2002 $ K) 51,000 126,000 190,000 230,000 289,000 258,000 318,000 703,000 975,000 973,000 877,000 1,297,000 1,609,000 1,629,000 1,387,000 1,288,000 1,272,000 1,079,000 729,000 399,000 and Au, 1989/2003 Source: Hendrickson Outline  Session Objective & Context  Project Financing      Financial Evaluation        Owner Project Contractor Additional issues Time value of money Present value Rates Interest Formulas NPV IRR & payback period Missing factors What are we Assuming Here?  That only quantifiable monetary benefits matter  Certainty about future cash flows  Main uncertainties:  Financial concerns     Currency fluctuations (international projects) Inflation/deflation Taxes variations Project risks Project Management Phase FEASIBILITY DESIGN PLANNING DEVELOPMENT Financing & Evaluation Risk CLOSEOUT OPERATIONS Risk Management  Case Study [...]... Objective & Context  Project Financing      Financial Evaluation        Owner Project Contractor Additional Issues Time value of money Present value Rates Interest Formulas NPV IRR & payback period Missing factors 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... Context  Project Financing      Financial Evaluation        Owner Project Contractor Additional Issues Time value of money Present value Rates Interest Formulas NPV IRR & payback period Missing factors 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. .. Build-Operate-Transfer) How Does Owner Finance a Project?  Public  Private  Project financing Outline  Session Objective & Context  Project Financing      Financial Evaluation        Owner Project Contractor Additional Issues Time value of money Present value Rates Interest Formulas NPV IRR & payback period Missing factors Public Financing  Sources of funds      Social benefits important... 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? ... 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) Outline  Session Objective & Context  Project Financing      Financial Evaluation        Owner Project Contractor Additional... investment in project) Drawback  Tensions among stakeholders Outline  Session Objective & Context  Project Financing      Financial Evaluation        Owner Project Contractor Additional Issues Time value of money Present value Rates Interest Formulas NPV IRR & payback period Missing factors Contractor Financing I  Payment schedule  Break out payments into components       Often some compromise... to fixed cost to establish   Investment in project through special purpose corporations    Often joint venture between several parties Need capacity for independent operation Benefits     Small projects not much benefit Off balance sheet (liabilities do not belong to parent) Limits risk External investors: reduced agency cost (direct investment in project) Drawback  Tensions among stakeholders... 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 Evaluation Example:  Project A  Project B  Construction=3 years  Construction=6 years  Cost = $1M/year  Cost=$1M/year  Sale Value=$4M  Sale Value=$8.5M  Total Cost?  Total Cost?  Profit?  Profit? ... 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 Cumulative costs $K 70 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    Contractors frequently borrow from   Front-end loaded bids (discounting) Unbalanced bids Banks (Need... firm, often high (e.g 20%) Private Owners w/Collateral Facility Distinct Financing Periods  Short-term construction loan  Bridge Debt    Long-term mortgage  Senior Debt     Risky (and hence expensive!) Borrowed so owner can pay for construction (cost) Typically facility is collateral Pays for operations and Construction financing debts Typically much lower interest Loans often negotiated as ... The role of project financing  Mechanisms for project financing  Measures of project profitability Project Management Phase FEASIBILITY DESIGN PLANNING DEVELOPMENT Financing & Evaluation Risk... 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 Evaluation Example:  Project A  Project. .. Objective & Context  Project Financing      Financial Evaluation        Owner Project Contractor Additional Issues Time value of money Present value Rates Interest Formulas NPV IRR & payback