Lecture 2 Project Financing & Evaluation

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 Dont 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
FEASIBILITY
DESIGN PLANNING
DEVELOPMENT
CLOSEOUT
OPERATIONS
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
Outline



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) $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 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 $0 $0 $0 $5,000,000 $0 $0 $0 $5,000,000 $0 $0 $0 $5,000,000
wner investment = contractor revenue

$10,000,000 $5,000,000 $0 ($5,000,000) ($10,000,000) ($15,000,000) ($20,000,000) ($25,000,000) ($30,000,000) ($35,000,000) 1 2 3 4 5 6 7 8 9 10 11 owner cum cashflow contractor cum cashflow
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) $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 $0 $0 $0 $5,000,000 $0 $0 $0 $5,000,000 $0 $0 $0 $5,000,000 $0 $0 $0 $5,000,000
$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

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) $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 $0 $0 $0 $5,000,000 $0 $0 $0 $5,000,000 $0 $0 $0 $5,000,000 $0 $0 $0 $5,000,000
$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

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



Missing factors
Public Financing
Sources of funds

General purpose or special-purpose bonds Tax revenues Capital grants subsidies International subsidized loans Benefits to region, quality of life, unemployment relief, etc.
Social benefits important justification
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) Borrow money Bonds
Debt

Because higher costs and risks, require higher returns
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
Outline



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
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)
Outline



Missing factors
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
S-curve Work
Man-hours
months
S-curve Cost
8 7 6 70 5 60 50 40 30 2 20 1 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 10 0 Cumulative costs $K 100 90 80
$K
4 3
Daily cost Cum. costs
Expense & Payment
Contractor Financing II
Owner keeps an eye out for

Front-end loaded bids (discounting) Unbalanced bids

Contractor Revenue Projection
Contractor Revenue Projection

140 120 100 Revenue 80 60 40
120 100 80 Revenue 60 40 20 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 Month
20 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 Month
Contractor Financing II
Owner keeps an eye out for

Front-end loaded bids (discounting) Unbalanced bids Banks (Need to demonstrate low risk) Some owners may assist in funding
Contractors frequently borrow from
Interaction with owners

Help secure lower-priced loan for contractor Big construction company, small municipality BOT
Sometimes assist owners in funding!

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


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 Good in the short-term Major concern on long run effects
Implications

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



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 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?
Quantitative Method
Profitability
Create value for the company
Profit
TOTAL EQUIVAL. $
REVENUES COSTS
Project management Engineering Material & transport Construction/commissionin g Contingencies
5,500,000. 00 4,600,000. 00
400,000.00 800,000.00 2,200,000.00 1,300,000.00 200,000.00
GROSS MARGIN Time factor?
900,000.0
Quantitative Method
Profitability
Create value for the company Time Value of Money
Opportunity Cost
A dollar today is worth more than a dollar tomorrow E.g. Project A - 8% profit, Project B - 10% profit
Investment relative to best-case scenario
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


Owner Project Contractor Additional issues

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) $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
0 $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 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
Then
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
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
Outline



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 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
Then
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 l = PV(r)
The loan l is the present value of r
Future to Present Revenue

If I know this is coming
x t
I can borrow this from the bank now

PV(x) 0 t
Ill pay this back to the bank -x later
PV(x)
The net result is that I can convert a sure x at time 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

0 -x If I know this cost is coming t
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
0 FV t v
PV
Summary
Because we can flexibly switch from one such value to another without cost, we can view these values as equivalent
0 FV t v = v(1+i)t
PV
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



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
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



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=PFactor)
Factor that will make your present value future value in single payment (F/P, i, n) = (1 + i )n
0 P 1 2 n F
Interest Formulas: Payment
Single Payment Present Value Factor (P=FFactor)
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 P F 1 n-1 n
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)?

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=AFactor)
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
Annuity occurs at the end of the interest period
Factor that will make your annuity value future value in series payment (F/A, i, n) =[(1+ i)n A - 1]/ i F=
F 0 1 2 n
Factor that will make your annuity value future value in series payment
n (F/A, i, n) =[(1+i)F -= 1]/ i A+A(1+i)
F 0 1 2 n
Factor that will make your annuity value future value in series payment (F/A, i, n) =[(1+i)n - 1]/ i
0 1 2 F = A + A(1+i) + + A(1 + i )n-1 n
Uniform Series Sinking Fund Factor (A=FFactor)
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)
1 A
2 A
n A F
Uniform Series Present Value Factor (P=AFactor)
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
P = A/ (1 + i ) 0 1 2 n
P = A/(1 + i ) + A/(1 + i )2 0 1 2 n
P = A/(1 + i ) + A/(1 + i )2 + + A/(1 + i )n 0 1 2 n
Verify it!
Uniform Series Capital Recovery Factor (A=PFactor)
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
1 A
2 A
n A
Verify it!
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?)

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



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) (-) Tax (-) Calculate Gross Return Calculate Net Return PV of Net Return Initial Invest (-I) NPV of the Project
Discount Rate (r)
Net Present Value Decision Rule

> NPV = <
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
Project Evaluation Example Revisit: Which one is better?

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?
Drawing out the examples
Project A
0 1 2 3
$4M
$1M
$1M
$1M $8.5M 6
Project B
0 1
$1M
$1M
$1M
$1M
$1M
$1M
Assume 10% discount rate Link
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
$235 M
NPV1 Cash Flow
Year 0
-$77 M
[NPV2]20% = -75.3 + (28)(P/A, 0.2, 5) = -75.3 + 83.7 = 8.4
$28 M each year
NPV2 Cash Flow
Year 0
-$75.3 M
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
-$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
$18 M $10 M $30 M
$50 M
Year 0
2
-$40 M
-$60 M
Source: Hendrickson and Au, 1989/2003
Solution
[NPV1] [NPV2] [NPV3] [NPV4]
= = = =
17.4 8.4 0.4 -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
Outline



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 projects 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>
=
r*
-r = IRR, * r = MARR
<
Accept Indifferent Reject
Accept a project with IRR larger than MARR

Alternatively,
Maximize IRR across mutually exclusive
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 Use NPV Verify IRR Check payback period
How can one compare them?

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 Looking at non-economic factors Discounting still often applied for noneconomic

Cost-effectiveness

$/Life saved
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.

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).
discount rate excluding i inflation discount rate including i' inflation
j annual inflation rate

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).
discount rate excluding i inflation discount rate including i' inflation
j annual inflation rate

i = i' j
When the inflation jrate approximated by:
is small, these relations can be or

n
i' = i + j
NPV = A0 + At / (1 + i ) t
t =1
NPV = A0 + At' / (1 + i ' )t

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
t =1
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 after-tax MARR specified by the company is 8% excluding inflation. Determine whether the 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)
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) Project Expenses (2002 $ 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
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



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
CLOSEOUT
OPERATIONS
Financing & Evaluation Risk
Risk Management
Case Study

Lecture 2 Project Financing &amp; Evaluation

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1.040/1.

Dr. SangHyun Lee

Your past project experience (strongly recommended if you have any)

Emerging construction technologies (e.g., 4D CAD, Virtual Reality, Sensing, )

Volunteers for next week?

Session Objective & Context Project Financing

Owner Project Contractor Additional Issues

Project Management Phase

Financing & Evaluation Risk

Context: Feasibility Phases

Site constraints Cost models Site infrastructural issues Permit requirements

Hendrickson PM for Construction on-line textbook

Session Objective & Context Project Financing

Owner Project Contractor Additional Issues

Financing Gross Cashflows

wner investment = contractor revenue

Financing Gross Cashflows

wner investment = contractor revenue

Financing Gross Cashflows

wner investment = contractor revenue

Early expenditure Takes time to get revenue

Aims to bridge this gap in the most beneficial way!

Critical Role of Financing

Makes projects possible Has major impact on

How Does Owner Finance a Project?

Public Private Project financing

Session Objective & Context Project Financing

Owner Project Contractor Additional Issues

Social benefits important justification

Major motivation for public/private partnerships

Invest corporate equity and retained earnings Offering equity shares

Because higher costs and risks, require higher returns

Private Owners w/Collateral Facility Distinct Financing Periods

Short-term construction loan

Loans often negotiated as a package

construction w/o tangible

Session Objective & Context Project Financing

Owner Project Contractor Additional Issues

Small projects not much benefit

Investment in project through special purpose corporations

Often joint venture between several parties

Need capacity for independent operation Benefits

Session Objective & Context Project Financing

Owner Project Contractor Additional Issues

Break out payments into components

retention on payments (usually, about 10%)

Often must cover deficit during construction

Daily cost Cum. costs

Expense & Payment

Owner keeps an eye out for

Front-end loaded bids (discounting) Unbalanced bids

Contractor Revenue Projection

120 100 80 Revenue 60 40 20 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 Month

Owner keeps an eye out for

Contractors frequently borrow from

Interaction with owners

Sometimes assist owners in funding!

Contractor Financing III

Agreed upon in contract

Certified by third party (Architect/engineer)

Session Objective & Context Project Financing

Many people forced to serve as lenders to owner due to delays in payments

Tax deductions for

Session Objective & Context Project Financing

Lecture 2 Project Financing & Evaluation

Lecture 2 Project Financing & Evaluation