Analysis of Relationship Between Time and Cost Overruns in some Infrastructure Projects 5

Analysis of Relationship between Time and

Cost Overruns in
some Infrastructure Projects
Hariharan S.* and P. H. Sawant**

Abstract : Projects undertaken in India have grown in size and large infrastructure
projects are being executed in various parts of the country. Indian construction
industry is expected to grow at 25-30% during 2010-2012. World Bank
estimates suggest that India's urban population will be close to 500
million by 2017, putting massive pressure on civic infrastructure. Risk
Management is gaining significance with increasing number of projects
and project complexities in Indian scenario. Risk level in a project varies
depending on the nature of the project and the parties that are involved
in the project. Impact of risk can be positive or negative and therefore
assessment of risk should be ongoing and dynamic. Previous research
findings related to risk management in Indian construction industry are
referred and significant findings are discussed. Researchers in the past
have identified schedule and cost over run as major problems associated
with Indian construction industry. Data related to schedule over run and
corresponding cost over run in Indian infrastructure projects of the past
20 years have been collected and presented in this paper. The paper
attempts to analyze whether the estimation of project time and cost is
realistic in Indian Infrastructure projects. Particular attention is paid to
schedule and cost over run in projects, associated risks and mitigation
measures. Pearson's correlation coefficient is used in understanding the
correlation between schedule and cost overrun. The result is confirmed
with the test findings using ANNOVA technique. Though there is a
strong correlation between time and cost over run the drivers of time
and cost overrun are not the same. While the time over run is attributed
to scope changes, delay in finalization of tender documents and short
bid submission time, lack of commitment of project participants, poor
coordination etc., cost overrun is attributed to more variations between
quantities estimated and actually executed. The research outcome suggests
that Indian construction industry needs to employ innovative technologies
and better contract management strategies to overcome surprises and
challenges as the project progresses. A shift from the current practices
towards electronic tendering process, online contract bidding document
etc can make the bidding process transparent and evaluation more realistic
in nature.

Keywords: Infrastructure Projects, Schedule Overrun, Cost Over Run, Pearson's Correlation,
Coefficient, Annova F-Test.

*Research Scholar and **Principal, Sardar Patel College of Engineering, Mumbai, India. Email : hari4444@yahoo.com
6 NICMAR-Journal of Construction Management, Vol. XXVII, No. 2&3, April-June & July-Sept. 2012
INTRODUCTION
Risk is not an entity to be managed separately
in a project as project management by itself is
risk management. In other words a good project
management signifies the ability of project team
to reasonably forecast uncertainties and develop
suitable mitigation measures as the project
progresses. Risk level in a project varies at various
stages depending on the nature of the project,
type of resources and the existing socio political
environment. Impact of risk can be positive or
negative and therefore assessment of risk should
be ongoing and dynamic. Considerable research
has already been carried out related to
performance of Indian construction industry.
Researchers in the past have identified schedule
and cost over run as major problems associated
with Indian construction industry (K.C. Iyer &
Jha 2006). Many factors have been attributed to
schedule and cost over run problems. Data related
to schedule over run and corresponding cost over
run in Indian infrastructure projects of the past
20 years have been analyzed in this paper. The
paper attempts to analyze whether the estimation
of project cost & time is realistic in Indian
Infrastructure projects. Particular attention is paid
to schedule and cost over run in projects, associated
risks and mitigation measures.
LITERATURE REVIEW
In Indian construction sector, problems start with
inception of the projects. Pre construction
planning, execution and post construction
planning in many cases are found to be unrealistic
where projects suffer from schedule related risk
and associated risk of cost escalation leading to
dispute. Various researchers have contributed to
construction risk management research in the past
and their findings are listed in this section.
Following sections describe factors identified by
researchers that drive schedule and cost over run
in Indian infrastructure projects. Ambiguity in
specification and delay in approval of completed
works by client were found to drive time and cost
overrun in projects (Satynarayana, K. N. & Iyer,
K. C., 1996).
Studies show that financial performance indicators
of a BOT project can be quite sensitive to the
selected D/E ratio and decline rapidly as the
promoter borrows more than the optimal amount
in an attempt to reach the project's debt capacity
level (Dias and Ioannau 1995, Esther Malini 1996).
Any BOT project is considered financially viable
when the following 3 conditions are simultaneously
satisfied. NPV should be positive for the project.
Financial IRR should have a value greater than
the discount rate. Cash flow (Liquidity) situation
in each year of concession period should be
satisfactory. In other words cash balance at the
end of every year should be positive. (Esther Malini
1999). Iyer, K. C & Jha, K. N (2005) observed
effective monitoring, feedback of project manager
and skills of PM as success attributes and negative
attribute of PM and inadequate problem
formulation at the beginning of project as failure
attributes in a project. They concluded that it is
not sufficient to maximize the result of positive
attribute but also important to minimize negative
impacts of failure factors. Sadi.A.Assaf and Sadiq.Al-
Hejji (2006) listed a number of factors influencing
timely completion in large construction projects.
Iyer & Jha (2006) reported that over 40% of Indian
construction projects are facing time overrun
ranging from 1 to 252 months. 55 attributes were
identified as factors responsible for impacting
performance of the projects and were presented
to Indian construction professionals in the form
of a questionnaire. Based on responses received
it is concluded that two success factors namely
commitment of project participants; owner's
competence and one failure factor namely conflict
among project participants contribute significantly
in enhancement of performance level of the
project.(Iyer and Jha 2006). In order to predict
when and where the risk will reach its highest
Analysis of Relationship Between Time and Cost Overruns in some Infrastructure Projects
level, analysis should be performed based upon
various information including statistical sources
such as accident histories and this should be done
in coordination with the activity scheduling. (Yi,
K.J., and Langford, D. 2006). The selection of
a lowest bidder is one of the major reasons for
project delivery problems as contractors, when
faced with shortage of work, desperately quoted
a low bid price simply to remain in business with
the expectation to be offset through claims (Singh
and Tiong 2006). M. Pilar de la Cruz et.al (2006)
included a list of 96 risk events, categorized and
prioritized first by impact, then by frequency. The
most relevant ones are related to issues such as
an inadequate prequalification system, insufficient
training of public servants, or political
considerations prevailing over real needs, among
others. Much of the project scheduling literature
treats task durations as deterministic. In reality,
however, task durations are subject to considerable
uncertainty, and that uncertainty can be influenced
by the resources assigned. (Vaziri, K., et al 2007).
Construction projects and contracts have become
complex with potentially greater risk. Project
completion depends largely on competent project
administration coupled with more accurately
worked out project risk management. Each one
is connected to the other through a network of
large number of activities creating rights and
obligations. Uncertainty of performance by one
or the other agency has serious ripple effect
challenging project managers to find solutions
almost on continued basis to eliminate or minimize
various risks. (Dave 2007). Construction activities
can be categorized as procurement, design,
construction and managerial but cannot be
standardized because each project is unique with
its specified condition. (Okmen, O.,and Oztas,
A. 2008). Lack of commitment, inefficient site
management, poor site coordination, improper
planning, lack of clarity in project scope, lack of
communication and substandard contract are
found to drive schedule and cost over run in Indian
7
infrastructure projects. (Sawhney Anil et.al., 2011).
Experts in the construction industry believe that
the traditional principle of choosing the lowest
possible price by adopting "hard bid" method carries
a high degree of risk. Public work constructions
based on the hard bid method have experienced
a surge in litigation during the 1990s which tend
to increase the risk of the project (Karam 1998).
The selection of a lowest bidder is one of the major
reasons for project delivery problems as contractors,
when faced with shortage of work, desperately
quoted a low bid price simply to remain in business
with the expectation to be offset through claims
(Singh and Tiong 2006). Project specific risk factors
such as size of project, tender selection methods,
location uniqueness, regulatory approvals, land
acquisition, utility shifting, flow of information
& finance were found to influence infrastructure
project completion to a greater extent in Indian
scenario. These risks shall be handled on a fair
basis by providing suitable built in mechanism in
the contract. Climatic conditions, equipment
breakdown and differing site conditions are very
closely related and need to be assessed as a single
combined factor. i.e the adverse climatic condition
coupled with equipment breakdown or differing
site condition can be serious and can increase the
project risk in geometric proportion. Therefore,
risk management is a dynamic process which
continues as the project progresses. In broad sense
parties should know the major risks that cannot
be transferred and needs to be apportioned among
project participants. Risk shall be assigned to the
party who has better ability to manage the risk.
Schedule and cost overrun factors can be best
managed by project managers and hence project
manager specific risks and mitigation measures
are discussed in this paper.
SCOPE AND OBJECTIVES
Project Managers have a critical role in estimating
the project cost and completion time. Objective
of this paper is to explain the significance of project
8 NICMAR-Journal of Construction Management, Vol. XXVII, No. 2&3, April-June & July-Sept. 2012
manager specific factors in smooth completion
of project in Indian scenario. The paper attempts
to analyze the relation between schedule and cost
overrun and evaluate whether the estimation of
project time & cost is realistic in Indian
Infrastructure projects. Particular attention is paid
to schedule and cost over run in projects, associated
risks and mitigation measures.
Infrastructure Project Scenario In India
Projects undertaken in India have grown in size
and large infrastructure projects are being executed
in various parts of the country. Government is
expected to spend more than one trillion dollars
on infrastructure upgrades between 2012 and 2017.
Indian construction industry is expected to grow
at 25-30% during 2010-2012. World Bank estimates
suggest that Indias urban population will be close
to 500 million by 2017, putting massive pressure
on civic infrastructure.
Fig. 1 shows number of projects under various
groups as per the Quarterly Project Implementation
Status Report on Central Sector Projects for the
quarter June, 2009 issued by the Ministry of
statistics & program implementation, Government
of India. The report reveals the status of various
infrastructure projects implemented in the country
in the past two decades. Fig. 2 shows percentage
of investments in these projects.
Number of Projects
600
500
400
300 499
200 340
100 112
0
Mega Major Medium
Projects Projects Projects
Number of Projects
Figure 1 : Number Of Mega,
Major & Medium Projects
% of Total Investment
80
70
60
50
68.01
40
30
20
28.78
10 3.21
0 Mega Major Medium
Projects Projects Projects
% of Total Investment
Figure 2 : Percentage Of Total Investment
The report covers a total of 951 projects which
comprises of 112 mega projects (each costing
` 1,000 crore and above), 499 major projects (each
costing between 100 crore and ` 1000 crore)
and 340 medium projects (each costing between
` 20 crore and ` 100 crore). Major and Mega
projects account for about 62% of the total
number of projects and about 96% of the total
anticipated cost.
Schedule And Cost Overrun Scenario In Indian
Infrastructure Projects
Cost is a primary measurement of the success of
every project. Unrealistic cost estimates and
unexpected expenditures can change an otherwise
successful capital investment into an investment
failure. The Status Report on Central Sector
Projects claims that a continuous decline in the
extent of time and cost overruns which is attributed
to closer monitoring and system improvements
by the Ministries concerned. The recorded data
for the period between 1991 to 2009 shows that
the cost overrun has declined from 61.6% in
March, 1991 to 12.1% in June, 2009
(Refer Fig. 4) which claims to have resulted in
substantial savings. Fig. 3 shows the variation in
time overrun during the same period.
Analysis of Relationship Between Time and Cost Overruns in some Infrastructure Projects 9

Factors Driving Delay In Indian Infrastructure coefficient (r) is a measure of the strength of the
Projects association between the two variables. Table 1 shows
Among all the cases discussed, Road Transport Pearson's correlation coefficient relating schedule
& Highway projects reported major schedule and cost overrun. Pearson's product moment
overrun. Out of 196 Road & Highway projects correlation coefficient for the given set of data
159 are found to be affected with schedule overrun is found to be 0.8146 indicating there is a strong
with delay ranging from 1 to 96 months. The positive correlation between the variables.
report also shows that only 12 of the 196 projects The above results were confirmed with ANNOVA
suffer a cost overrun of 22.54%. 67 out of 257 test. F Test using ANNOVA Technique is
railway projects reported time overrun with time performed on the above sample and the following
delays ranging from 8 - 180 months where 189 results were obtained. Table 2 shows F Test using
of 257 projects suffer a cost over run close to 129%. ANNOVA Technique. The calculation results in
Fig. 5 shows the details of major factors that drive F value for the analyzed data equal to 11.31 with
schedule overrun in Indian scenario. It is also found significance level of 0.0019 shows that correlation
that many of the large infrastructure projects suffer between factors is significant. As the value of
due to lack of planning and coordination resulting is 0.0019 is found to be less than 0.05, the variation
in claims and disputes. is realistic and not by chance. However, the question
RESEARCH METHODOLOGY that remains unanswered is the extent to which
schedule over run drives the cost over run. The
Research methodology involves analyzing the
drivers for schedule delays are not necessarily
statistical data related to schedule and cost over
contributing to cost over run in Indian
run in projects with Pearson's correlation
infrastructure projects. Some significant
coefficient and confirming the validity of the same
observations made by the authors are listed below.
using F-test. Correlation is a technique for
investigating the relationship between two Table 3 & Table 4 shows sector-wise total number
quantitative, continuous variables, for example, of projects & number of projects that reported
schedule and cost overrun. Pearson's correlation only cost overrun and only time overrun. Table

Trend of Time Overrn

% of Time Overrun

70
60
50
40
30
20
10
0
June, 2009
March, 93
March, 94
March, 95
March, 96
March, 97
March, 98
March, 99

March, 2003
March, 2004

March, 2006

March, 2009
March, 2001

March, 2008
March, 2000

March, 2005

March, 2007
March, 2002

Figure 3 : Trend Of Time Overrun

10 NICMAR-Journal of Construction Management, Vol. XXVII, No. 2&3, April-June & July-Sept. 2012

Trend Of Cost Overrun

% of Time Overrun
70
60
50
40
30
20
10
0

98

June, 2009
March, 91
March, 92
93
94
95
96
97

March, 2001
March, 2002

March, 2004

March, 2007
March, 2008
March, 2009
March, 99

March, 2006
March, 2003

March, 2005
March, 2000
March,
March,
March,
March,
March,
March,

Figure 4: Trend Of Cost Overrun

Major Drivers for Delay in Projects

70
123
123
123
123 Fund Constraints
60 123
123
123
123
123
50 123
123
123 123 Land Acquisition
123
123 123
123 123
40 123 Problems
123
123
123
123
123
30 123 123
123 123 Slow Progress in Works
123 123
123
123
20 123 Other than Civil Works
123
123
123
123
123
123
10 123
123
123
123
123 123 123 12 Delay in Supply of
123
123 123 123 123 12
123 123 123 123 12
123
123
123
123
123
12
123
123
123
123
123
123
123
123
123 12
12312
123 123123
123 123
123123
123
123 Equipment
0
Petroleum
Railways

Coal

Power

Steel

12
12 Environmental Clearance

Figure 5 : Major Drivers Of Delay In Infrastructure Projects

5 number of projects reported both time and cost
overrun. It is found that out of 951 projects 32.5%
of projects reported only time over run and 50%
of projects reported only cost overrun. However,
14.6% projects were found to be affected with
both time and cost overrun. Though there is a
strong correlation between time and cost overrun,
Pearsons moment correlation coefficient between
projects reported only time over run and only cost
overrun show value of 0.33 indicating that they
are driven by factors independent of each other.
It is interesting to note that while a total of 334
projects were found to run under time over run
with only 170 projects reporting cost over run.
FINDINGS & DISCUSSION
Out of 951 projects 140 projects were found to
have both time and cost overrun. 334 projects
Analysis of Relationship Between Time and Cost Overruns in some Infrastructure Projects 11

Table 1: Pearson Correlation Table such poor estimation. Some of the projects were
reported as projects completed within estimated
% of Time % of Cost
Year
Overrun Overrun
cost in spite of a time over run of 9 to 33 months.
It is worth mentioning that during these years
March, 1993 62.22 56.80
(between years 2003 to 2010) the price of steel
March, 1994 58.22 57.50
and cement saw an increase of 60% and 76%
March, 1995 62.70 51.40 respectively. This raises a serious question whether
March, 1996 58.35 46.90 the cost arrived at originally was based on realistic
March, 1997 57.73 45.00 estimates. Out of total 146 contracts that were
March, 1998 46.94 37.30 considered for performance audit, 34 were found
March, 1999 53.11 40.90 to run under a time delay of 1 to 17 months. The
March, 2000 44.99 36.00 time over run was mainly attributed to delay in
March 2001 37.66 36.00 finalization of tender documents. In many of the
March, 2002 31.72 26.00 cases Notice Inviting Tender (NIT) were issued
close to the date of awarding of contract leaving
March, 2003 39.44 22.30
little scope for judiciously evaluating and finalizing
March, 2004 37.15 22.40
the bids. In-order to gain time for execution, it
March, 2005 39.02 17.70
is observed that bid preparation time is kept to
March, 2006 38.80 17.40 the minimum (Mithun K, 2010).
March, 2007 34.13 14.51
Single stage single envelope system is still followed
March 2008 41.91 12.06
in many of the cases where as the recommended
March, 2009 48.11 13.45
being single stage double envelope system. It is
June, 2009 40.84 12.10 also found in the present study that lowest bid
reported within cost but having time over run criteria in many of the cases resulted in contracts
(which comprises of 25 Mega Projects,209 major being awarded to those contractors who failed in
projects and 100 medium projects). 170 projects mobilizing adequate manpower and timely
were having only cost over run but were completed completion of work in the past. There is an urgent
within estimated time (which comprises of 7 Mega need in bringing qualitative change in project
Projects, 97 major projects and 64 medium planning, monitoring and control. More scientific
projects). and realistic methods need to be adopted while
estimating time & cost. The report on Delay
Many projects that reported cost over run either analysis of Narmada Valley dams and canal projects
directly or indirectly (Such as poor assessment of reveals the short bid preparation time lead to a
site conditions due to short bid time) refer to lack number of errors and omission on the part of
of time in preparing realistic estimates. It is found the contractor which they tried to settle through
that many companies do not have a mechanism claims, leading to disputes and schedule over runs.
of more realistically estimating the quantities. A Almost during all the tenders that were invited
recent performance audit of infrastructure by Narmada Valley Development Authority,
contracts revealed that out of 146 contracts, 57 contractors including HCC, L&T etc had
had variation of cost (positive or negative) that requested for time extension to extend submission
ranged between 10 to 54 percent supporting the date which was not entertained.
belief that cost estimates were not realistic. Lack
of time and tight schedules were found to drive From the above discussion, it is clear that there
12 NICMAR-Journal of Construction Management, Vol. XXVII, No. 2&3, April-June & July-Sept. 2012

Table 2 : F Test Using ANNOVA Technique

Group 1: Group 2:
% Time % Cost Group 1: x 2 Group 2: x 2 Details of Analysis for F- Test
Overrun Overrun
62.22 56.80 3871 3226 Sum of Group 1 Scores = 833
58.22 57.50 3390 3306 Sum of Group 2 Scores = 566
62.70 51.40 3931 2642 (x 2 ) for Group 1 = 40269.6512
58.35 46.90 3405 2200 (x 2 ) for Group 2 = 22029.5562
57.73 45.00 3333 2025 n = 18
46.94 37.30 2203 1391 N = 36
53.11 40.90 2821 1673 (x) = 1398.76
44.99 36.00 2024 1296 ((x 2)) = 62299.2074
37.66 36.00 1418 1296 ((x) 2 ) = 1013994.76
31.72 26.00 1006 676 -
39.44 22.30 1556 497 Sum of Squares Total = 7951.1646
37.15 22.40 1380 502 Sum of Squares Between = 1984.999
39.02 17.70 1523 313 Sum of Squares Within = 5966.165
38.80 17.40 1505 303 -
34.13 14.51 1165 211 Degrees of Freedom Between = 1
41.91 12.06 1756 145 Degrees of Freedom Within = 34
48.11 13.45 2315 181 MS Between = 1985
40.84 12.10 1668 146 MS Within = 175.475

is a scope for more realistically estimating both
time and cost involved in a project. While the
time over run is attributed to delay in finalization
of tender documents, cost overrun is attributed
to more variations in quantities estimated and
actually executed. The basis of estimating cost of
each item requires understanding of market options
and the new technologies available. The estimation
of cost also requires careful evaluation by project
manager and better coordination with various
stakeholders. There are various components of
cost such as material cost, installation cost,
manpower cost, running cost, etc. In practice the
material quantities are verified with bill of quantities
(BOQ) as per the drawings and specifications and
the rates are worked out based on previous data
available with the contractor. The installation cost
is decided based on methodology of job, job
duration, job location & size, client requirement,
contractor installation policy, equipment/plant
consideration, etc. The manpower quantum is
defined based on project duration, client
requirement, labor productivity, trade union
practices, expert requirement & labor department
guidelines. Running cost or time related cost is
decided based on the previous job actual estimate,
present trend & practices, own resources
availability, etc. Due to schedule creep or extended
completion, the time related cost will be increased
proportionately. This covers expenses like salary,
rent, travelling, postage, phone, electricity,
stationary, watch & ward, insurance premium,
bank guarantee charges, interest, financial cost,
increase in equipment hire charges etc. As the
bills of quantities of items are not exactly reflecting
in the construction schedule, estimating the actual
cost is found to be more challenging. While some
of the items show negative variation, there are
Analysis of Relationship Between Time and Cost Overruns in some Infrastructure Projects 13

Table 3: Sectorwise Total Number Of Projects & Number Of Projects Reported Only Cost Overrun
No. of Range
Total
Original Anticipated Cost Projects Original Anticipated of
Sr. No.
Sector Cost Cost Overrun BOTH Cost Cost time
No. of
` Crore) (`
(` ` Crore) % TOR & (` ` Crore) (`
` Crore) in
Projects
COR months
1 ATOMIC ENERGY 5 25054.29 24123.29 -3.72 0 0.00 0.00 0.00
2 CIVIL AVIATION 31 5982.28 6015.24 0.55 6 300.16 333.12 10.98
3 COAL 129 30419.28 32126.93 5.61 19 6734 8777.73 30.35
4 I & B 1 35 35 0.00 0 0.00 0.00 0.00
5 MINES 1 4091.51 4091.51 0.00 0 0.00 0.00 0.00
6 STEEL 54 47321.43 50947.77 7.66 17 11252.27 15648.98 39.07
7 PETROLEUM 60 121711.09 130859.52 7.52 19 34415.76 48808.29 41.82
8 POWER 88 159797.95 165567.34 3.61 23 32477.98 38427.39 18.32
9 HEALTH & FW 1 71.18 443.15 522.58 1 71.18 443.15 522.58
10 RAILWAYS 257 45722.88 90228.82 97.34 189 34462.45 79028.38 129.32
11 ROAD & 196 54558.11 54874.45 0.58 12 2897.42 3550.58 22.54
HIGHWAYS
12 SHIPPING & 53 14952.89 15304.93 2.35 15 1963.29 2476.07 26.12
PORTS
13 TELE
COMMUNICATION 44 15663.41 15040.02 -3.98 4 1504.71 1775.02 17.96
14 URBAN 28 15659.58 16255.74 3.81 2 8201.67 8811.03 7.43
DEVELOPMENT
15 WATER RESOURCES 1 542.9 1187 118.64 1 542.9 1187 118.64
16 INFORMATION 2 64.9 86.86 33.84 1 20 41.96 109.8
TECHNOLOGY
Total 951 541648.68 607187.57 12.1 309 134843.79 209308.7 55.22

many items that show positive variation throwing CONCLUSION

surprises to project managers as the project
progresses. Documents pertaining to Qualifying
Requirements (QR) should serve as a mechanism
to promote more healthy competition and not
as a barrier for contractors to bid. For example,
the Delhi Metro Railway Project phase-I was
completed on schedule and within the budgeted
cost. The Design Build Turnkey project involved
international contractors for construction of a total
length of 6,569 m of metro rail and was completed
in a 5-year period at a total cost of ` 1,800 crores.
The success was attributed to transparency in the
tendering system and proper planning.
Though there is a strong correlation between time
and cost over run, the drivers of time and cost
overrun are not the same. While the time over
run is attributed to scope changes, delay in
finalization of tender documents and short bid
submission time, lack of commitment of project
participants, poor coordination etc., cost overrun
is attributed to more variations between quantities
estimated and actually executed. The research
outcome suggests that Indian construction industry
needs to employ innovative technologies and better
contract management strategies to overcome
surprises and challenges. Conventional "Hard bid
methods" require a serious relook. It is also
14 NICMAR-Journal of Construction Management, Vol. XXVII, No. 2&3, April-June & July-Sept. 2012

Table 4: Sectorwise Total Number Of Projects & Number Of Projects Reported Only Time Overrun
No. of Range
Total
Original Anticipated Cost Projects Original Anticipated of
Sr. No.
Sector Cost Cost Overrun BOTH Cost Cost time
No. of
` Crore) (`
(` ` Crore) % TOR & (` ` Crore) (`
` Crore) in
Projects
COR months
1 ATOMIC ENERGY 5 25054.29 24123.29 -3.72 3 20456 19525 2 to22

2 CIVIL AVIATION 31 5982.28 6015.24 0.55 22 1824.33 1857.29 3 to 50

3 COAL 129 30419.28 32126.93 5.61 55 11438.92 13380.82 4 to 192

4 I & B 1 35 35 0.00 0 0.00 0.00 0

5 MINES 1 4091.51 4091.51 0.00 1 4091.51 4091.51 11

6 STEEL 54 47321.43 50947.77 7.66 37 45474.51 48602.96 2 to 28

7 PETROLEUM 60 121711.09 130859.52 7.52 33 78123.11 87629.27 1 to 74

8 POWER 88 159797.95 165567.34 3.61 33 70245.57 75475.06 1 to 68

9 HEALTH & FW 1 71.18 443.15 522.58 0 0.00 0.00 0

10 RAILWAYS 257 45722.88 90228.82 97.34 67 17338.07 39044.68 8 to 180

11 ROAD &
196 54558.11 54874.45 0.58 159 41422.50 41715.73 1 to 96
HIGHWAYS

12 SHIPPING &
53 14952.89 15304.93 2.35 24 3506.84 3751.32 1 to 94
PORTS

13 TELE
44 15663.41 15040.02 -3.98 27 7255.26 6925.54 1 to 62
COMMUNICATION

14 URBAN
28 15659.58 16255.74 3.81 12 8458.94 9006.02 4 to 71
DEVELOPMNT

15 WATER RESOURCES 1 542.9 1187 118.64 1 542.90 1187 60

16 INFO TECH 2 64.9 86.86 33.84 0 0.00 0.00 0

TOTAL 951 541648.68 607187.57 12.1 474 310178.46 352192.2

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Bridge projects in India, Journal of Management
Engineering, Vol. 15, No. 4, 1999.
Analysis of Relationship Between Time and Cost Overruns in some Infrastructure Projects 15

Table 5 : Sectorwise Total Number Of Projects & Number Of Projects Reported Both
Time And Cost Overrun
No. of Range
Total
Original Anticipated Cost Projects Original Anticipated of
Sr. No.
Sector Cost Cost Overrun BOTH Cost Cost time
No. of
` Crore) (`
(` ` Crore) % TOR & (` ` Crore) (`
` Crore) in
Projects
COR months
1 ATOMIC ENERGY 5 25054.29 24123.29 -3.72 0 0 0 0
2 CIVIL AVIATION 31 5982.28 6015.24 0.55 6 300.16 333.12 5 to 19
3 COAL 129 30419.28 32126.93 5.61 16 6584.19 8592.17 4 to 72
4 I & B 1 35 35 0.00 0 0.00 0.00 0
5 MINES 1 4091.51 4091.51 0.00 0 0.00 0.00 0
6 STEEL 54 47321.43 50947.77 7.66 12 10405.10 14303.92 3 to 28
7 PETROLEUM 60 121711.09 130859.52 7.52 17 27570.76 41195.29 2 to 74
8 POWER 88 159797.95 165567.34 3.61 16 29290.60 34612.15 7 to 47
9 HEALTH & FW 1 71.18 443.15 522.58 0 0.00 0.00 0
10 RAILWAYS 257 45722.88 90228.82 97.34 48 12420.92 34152.86 9 to 180
11 ROAD & 196 54558.11 54874.45 0.58 11 2677.42 3307.47 10 to 85
HIGHWAYS
12 SHIPPING & 53 14952.89 15304.93 2.35 8 1645.04 1896.73 7 to 48
PORTS
13 TELE 44 15663.41 15040.02 -3.98 3 596.41 858.32 19 to 54
COMMUNICATION
14 URBAN 28 15659.58 16255.74 3.81 1 8118.00 8676.00 4
DEVELOPMENT
15 WATER RESOURCES 1 542.9 1187 118.64 1 542.90 1187.00 60
16 INFORMATION 2 64.9 86.86 33.84 0 0.00 0.00 0
TECHNOLOGY
TOTAL 951 541648.68 607187.57 12.1 139 100151.5 149115.03

Iyer, K. C. and Jha ,K.N, Critical factors affecting
cost performance: Evidence from Indian
Construction Projects, International Journal
of Project Management, Vol. 23,
pp. 283-295, 2005.
Iyer, K.C. and Jha, K.N, Critical factors affecting
schedule performance: Evidence from Indian
construction projects, Journal of Construction
Engineering and Management,
Vol. 132, No. 8, pp. 871-880, 2006.
Mithun, K., Delay in construction of Dams and
Canals by NVDA 2010. Available: http://
96.0.26.98/attachments/.../Mithun%20
Kartikeyan_IIM_Indore.pdf
Okmen O. and Oztas, A., Construction project
network evaluation with correlated schedule
risk analysis model Journal of Construction
Engineering and Management, Vol. 134,
No. 1, pp. 49-63, 2008.
Pilar, M. de la C., et. al, Downside risks in
construction projects developed by the civil
Service: The case of Spain, Journal of Construction
Engineering and Management, Vol. 132,
No. 8, pp. 844-851, 2006.
Satynarayana, K. N. and Iyer, K. C., Evaluation
of Delays in Indian Construction Contracts,
Journal of The Institution of Engineers (India),
Vol. 77, pp. 14-22, 1996.
16 NICMAR-Journal of Construction Management, Vol. XXVII, No. 2&3, April-June & July-Sept. 2012

Table 6 : Sectorwise Comparison Of Total Projects & Number Of Projects Reported Only Time, Cost,
Time & Cost Overrun
Total No. of No. of No. of
No. of Projects Projects Projects
Sr. No Sector
Projects Only Only BOTH TOR
COR TOR & COR
1 ATOMIC ENERGY 5 0 3 0
2 CIVIL AVIATION 31 6 22 6
3 COAL 129 19 55 16
4 I&B 1 0 0 0
5 MINES 1 0 1 0
6 STEEL 54 17 37 12
7 PETROLEUM 60 19 33 17
8 POWER 88 23 33 16
9 HEALTH & FW 1 1 0 0
10 RAILWAYS 257 189 67 48
11 ROAD TRANSPORT & HIGHWAYS 196 12 159 11
12 SHIPPING & PORTS 53 15 24 8
13 TELECOMMUNICATION 44 4 27 3
14 URBAN DEVELOPMENT 28 2 12 1
15 WATER RESOURCES 1 1 1 1
16 INFORMATION TECHNOLOGY 2 1 0 0
Total 951 309 474 139

Singh, D. and Tiong, R.L.K., Contractor selection Vaziri, K. et.al, Project planning for construction
criteria: Investigation of opinions of Singapore under uncertainty with limited resources,
construction practitioners, Journal of Construction Journal of Construction Engineering and Management,
Engineering and Management, Vol. 132, No. Vol. 133, No. 4, pp. 268-275, 2007.
9, pp. 998-1006, 2006. Assaf, S.A. and Hejji, S. A., Causes of delay in
Abi-Karam, T., Editors Letter: The Professional large construction projects, International Journal
Services Race: Design/Build Reality Journal of Project Management, 24, pp. 349-357,
of Management in Engineering, Vol. 14, 2006.Engineering and Management,
No. 6, p. 3, 1998. Vol. 132, No. 9, pp. 998-1006, 2006.
Sawhney, Anil et.al, Latent Variables and Their
Impact on Time Performance of Indian
Construction Projects, PMI Conference,
Dec. 9-10, India. 2011.
Quarterly Project Implementation Status Report
on Central Sector Projects for the quarter
June, 2009 issued by the Ministry of statistics
& program implementation, Government
of India. Available : www.mospi.gov.in (Accessed
on 14 th Feb. 2012)

Importance of Cash Flow Hedging in Projects from Corporate Sustainability 17

Importance of Cash Flow Hedging in Projects

from Corporate Sustainability
Hiren Maniar*

Abstract : A cash flow hedge protects from the variability of cash flow of the hedged
item, variables such as a particular risk associated with an asset or liability
(such as interest payments on a variable rate debt) or the effects of profit
or loss, by offsetting such variability with the cash flow of the hedging
instrument. This paper studies the scenario of unrealized cash flow hedge
gains/losses for future profitability and project returns, which ultimately
decides in a longer run corporate sustainability of any project driven
company. An unrealized gain on a cash flow hedge suggests that the price
of the underlying hedged item (i.e. commodity price, foreign currency
exchange rate or interest rate) moved in a direction that negatively affects
the project firm. Based on this inverse relation, it is found that unrealized
cash flow hedge gains/losses are negatively associated with future gross
margin. This association is weaker for project firms that have the ability
to pass input price changes through to customers. Finally, it has been
observed that project companies do not immediately price the information
conveyed by cash flow hedges. Instead, project companies appear surprised
by future realizations of gross margin, consistent with the view that a
lack of transparent disclosure on future hedged transactions leads to a
delay in pricing.

Keywords : Cash flow, Hedging, Cash, Corporate Sustainability, Credit Line, Cash
Flow Risk, Project Companies

JEL Classification : G30; G31; G32

INTRODUCTAION purchases. This financial strategy uses derivative

A cash hedge is a type of investment strategy set
up to protect an individual against the risk of
variable cash flow of a specific hedged item. Such
a risk may be caused by particular assets or liabilities
that generate revenue differently than expected,
and are possibly reducing expected profits or
increasing losses. For example, a cash flow hedge
could protect against increases in the repayment
installments of a variable rate loan, increases in
the exchange rate of a foreign currency in which
the individual expects to make a future transaction,
or increases in the prices of planned inventory
*Corporate Trainer - Finance, L & T Institute of Project Management, Vadodara 390019, Gujarat, India.
Email. : hmaniar@lntipm.org
instruments such as call options or put options
to help limit the individual's exposure to such risks.
Specific information, such as the strategy and risk
of the original hedge, must be documented before
a cash flow hedge can be properly established;
in most cases, a financial advisor can help investors
create financial protection for hedged items.
A cash-flow hedge protects from the variability
of cash flow of the hedged item, variables such
as a particular risk associated with an asset or liability
(such as interest payments on a variable rate debt)
or the effects of profit or loss, by offsetting such
18 NICMAR-Journal of Construction Management, Vol. XXVII, No. 2&3, April-June & July-Sept. 2012
variability with the cash flow of the hedging
instrument. In short cash flow hedge is a hedge
of an upcoming, forecasted event. To qualify for
cash flow hedge treatment, a key requirement
is that exposure involves the risk of an uncertain
(i.e., variable) cash flow.
A cash flow hedge is a hedge of the exposure to
the variability of cash flow that
1. Is attributable to a particular risk associated
with a recognized asset or liability, such as
all or some future interest payments on variable
rate debt or a highly probable forecast transaction
and
2. Could affect profit or loss
A cash flow hedge is a hedging relationship where
the variability of the hedged item's cash flows is
offset by the cash flows of the hedging instrument.
Key aspects are:
z Hedged item may be a forecasted transaction
with no contracted future price (i.e., not a
firm commit.)
z Effective portion of derivative's gain or loss
reported in firms' financial statements
z Earnings recognition matches hedged transaction
z Ineffective gain or loss recorded in earnings
The uncertainty of cash flows and the risk of
adverse cash flow shocks are central concerns in
Projects, and are taken seriously by both project
managers and project companies. Theory suggests
that corporate risk management in projects can
effectively mitigate cash f low risks. Yet, the
empirical literature offers no conclusive evidence
on the overall value of risk management and cash
flow hedging. Movements in external factors such
as exchange rates, interest rates and commodity
prices can disrupt a project's internally generated
cash flows.
Hence for good project cash flow hedging, one
needs to forecast cash flow in highly accurate
manner. Judging by industry surveys, cash flow
forecasting is a recurring priority and pain point
for corporate treasurers. What is it that makes
this issue a constant 'top of mind' topic for
treasurers? So much is written and said about the
topic of cash flow forecasting and hedging that
it can get confusing. Many companies thought
that it is the single most important task a cash
manager does. But this is not the case. The
consequences of getting cash forecasting wrong
are all too clear. The project can lose money when
project borrows more than what is actually needed
or invest money project managers thought they
had but don't, due to poor forecasting. And therein
lies the problem and the reason that some
treasurers don't bother forecasting at all. So it
seems there are a few issues to focus on here:
z Getting the Project companies to forecast
cash f low regularly.
z Getting the Project companies to forecast
cash f low accurately.
z Having the ability to control how forecasting
works.
A logical step by step approach may be what is
needed. Treasury, in theory, should have
knowledge of at least some of the line items that
go to make up a good forecast. Following point
should be considered for effective forecasting of
cash flow.
z Cash flows generated from financial transactions
(e.g. foreign exchange (FX), debt and investment).
z Possible mergers and acquisitions (M&A)
or divestures.
z Treasury related transfers (e.g. tax and cash
pooling).
z Human resource transfers (e.g. tax and payroll).
z Bank fees.
z Financial institution debt and credit line
issuance costs and fees.
z Accounts payable (A/P) accounts receivable
(A/R) and forecast sales.
Importance of Cash Flow Hedging in Projects from Corporate Sustainability
z Summary cash flows generated from quantitative
modeling.
Technology can play a key role in the success or
otherwise of cash flow forecasting from a number
of perspectives including the gathering of cash
forecast data and the analysis of the data. Treasuries
who are successful in forecasting agree on one
thing that project managers have to make it easy
for the suppliers (subsidiaries or business units)
of the forecast to provide the forecast. But this
is only one aspect of the issue. Project managers
also need to compare the forecast with the actual
for accuracy. It is this area that some project
companies find most difficult and possibly why
they give up or don't bother in the first place.
If group treasury does not have the power to
improve the accuracy then it can be a meaningless
task.
RELEVANCE OF CASH FLOW HEDGING
IN PROJECTS FROM CORPORATE
SUSTAINABILITY POINT OF VIEW
What are the financial consequences and value
implications of corporate hedging? Clearly, the
uncertainty of cash flows and the risk of adverse
cash flow shocks are central concerns in corporate
finance, shareholders and managers take them
seriously. In today's economic turmoil
environment, corporate sustainability for
companies is a difficult task due to volatility in
commodity, equity, interest rate, inflation and
foreign exchange markets. As per corporate
sustainability practices, project companies are using
derivative instruments as hedging tools to manage
its balance sheet against impending risk due to
volatility in commodity, foreign exchange, interest
rate and credit flows. Project companies enter into
fair value hedges, cash flow hedges and hedges
of net investments in foreign operations pertaining
to various domestic as well as international projects.
This really indicates in the economic performance
of various projects of project companies in terms
of Economic Value Generation (Revenue generated
19
by projects for company) and EBDITA (Gross Profit
Margin of projects for the company). However,
same also decides the corporate sustainability of
project companies in managing cash flow hedging
for commodity, foreign exchange, interest rate
and credit flows.
The majority of the project companies do cash
flow hedges related to exposure to variability in
project's future payments and receipts on forecast
transactions and on recognised financial assets and
financial liabilities of projects. The project company
hedges its international project net investments
in foreign operations with currency borrowings
and forward foreign exchange contracts.
It is found that cash flow hedging reduces the
firm's precautionary demand for cash and allows
it to rely relatively more on bank for lines of credit
for liquidity provision. Furthermore, firm is able
to identify a significant positive value effect of
cash flow hedging as a result of facilitating a more
cost efficient liquidity policy. Same is a driving
factor in today's economic turmoil era, where many
cash strapped companies are facing challenges for
managing of their cash flow.
In the last couple of years (based on result analysis
of several project companies in India), Indian
project companies incurred a huge foreign
exchange loss in running their project business;
some envisaged the need of effective cash flow
hedging of foreign exchange and other financial
resources for corporate sustainability of project
companies. This research article will give an idea
about why cash flow hedging is required for the
projects and how cash flow hedging can play an
important role in terms of corporate sustainability
for any project driven organisation.
ROLE OF CASH FLOW HEDGING IN
PROJECTS
The project cash flow hedge protects an individual
from the risks of particular assets or liabilities
generating cash flows different from those he or
20 NICMAR-Journal of Construction Management, Vol. XXVII, No. 2&3, April-June & July-Sept. 2012
she expected, possibly reducing expected profits
or increasing losses. There are various types of
risk a project faces during its life cycle like currency
risk, commodity risk, price risk, etc. Currency risks
include those associated with a future transaction
in a foreign currency or a debt denominated in
a foreign currency. Price risks refer to the possibility
of the purchase price of non-financial goods
increasing or the sale price of non-financial goods
decreasing. It can also protect against increases
in the repayment installments of a variable rate
loan, increases in the exchange rate of a foreign
currency in which the individual expects to make
a future transaction or increases in the prices of
inventory to purchase. A cash flow hedge uses
derivative instruments such as call options or put
options to limit the individual's exposure to such
risks.
Cash flow effects of financial instruments for
projects could be due to price changes, benchmark
interest rate changes, changes in the credit spread
between the interest rate of the hedged item and
the benchmark interest rate, and defaults or
changes in creditworthiness. In a cash flow hedge,
derivatives are used to offset the variability in cash
flows from a forecasted transaction for which there
is currently no legal commitment and which is
too uncertain to be documented. Management
anticipates that a transaction is likely to occur in
the future and hedges the associated price risk
by taking a position in the derivatives market.
The price of the derivative fluctuates during the
period interim to taking the derivative position
and its settlement.
The gains or losses arising from price fluctuations
are reported in the earnings statement (or in "other
comprehensive income"). However, the forecasted
transaction, that is the basis for the hedge, is not
recognized until its realization in the future - hence,
during the interim period, there is no recognition
of an offset to the reported gains or losses on
derivatives. This implies that outsiders assessing
the firm's financial condition are left to make their
own judgments regarding the extent to which the
reported gains or losses will reverse in the future.
If the hedged item is denominated in a foreign
currency, an entity may designate any of the
following types of hedges of foreign currency
exposure:
(a) A fair value hedge of an unrecognized firm
commitment or a recognized asset or liability
(including an available-for-sale security)
(b) A cash flow hedge of any of the following:
1. A forecasted transaction
2 . An unrecognized firm commitment
3 . The forecasted functional currency equivalent
cash flows associated with a recognized
asset or liability
4 . A forecasted intra-entity transaction
(c) A hedge of a net investment in a foreign
operation
LITERATURE REVIEW
There is a large literature which has studied cash
f low hedging in terms corporate of risk
management. Stulz (1984), Smith and Stulz (1985),
Stulz (1990), Bessembinder (1991), and Froot et.
al (1993) find that hedging increases firm value
in the presence of market imperfections such as
costs of external financing and a progressive tax
rate schedule. Given these frictions, the optimal
hedging strategies are analyzed. Such studies of
optimal hedging strategies posit that the firm's
cash flows are a deterministic function of some
common factors and the fluctuations in cash flow
come solely from the fluctuations of the factors.
In our framework, a firm's cash flow is uncertain
conditional on the common factor and it depends
on whether or not the firm has won the auction.
The relationship between hedging and project
market competition has been analyzed by Adam,
Dasgupta and Titman (2005). They characterize
Cournot equilibrium in which project firms may
Importance of Cash Flow Hedging in Projects from Corporate Sustainability
hedge input costs. They find that hedging strategy
is jointly determined in equilibrium with the
project market competition and that there can
be asymmetric equilibrium. Mello and Ruckes
(2005) also consider firms with financial
constraints who compete in project markets. They
find that even though reducing cash flow volatility
may be desirable, project firms may choose not
to hedge for competitive reasons. In this research,
we find the reverse, that firms in active competition
will always hedge and ex post those who lose the
competition have too much exposure to the
common factor. Loss (2002) demonstrates that
a firm in competition chooses to hedge strategically,
in particular, hedging is valuable if investments
are strategic substitute (as opposed to strategic
complements). Conceptually, this research differs
from these papers in one important way. This
research considers competition in indivisible
projects. This means that only one firm will win."
The other firms will necessarily lose," which is the
source of business risk.
A literature has considered the interaction between
hedging and bidding. Eaker and Grant (1985)
model a project firm with an exogenous probability
of winning a project whose payoff is exposed to
foreign exchange rate risk. They study the optimal
exposure to a forward contract on the exchange
rate. In a similar framework, Lien and Wong
(2004) incorporate a single bidder facing an
exogenous function that links bids to winning
probabilities. We extend this literature, by rendering
the bids and hedging endogenous. Therefore, we
can consider the interaction between financial
markets on project firms bidding behavior.
This paper also contributes to the auction literature
through the observation that, through financial
markets, agents may affect their valuations. The
incentive to hedge in this model arises because
firms face a convex cost of capital. Thus, the model
resembles auction models with risk averse bidders.
21
Eso and White (2003) examine the effect of
idiosyncratic risk on risk averse bidders. They find
that idiosyncratic risk can increase agents' expected
utility. Rhodes-Kropf and Viswanathan (2005) also
consider bidders who are financially constrained.
In their framework, bidders with differing cash
positions raise money which may be conditional
on the ex post value of the firm. They show that
capital markets may render the auction inefficient.
By contrast to their work, as we are interested
in how competition affects the investment
decisions of firms, was assume that the cost of
accessing the financial market either through
hedging or raising extra capital does not depend
on the bid or private information of the bidders.
The rest of the paper is organized as follows. Process
of cash flow hedging in projects followed by the
research model to calculate Net Currency Project
Cash Flow for Hedging, and we also derive
Sensitivity Analysis for Project Cash Flow Hedging.
In the last section of how to hedge project cash
flow, we assessed the impact of changed debt
currency on Project Cash Flow.
PROCESS OF CASH FLOW HEDGING IN
PROJECTS
The value of the project has a private value
component and a common value component. Both
are random, and therefore winning generates
uncertain internal capital. As each project firm
faces financial constraints, and hence invests
internal capital in an ongoing growth opportunity,
all firms behave as if they are risk averse in the
auction stage. They thus have an incentive to hedge
cash flow risk. The random common value
component of the project is correlated with
financial instruments which they can use to hedge
it. However, by assumption, contracts are not
written on who wins the auction, and markets
are necessarily incomplete so hedging with financial
instruments cannot eliminate all cash flow
uncertainty. Thus, while all firms may find it
optimal to hedge before the auction, all losers
22 NICMAR-Journal of Construction Management, Vol. XXVII, No. 2&3, April-June & July-Sept. 2012
in the auction find themselves exposed to the
common risk factor after the auction. This effect
may be termed as "business risk".
The incompleteness in projects requires that a
project firm hedges before the winner of the project
is announced. This timing friction is called "the
bid to award period." It arises from two sources.
First, bids for complicated projects can take a long
time to evaluate because factors other than price
such as political considerations, a bidder's technical
credentials, and the payment schedule are relevant.
For large and complex projects, a two-stage bidding
process may even be employed where bidders are
first invited to submit technical offers without
prices, which are then evaluated to set an acceptable
technical standard for all bidders, and then bidders
are asked to resubmit bids with prices (Asian
Development Bank, April 2006). Second, the bid
to award period also includes the time in which
the auction is anticipated but has not yet taken
place.
It has been found that this friction and the existence
of financial instruments make firms compete more
aggressively because by entering into a hedging
position, bidders run the risk of being over hedged
if they lose. It has been observed that the spillover
between projects can affect firms' investment in
projects that they do not compete over. The
existence of hedging instruments increases the
variability of industry wide investment and returns
of the firm because even though ex ante firms
are identical, their hedging positions vary and thus
make them all different ex post. It has been found
that even though the hedging instruments make
bidding more aggressive and thus increase seller's
profit, business risk reduces it. The seller suffers
a loss because bidders have to make hedging
decisions prior to knowing the auction outcome,
and the loss increases with bid-to-award length.
Thus, it is to the seller's advantage to accelerate
the evaluation process. This suggests that the
framework is most appropriate in markets in which
the seller also faces financing constraints and
therefore does not provide the hedge or finds it
optimal for bidders to retain some risk.
RESEARCH METHODOLOGY OF PROJECT
CASH FLOW HEDGING CALCULATION
In order to calculate project cash flow exposure
and hedging requirements, we need to construct
a research model for calculating project cash flow
exposure in multiple currencies (depends on
number of currencies being used in any project
as per the project bid document) for three crucial
stages of project like pre award stage, post award
stage and execution stage. After calculating net
project cash flow per currency for three stages,
we need to make sensitivity analysis (main purpose
of sensitivity analysis is to check impact of exchange
rate movements on cash flow valuation to
understand hedging requirements) for project cash
flow hedging in terms of pre-interest cash flow
per currency and consider project net average
interest expense (or income) per currency to get
a final net cash flow per currency. Then add on
a simple sensitivity analysis to show the effects
of exchange rate movements.
Finally to achieve cash flow hedging aim of
minimise net foreign currency cash flow and
maximise net base currency (local currency) cash
flow, we need to change the currency of the debt
and hence the interest expense to local currency.
Main purpose of this research exercise is to calculate
interest rate impact on overall project cash flow
if we charge the debt currency. Crux of this research
exercise is to compare project cash flow fluctuation
based on currency fluctuation against change in
debt currency. Let us understand utility of above
research model given in below sections.
HOW TO CALCULATE NET CURRENCY
PROJECT CASH FLOW FOR HEDGING?
In order to calculate net currency project cash flow
for hedging, first of all draw up one Table 1 showing
project net cash flows per annum in various key
Importance of Cash Flow Hedging in Projects from Corporate Sustainability 23

operating currencies (for three crucial stages of
project: Pre Award stage, Post Award stage and
Execution stage) before interest payments but after
tax. To get better project cash flow picture some
care has to be taken in collating these numbers.
Sometimes there are significant foreign currency
cash flows taking place in US $, , etc., which
depend on project location (i.e. country) and in
which currency cash flow is taking place. Also cash
tax is often not the same as the tax shown in the
statutory accounts. Foreign currency debt
repayments or planned material acquisitions or
disposals must also be included in an appropriate
manner. Table 1 indicates the format to be used
while calculating net currency (net cash flow being
calculated after considering three currencies
(Indian Rupees INR, US Dollar $, Euro , being
widely used by Indian project companies).
Table 1: Estimated Net Cash Flow Per Annum During Various Stages Of Project
(In Multiple Currencies)
cash flow estimation, here the project cash flow
has been split between the three currencies. There
will undoubtedly be required some numbers that
cannot be taken straight from the management
or statutory accounts, but generally some informed
and reasoned judgments will give sufficient accuracy.
Table 2 : Net Project Cash Flow
Per Currency
Project Cash Flow Factors Average of Three Stages
(All figures in millions) INR US $ Total in INR
Net Cash Flow Pre Interest
Interest
Net Cash Flow
The next thing to do is to average the project
cash flow numbers per currency across the three
stages of project. If there is a trend over time then
some weighting of the average is appropriate.

* Total can be calculated after converting foreign currency in INR based on respective date conversion rates.

To calculate the same; some forward looking
numbers are required, so some judgment is needed
(and no reason to limit up to three stages of project.
For minute prediction of project net cash flow,
further split in multiple stages as per WBS (Work
Breakdown Structure) of project is possible). To
illustrate the importance of project cash flow
hedging and for broad-brush accuracy of project
Having got an average for the pre-interest cash
flow per currency, next consider project net average
interest expense (or income) per currency, to give
final net cash flow per currency. Then add on
a simple sensitivity analysis to show the effects
of exchange rate movements as shown in
Table 3. To understand sensitivity analysis for project
cash flow hedging let us consider following case.
24 NICMAR-Journal of Construction Management, Vol. XXVII, No. 2&3, April-June & July-Sept. 2012
PROJECT CASE FOR CALCULATING
SENSITIVITY ANALYSIS FOR PROJECT
CASH FLOW HEDGING
In order to understand sensitivity analysis for
project cash flow hedging, assume one project
which has average net cash flow pre interest (for
three crucial stages of project: Pre Award stage,
Post Award stage and Execution stage) in three
different currencies (INR, $ and which includes
local currency (INR)) are 30,10 and 7 million
respectively. Borrowing cost (i.e. Interest
applicable) for raising fund in $ and are 3 and
2 million respectively. After plugging above values
in Table 3 of sensitivity analysis for project cash
flow hedging, we can calculate net cash flow in
INR which is coming to 42 million. In this scenario
if we assume INR depreciation & appreciation
by 5%, then we can find that net cash flow is
fluctuating between 40.5 to 43.5 million for 42
million base figures with a fluctuation rate of 3.57%.
Table 3 : Sensitivity Analysis For
Project Cash Flow Hedging
Project Cash Flow Factors Average of Three Stages
(All figures in millions) INR US $ Total in INR
Net Cash Flow Pre Interest 30 10 7 47
Interest -3 -2 -5
Net Cash Flow 30 7 5 42
INR Depreciate by 5 % 31.5 7 5 43 .5
INR Appreciate by 5 % 28.5 7 5 40 .5
Fluctuation *+/-3. 57%
Now to understand foreign exchange fluctuation
and its impact on cash flow of project and what
if projections, there is need to calculate the current
value of the project based on its potential future
performance and especially its potential future net
cash flows. In this case, suppose if both foreign
currencies $ and appreciates against local currency
INR by 5 % then the project is going to be worth
some 3.57 % less to its company and vice-versa
if both currencies $ and depreciates against INR
by 5 % then the project is going to be worth some
3.57 % more to its company.
In this case, project company treasury is going to
see that this exposure (i.e. 42 million) is unhedged.
Corporate treasury will mark down the cash flow
for the uncertainty, and of course if INR does
appreciate, then treasury will mark down the cash
flow for the fact. Now the question is how can
project company hedge against these potentially
substantial value impacts?
HOW TO HEDGE PROJECT CASH FLOW?
Main objective behind this exercise is to minimise
net foreign currency cash flow and maximise net
base currency cash flow. The less foreign currency
cash flow project has as a part of the total cash
f low, the less the impact of exchange rate
movements on value. The answer in most real-
life projects is to look at the only thing that project
has to play with i.e. the currency of the interest
expense (or income) on debt (or cash).
PROJECT CASE FOR CALCULATING
IMPACT OF CHANGED DEBT CURRENCY
ON PROJECT CASH FLOW
To understand impact of change in debt currency
on project cash flow let us assume following scenario.
In the continuation of above project cash flow
example (as mentioned above for calculating
Sensitivity Analysis for Project Cash Flow Hedging),
look at what happens if we change the currency
of the debt from foreign currencies $ and to
local currency INR and hence the interest expense
to INR. If we assume for the sake of simplicity
roughly similar interest rate expense (i.e. 5 million
as mentioned in Table 3) as indicated in Table 4.
Table 4 : Impact Of Changed Debt Currency On
Project Cash Flow
Project Cash Flow Factors Average of Three Stages
(All figures in millions) INR US $ Total in INR
Net Cash Flow Pre Interest 30 10 7 47
Interest -5 -5
Net Cash Flow 25 10 7 42
INR Depreciate by 5 % 26.25 10 7 43 .25
INR Appreciate by 5 % 23.75 10 7 40 .75
Fluctuation *+/-2. 98 %
If we go ahead with similar depreciation and
appreciation of INR by 5% then we can find that
Importance of Cash Flow Hedging in Projects from Corporate Sustainability
the net cash flow is fluctuating between 40.75
to 43.25 million for 42 million base figures with
a fluctuation rate of 2.98%. Hence as we can
observed in Table 3 & 4 that the sensitivity (after
comparing Table-3 & 4) has been come down by
0.59% (3.57% - 2.98%) between both the scenario.
This will reduce the current value mark-down due
to uncertainty, and will reduce the actual value
mark-down if an adverse change actually occurs
a significant enhancement to company valuation.
However, in real-life scenario, situations are rarely
quite simple like above. Usually, company treasury
cell will ask to undertake currency exposure reviews
often by FDs and treasurers because they suspect
that the company is misaligned but they haven't
quite put their finger on the problem, or they
want an independent recommendation to support
a proposal to the management. Often project
companies do have significant unhedged net
currency cash flow exposure, and they also have
the means of reducing the exposure, sometimes
quite dramatically.
CONCLUSION
There can be no doubt that, alongside the
traditional Profit & Loss account and balance sheet
views of currency exposure, treasurers should also
obtain a net currency cash flow exposure analysis.
Suggested outcome of this research can strongly
influence aspects of the project treasurer's currency
hedging activity, and in particular lead to a change
in the currency of the project's debt or cash. Failure
to include the results of a net currency cash flow
exposure analysis in currency exposure
management decisions means that exposure of
the project company's value to currency movements
has been overlooked, and its management may
well not be optimized.
This research has exhibited cash flow hedging
strategies during the three crucial stages (Pre-Award,
Post-Award and Execution) of project. Project
bidders know they will face a convex cost of capital
in the future, and have an incentive to hedge the
25
cash flow as they bid. Because the bidders' hedging
decisions are made prior to the award
announcement, they face a basic tradeoff between
maximally hedging the cash flow in the event of
winning the auction and not hedging any amount
in the case of losing. Their optimal hedging strategy
depends on their winning probability. Indeed,
research has established that the larger the bidder's
winning probability, the more complete the
hedging will be. The increase in hedging coverage
depends on how sensitive the firm's overall payoffs
are to changes in internal capital. For Project cash
flow hedging relationships, the initial and ongoing
prospective effectiveness is assessed by comparing
movements in the fair value of the expected highly
probable forecast interest cash flows with
movements in the fair value of the expected
changes in cash flows from the hedging interest
rate swap or by comparing the respective changes
in the price value of a basis point.
Further, the fact that project firms can hedge makes
them bid more aggressively. After a project firm
commits to a hedging position, it has more to
lose because of the business risk that it faces: it
is over hedged if it does not win the project. Indeed,
the hedging position for a project firm with a large
probability of winning can be large enough such
that the bid will even exceed that when contracts
can be written contingent on winning the auction
such that the variation in cash flow can be
completely removed. As a result, hedging
instruments increase a seller's profit.
Overall, this research paper presents a framework
in which the effect of a financing friction is
magnified in project business due to competition.
All Project firms hedge as they anticipate future
cash flow constraints. Due to competition, project
firms bid away benefits to hedging and in aggregate
exacerbate the project industry's constraints. Last
but not least effective cash flow hedging strategies
will decide any project company's corporate
sustainability in a longer run of the firm.
26 NICMAR-Journal of Construction Management, Vol. XXVII, No. 2&3, April-June & July-Sept. 2012
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