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401
Project Management
Spring 2007
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
CONTRACTOR
costs ($4,000,000) ($7,000,000) ($14,000,000) $0 $0 $0 $0 $0 $0 $0
revenues $0 $10,000,000 $20,000,000 $0 $0 $0 $0 $0 $0 $0
contractor cashflow ($4,000,000) $3,000,000 $6,000,000 $0 $0 $0 $0 $0 $0 $0
contractor cum cashflow
($4,000,000) ($1,000,000) $5,000,000 $5,000,000 $5,000,000 $5,000,000 $5,000,000 $5,000,000 $5,000,000 $5,000,000
CONTRACTOR
costs ($4,000,000) ($7,000,000) ($14,000,000) $0 $0 $0 $0 $0 $0 $0
revenues $0 $10,000,000 $20,000,000 $0 $0 $0 $0 $0 $0 $0
contractor cashflow ($4,000,000) $3,000,000 $6,000,000 $0 $0 $0 $0 $0 $0 $0
contractor cum cashflow
($4,000,000) ($1,000,000) $5,000,000 $5,000,000 $5,000,000 $5,000,000 $5,000,000 $5,000,000 $5,000,000 $5,000,000
CONTRACTOR
costs ($4,000,000) ($7,000,000) ($14,000,000) $0 $0 $0 $0 $0 $0 $0
revenues $0 $10,000,000 $20,000,000 $0 $0 $0 $0 $0 $0 $0
contractor cashflow ($4,000,000) $3,000,000 $6,000,000 $0 $0 $0 $0 $0 $0 $0
contractor cum cashflow
($4,000,000) ($1,000,000) $5,000,000 $5,000,000 $5,000,000 $5,000,000 $5,000,000 $5,000,000 $5,000,000 $5,000,000
• Early expenditure
• Takes time to get revenue
Project Financing
Public
Private
“Project” financing
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
Public Financing
Sources of funds
General purpose or special-purpose bonds
Tax revenues
Capital grants subsidies
International subsidized loans
Social benefits important justification
Benefits to region, quality of life, unemployment relief, etc.
Important consideration: exemption from taxes
Public owners face restrictions (e.g. bonding caps)
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)
Debt
Borrow money
Bonds
Because higher costs and risks, require higher
returns
MARR varies per firm, often high (e.g. 20%)
Private Owners w/Collateral
Facility Distinct Financing
Periods
Short-term construction loan
Bridge Debt
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
Man-hours
months
S-curve Cost
8 100
90
7
80
6
70
Cumulative costs $K
5
60
4 50 Daily cost
$K
Cum. costs
40
3
30
2
20
1
10
0 0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22
Working days
Expense & Payment
Contractor Financing II
Owner keeps an eye out for
Front-end loaded bids (discounting)
Unbalanced bids
Contractor Financing II
Owner keeps an eye out for
Front-end loaded bids (discounting)
Unbalanced bids
Contractors frequently borrow from
Banks (Need to demonstrate low risk)
Interaction with owners
Some owners may assist in funding
Help secure lower-priced loan for contractor
Sometimes assist owners in funding!
Big construction company, small municipality
BOT
Contractor Financing III
Project A Project B
Construction=3 Construction=6
years years
Cost = $1M/year Cost=$1M/year
Sale Value=$4M Sale Value=$8.5M
Total Cost? Total Cost?
Profit? Profit?
Quantitative Method
Profitability
Create value for the company
Profit
TOTAL
EQUIVAL. $
REVENUES 5,500,000.
00
COSTS 4,600,000.
00
Project management 400,000.00
Engineering 800,000.00
Material & transport 2,200,000.00
Construction/commissioni 1,300,000.00
ng
Contingencies 200,000.00
Time factor?
GROSS MARGIN 900,000.0
Quantitative Method
Profitability
Create value for the company
Opportunity Cost
Time Value of Money
A dollar today is worth more than a dollar tomorrow
Investment relative to best-case scenario
E.g. Project A - 8% profit, Project B - 10% profit
Money Is Not
Everything
Social Benefits
Hospital
School
Highway built into a remote village
Intangible Benefits (E.g, operating and
competitive necessity)
New warehouse
New cafeteria
Outline
Session Objective & Context
Project Financing
Owner
Project
Contractor
Additional issues
Financial Evaluation
Time value of money
Present value
Rates
Interest Formulas
NPV
IRR & payback period
Missing factors
Basic Compounding
Suppose we invest $x in a bank offering interest rate
i
If interest is compounded annually, asset will be
worth
$x(1+i) after 1 year
$x(1+i)2 after 2 years
$x(1+i)3 after 3 years ….
$x(1+i)n after n years
$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
Then
Money in the present can be thought as of
“equal worth” to a larger amount of money in the
future
Money in the future can be thought of as having
an equal worth to a lesser “present value” of
money
Equivalence of Present
Values
STELLAR access:
http://stellar.mit.edu/S/course/1/sp07/1.040/
Next Tuesday Recitation: Skyscraper Part I
Please set up an appointment to discuss
your AS2 if you choose emerging
technologies (MF preferred)
Office: 1-174
TA (50%) for our class
Send your resume (or brief your experience) by
this Sunday
Outline
Session Objective & Context
Project Financing
Owner
Project
Contractor
Additional issues
Financial Evaluation
Time value of money
Present value
Rates
Interest Formulas
NPV
IRR & payback period
Missing factors
Time Value of Money:
Revisit
If we assume
That money can always be invested in the bank
(or some other reliable source) now to gain a
return with interest later
That as rational actors, we never make an
investment which we know to offer less money
than we could get in the bank
Then
Money in the present can be thought as of
“equal worth” to a larger amount of money in the
future
Money in the future can be thought of as having
an equal worth to a lesser “present value” of
money
Present Value (Revenue)
0 t
PV(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
FV v’
0
PV v t
Summary
Because we can flexibly switch from one such
value to another without cost, we can view these
values as equivalent
FV v’= v(1+i)t
0
PV v t
Where:
0 1 2 … n
F
P
Interest Formulas:
Payment
0 1 … n-1 n
P
F
Interest Formulas:
Payment
- Example
If you wish to have $100,000 at the end
of five years in an account that pays 12
percent annually, how much would you
need to deposit now?
Interest Formulas:
Payment
- Example
If you wish to have $100,000 at the end
of five years in an account that pays 12
percent annually, how much would you
need to deposit now?
0 n
P=? F=$100,000
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
F
0 1 2 … n
A A A A
A A A A
Interest Formulas: Series
A A A A
Interest Formulas: Series
A A A A
Interest Formulas: Series
0 1 2 … n
A A A A
F
Interest Formulas: Series
P
0 1 2 … n
A A A A
Interest Formulas: Series
0 1 2 … n
A A A A
Interest Formulas: Series
0 1 2 … n
A A A A
Interest Formulas: Series
0 1 2 … n
A A A A
Verify it!
Interest Formulas: Series
0 1 2 … n
A A A A
P
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?
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?
= -5,373
= -18,011
Outline
Session Objective & Context
Project Financing
Owner
Project
Contractor
Additional issues
Financial Evaluation
Time value of money
Present value
Rate
Interest Formulas
NPV
IRR & payback period
Missing factors
Net Present Value
Calculate Gross
Return
Tax (-)
Calculate Net
Return
Discount Rate (r)
PV of Net Return
Initial Invest (-I)
NPV of the Project
Net Present Value
Decision Rule
> Accept the project
NPV = 0 Indifferent to the project
< Reject the project
Project B $8.5M
0 1 6
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)
-$77 M
[NPV2]20%
= -75.3 + (28)(P/A, 0.2, 5) = -75.3 + 83.7
= 8.4
$28 M each year
-$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 $50 M
$30 M
$18 M $10 M
-$40 M
-$60 M
Source: Hendrickson and Au, 1989/2003
Solution
[NPV1] = 17.4
[NPV2] = 8.4
[NPV3] = 0.4
[NPV4] = -1.6
Link
Selection of Discount Rate:
Example
2 pieces of equipment: one needs a human operator (initial cost $10,000,
annual $4,200 for labor); the second is fully automated (initial cost $18,000,
annual #3,000 for power). n=10years.
Is the additional $8,000 in the initial investment of the second equipment
worthy the $1,200 annual savings? (discount rate: 5 or 10%)
There is a critical value of i that changes the equipment choice
(approximately 8.15%)
Example: The US Federal Highway Administration promulgated a regulation
in the early 1970s that the discount rate for all federally funded highways
would be zero. This was widely interpreted as a victory for the cement
industry over asphalt industry. Roads made of concrete cost significantly
more than those of made of asphalt while requiring less maintenance and
less replacement [Shtub et al., 1994] - Link
Outline
Session Objective & Context
Project Financing
Owner
Project
Contractor
Additional issues
Financial Evaluation
Time value of money
Present value
Rate
Interest Formulas
NPV
IRR & payback period
Missing factors
Internal Rate of Return
(IRR)
IRR
IRR Investment Rule
> Accept
r- =
r* Indifferent
< Reject
r- = IRR,
* r = MARR
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
n
NPV A0 At / (1 i ) t
t 1
n
NPV A0 At' / (1 i ' ) t
t 1
At → cash flow in year t expressed in terms of constant
(base year) dollars
A't → cash flow in year t expressed in terms of inflated
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 investment is worthwhile.
Link
Solution
Depreciation costs are not inflated to current dollars in conformity with the
practice recommended by the U.S. Internal Revenue Service.
Financing &
Evaluation
Risk
Risk Management
Case Study