Professional Documents
Culture Documents
Lecture 2 Project Financing & Evaluation
Lecture 2 Project Financing & Evaluation
Lecture 2 Project Financing & Evaluation
401
Project Management
Spring 2007 Project Financing & Evaluation
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
Size of project is not important! Project main figures Main managerial aspects Project management practices Problems, strengths, weaknesses, risks Your learning
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
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
FEASIBILITY
DESIGN PLANNING
DEVELOPMENT
CLOSEOUT
OPERATIONS
Project Concept Land Purchase & Sale Review Evaluation (scope, size, etc.) Constraint survey
Summary Report Decision to proceed Regulatory process (obtain permits, etc) Design Phase
Lecture 2 - References
More details on:
Chapter 7
Outline
Financial Evaluation
Time value of money Present value Rates Interest Formulas NPV IRR & payback period
Missing factors
Design/Preliminary
years OWNER investment operation incomes owner cashflow owner cum cashflow 1
$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
$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
Project Financing
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)
Outline
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 Benefits to region, quality of life, unemployment relief, etc.
Important consideration: exemption from taxes Public owners face restrictions (e.g. bonding caps)
MARR (Minimum Attractive Rate of Return) much lower (e.g. 8-10%), often standardized
Private Financing
Major mechanisms
Equity
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
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
operation w/ tangible
time
Outline
Financial Evaluation
Time value of money Present value Rates Interest Formulas NPV IRR & payback period
Missing factors
Project Financing
Investment is paid back from the project profit rather than the general assets or creditworthiness of the project owners For larger projects due to fixed cost to establish
Off balance sheet (liabilities do not belong to parent) Limits risk External investors: reduced agency cost (direct investment in project)
Outline
Financial Evaluation
Time value of money Present value Rates Interest Formulas NPV IRR & payback period
Missing factors
Contractor Financing I
Payment schedule
Advance payment Periodic/monthly progress payment (itemized breakdown structure) Milestone payments
Often some compromise between contractor and owner Architect certifies progress Agreed-upon payments
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
Contractor Financing II
20 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 Month
Contractor Financing II
Front-end loaded bids (discounting) Unbalanced bids Banks (Need to demonstrate low risk) Some owners may assist in funding
Help secure lower-priced loan for contractor Big construction company, small municipality BOT
Often structure proposed by owner Should be checked by owner (fair-cost estimate) Often based on Masterformat Cost Breakdown Structure (Owner standard CBS)
Outline
Owner Project Contractor Additional Issues Time value of money Present value Rates Interest Formulas NPV IRR & payback period
Financial Evaluation
Missing factors
Latent Credit
Designers Contractors Consultants CM Suppliers Good in the short-term Major concern on long run effects
Implications
Role of Taxes
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
Financial Evaluation
Time value of money Present value Rates Interest Formulas NPV IRR & payback period
Missing factors
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 A Construction=3 years Cost = $1M/year Sale Value=$4M Total Cost? Profit?
Quantitative Method
Profitability
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
900,000.0
Quantitative Method
Profitability
Opportunity Cost
A dollar today is worth more than a dollar tomorrow E.g. Project A - 8% profit, Project B - 10% profit
Social Benefits
Outline
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
0 $x
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
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
Financial Evaluation
Time value of money Present value Rates Interest Formulas NPV IRR & payback period
Missing factors
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
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)
PV(x)
The net result is that I can convert a sure x at time t into a (smaller) PV(x) now!
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
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
Financial Evaluation
Time value of money Present value Rates Interest Formulas NPV IRR & payback period
Missing factors
Rates
Rates
Outline
Financial Evaluation
Time value of money Present value Rates Interest Formulas NPV IRR & payback period
Missing factors
Interest Formulas
i = Effective interest rate per interest period (discount rate or MARR) n = Number of compounding periods PV = Present Value FV = Future Value A = Annuity (i.e., a series of payments of set size) at end-of-period
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
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
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?
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
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?
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
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
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
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
Factor that will make your annuity value present value in series payment (P/A, i, n) = [ (1 + i )n -1 ] / [ i (1 + i )n ]
P = A/ (1 + i ) 0 1 2 n
Factor that will make your annuity value present value in series payment (P/A, i, n) = [ (1 + i )n -1 ] / [ i (1 + i )n ]
P = A/(1 + i ) + A/(1 + i )2 0 1 2 n
Factor that will make your annuity value present value in series payment (P/A, i, n) = [ (1 + i )n -1 ] / [ i (1 + i )n ]
Verify it!
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!
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?
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?)
A ranch is offered for sale in Mexico with a 15 year mortgage rate at 40% compounded annually, and 20% down payment. Annual payments are to be made. The first cost of the ranch is 5 million pesos. What yearly payment is required?
Down Payment = 5,000,000 * 0.2 = 1,000,000 P = 5,000,000 1,000,000 = 4,000,000 A = P * (which factor?) = P * (A/P, 0.4, 15) A = 4,000,000 * 0.40259 = 1,610,400 pesos/year
Equipment Example
$ 20,000 equipment expected to last 5 years $ 4,000 salvage value Minimum attractive rate of return 15% What are the?
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
Outline
Financial Evaluation
Time value of money Present value Rate Interest Formulas NPV IRR & payback period
Missing factors
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
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 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?
Project A
0 1 2 3
$4M
$1M
$1M
$1M $8.5M 6
Project B
0 1
$1M
$1M
$1M
$1M
$1M
$1M
Project A
Project B
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
Year 0
-$77 M
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
Solution
= = = =
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.
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
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
Financial Evaluation
Time value of money Present value Rate Interest Formulas NPV IRR & payback period
Missing factors
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
r*
-r = IRR, * r = MARR
<
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
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
Minimal length of time over which benefits repay costs Typically only used as secondary assessment
Payback Period
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
Comparing Projects
Suppose that one had to choose between 2 investment projects Use NPV Verify IRR Check payback period
Other Methods
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 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
NPV = A0 + At / (1 + i ) t
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)
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
Financial Evaluation
Time value of money Present value Rates Interest Formulas NPV IRR & payback period
Missing factors
That only quantifiable monetary benefits matter Certainty about future cash flows
Main uncertainties:
Financial concerns
Project risks
FEASIBILITY
DESIGN PLANNING
DEVELOPMENT
CLOSEOUT
OPERATIONS
Risk Management
Case Study