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7. Financing of Constructed Facilities 7.1 The Financing Problem Investment in a constructed facility represents a cost in the short term that returns benefits only over the long term use of the facility. Thus, costs occur earlier than the benefits, and owners of facilities must obtain the capital resources to finance the costs of construction. A project cannot proceed without adequate financing, and the cost of providing adequate financing can be quite large. For these reasons, attention to project finance is an important aspect of project management. Finance is also a concern to the other organizations involved in a project such as the general contractor and material suppliers. Unless an owner immediately and completely covers the costs incurred by each participant, these organizations face financing problems of their own. At a more general level, project finance is only one aspect of the general problem of corporate finance. If numerous projects are considered and financed together, then the net cash flow requirements constitutes the corporate financing problem for capital investment. Whether project finance is performed at the project or at the corporate level does not alter the basic financing problem. In essence, the project finance problem is to obtain funds to bridge the time between making expenditures and obtaining revenues. Based on the conceptual plan, the cost estimate and the construction plan, the cash flow of costs and receipts for a project can be estimated. Normally, this cash flow will involve expenditures in early periods. Covering this negative cash balance in the most beneficial or cost effective fashion is the project finance problem. During planning and design, expenditures of the owner are modest, whereas substantial costs are incurred during construction. Only after the facility is complete do revenues begin. In contrast, a contractor would receive periodic payments from the owner as construction proceeds. However, a contractor also may have a negative cash balance due to delays in payment and retainage of profits or cost reimbursements on the part of the owner. Plans considered by owners for facility financing typically have both long and short term aspects. In the long term, sources of revenue include sales, grants, and tax revenues. Borrowed funds must be eventually paid back from these other sources. In the short term, a wider variety of financing options exist, including borrowing, grants, corporate investment funds, payment delays and others. Many of these financing options involve the participation of third parties such as banks or bond underwriters. For private facilities such as office buildings, it is customary to have completely different financing arrangements during the construction period and during the period of facility use. During the latter period, mortgage or loan funds can be secured by the value of the facility itself. Thus, different arrangements of financing options and participants are possible at different stages of a project, so the practice of financial planning is often complicated. On the other hand, the options for borrowing by contractors to bridge their expenditures and receipts during construction are relatively limited. For small or medium size projects, overdrafts from bank accounts are the most common form of construction financing. Usually, a maximum limit is imposed on an overdraft account by the bank on the basis of expected expenditures and receipts for the duration 210 of construction. Contractors who are engaged in large projects often own substantial assets and can make use of other forms of financing which have lower interest charges than overdrafting. In recent years, there has been growing interest in design-build-operate projects in which owners prescribe functional requirements and a contractor handles financing. Contractors are repaid over a period of time from project revenues or government payments. Eventually, ownership of the facilities is transferred to a government entity. An example of this type of project is the Confederation Bridge to Prince Edward Island in Canada. In this chapter, we will first consider facility financing from the owner's perspective, with due consideration for its interaction with other organizations involved in a project. Later, we discuss the problems of construction financing which are crucial to the profitability and solvency of construction contractors. Back to top 7.2 Institutional Arrangements for Facility Financing Financing arrangements differ sharply by type of owner and by the type of facility construction. As one example, many municipal projects are financed in the United States with tax exempt bonds for which interest payments to a lender are exempt from income taxes. As a result, tax exempt municipal bonds are available at lower interest charges. Different institutional arrangements have evolved for specific types of facilities and organizations. A private corporation which plans to undertake large capital projects may use its retained earnings, seek equity partners in the project, issue bonds, offer new stocks in the financial markets, or seek borrowed funds in another fashion. Potential sources of funds would include pension funds, insurance companies, investment trusts, commercial banks and others. Developers who invest in real estate properties for rental purposes have similar sources, plus quasi-governmental corporations such as urban development authorities. Syndicators for investment such as real estate investment trusts (REITs) as well as domestic and foreign pension funds represent relatively new entries to the financial market for building mortgage money. Public projects may be funded by tax receipts, general revenue bonds, or special bonds with income dedicated to the specified facilities. General revenue bonds would be repaid from general taxes or other revenue sources, while special bonds would be redeemed either by special taxes or user fees collected for the project. Grants from higher levels of government are also an important source of funds for state, county, city or other local agencies. Despite the different sources of borrowed funds, there is a rough equivalence in the actual cost of borrowing money for particular types of projects. Because lenders can participate in many different financial markets, they tend to switch towards loans that return the highest yield for a particular level of risk. As a result, borrowed funds that can be obtained from different sources tend to have very similar costs, including interest charges and issuing costs. 211 As a general principle, however, the costs of funds for construction will vary inversely with the risk of a loan. Lenders usually require security for a loan represented by a tangible asset. If for some reason the borrower cannot repay a loan, then the borrower can take possession of the loan security. To the extent that an asset used as security is of uncertain value, then the lender will demand a greater return and higher interest payments. Loans made for projects under construction represent considerable risk to a financial institution. If a lender acquires an unfinished facility, then it faces the difficult task of reassembling the project team. Moreover, a default on a facility may result if a problem occurs such as foundation problems or anticipated unprofitability of the future facility. As a result of these uncertainties, construction lending for unfinished facilities commands a premium interest charge of several percent compared to mortgage lending for completed facilities. Financing plans will typically include a reserve amount to cover unforeseen expenses, cost increases or cash flow problems. This reserve can be represented by a special reserve or a contingency amount in the project budget. In the simplest case, this reserve might represent a borrowing agreement with a financial institution to establish a line of credit in case of need. For publicly traded bonds, specific reserve funds administered by a third party may be established. The cost of these reserve funds is the difference between the interest paid to bondholders and the interest received on the reserve funds plus any administrative costs. Finally, arranging financing may involve a lengthy period of negotiation and review. Particularly for publicly traded bond financing, specific legal requirements in the issue must be met. A typical seven month schedule to issue revenue bonds would include the various steps outlined in Table 7-1. [1] In many cases, the speed in which funds may be obtained will determine a project's financing mechanism. TABLE 7-1 Illustrative Process and Timing for Issuing Revenue Bonds Activities Time of Activities Analysis of financial alternatives Preparation of legal documents Preparation of disclosure documents Forecasts of costs and revenues Bond Ratings Bond Marketing Bond Closing and Receipt of Funds Weeks 0-4 Weeks 1-17 Weeks 2-20 Weeks 4-20 Weeks 20-23 Weeks 21-24 Weeks 23-26 Example 7-1: Example of financing options Suppose that you represent a private corporation attempting to arrange financing for a new headquarters building. These are several options that might be considered: • • Use corporate equity and retained earnings: The building could be financed by directly committing corporate resources. In this case, no other institutional parties would be involved in the finance. However, these corporate funds might be too limited to support the full cost of construction. Construction loan and long term mortgage: In this plan, a loan is obtained from a bank or other financial institution to finance the cost of construction. Once the building is complete, a 212 • • variety of institutions may be approached to supply mortgage or long term funding for the building. This financing plan would involve both short and long term borrowing, and the two periods might involve different lenders. The long term funding would have greater security since the building would then be complete. As a result, more organizations might be interested in providing funds (including pension funds) and the interest charge might be lower. Also, this basic financing plan might be supplemented by other sources such as corporate retained earnings or assistance from a local development agency. Lease the building from a third party: In this option, the corporation would contract to lease space in a headquarters building from a developer. This developer would be responsible for obtaining funding and arranging construction. This plan has the advantage of minimizing the amount of funds borrowed by the corporation. Under terms of the lease contract, the corporation still might have considerable influence over the design of the headquarters building even though the developer was responsible for design and construction. Initiate a Joint Venture with Local Government: In many areas, local governments will help local companies with major new ventures such as a new headquarters. This help might include assistance in assembling property, low interest loans or proerty tax reductions. In the extreme, local governments may force sale of land through their power of eminent domain to assemble necessary plots. Back to top 7.3 Evaluation of Alternative Financing Plans Since there are numerous different sources and arrangements for obtaining the funds necessary for facility construction, owners and other project participants require some mechanism for evaluating the different potential sources. The relative costs of different financing plans are certainly important in this regard. In addition, the flexibility of the plan and availability of reserves may be critical. As a project manager, it is important to assure adequate financing to complete a project. Alternative financing plans can be evaluated using the same techniques that are employed for the evaluation of investment alternatives. As described in Chapter 6, the availability of different financing plans can affect the selection of alternative projects. A general approach for obtaining the combined effects of operating and financing cash flows of a project is to determine the adjusted net present value (APV) which is the sum of the net present value of the operating cash flow (NPV) and the net present value of the financial cash flow (FPV), discounted at their respective minimum attractive rates of return (MARR), i.e., (7.1) where r is the MARR reflecting the risk of the operating cash flow and rf is the MARR representing the cost of borrowing for the financial cash flow. Thus, 213 (7.2) where At and are respectively the operating and financial cash flows in period t. For the sake of simplicity, we shall emphasize in this chapter the evaluation of financing plans, with occasional references to the combined effects of operating and financing cash flows. In all discussions, we shall present various financing schemes with examples limiting to cases of before-tax cash flows discounted at a before-tax MARR of r = rf for both operating and financial cash flows. Once the basic concepts of various financing schemes are clearly understood, their application to more complicated situations involving depreciation, tax liability and risk factors can be considered in combination with the principles for dealing with such topics enunciated in Chapter 6. In this section, we shall concentrate on the computational techniques associated with the most common types of financing arrangements. More detailed descriptions of various financing schemes and the comparisons of their advantages and disadvantages will be discussed in later sections. Typically, the interest rate for borrowing is stated in terms of annual percentage rate (A.P.R.), but the interest is accrued according to the rate for the interest period specified in the borrowing agreement. Let ip be the nominal annual percentage rate, and i be the interest rate for each of the p interest periods per year. By definition (7.3) If interest is accrued semi-annually, i.e., p = 2, the interest rate per period is ip/2; similarly if the interest is accrued monthly, i.e., p = 12, the interest rate per period is ip/12. On the other hand, the effective annual interest rate ie is given by: (7.4) Note that the effective annual interest rate, ie, takes into account compounding within the year. As a result, ie is greater than ip for the typical case of more than one compounding period per year. For a coupon bond, the face value of the bond denotes the amount borrowed (called principal) which must be repaid in full at a maturity or due date, while each coupon designates the interest to be paid periodically for the total number of coupons covering all periods until maturity. Let Q be the amount borrowed, and Ip be the interest payment per period which is often six months for coupon bonds. If the 214 coupon bond is prescribed to reach maturity in n years from the date of issue, the total number of interest periods will be pn = 2n. The semi-annual interest payment is given by: (7.5) In purchasing a coupon bond, a discount from or a premium above the face value may be paid. An alternative loan arrangement is to make a series of uniform payments including both interest and part of the principal for a pre-defined number of repayment periods. In the case of uniform payments at an interest rate i for n repayment periods, the uniform repayment amount U is given by: (7.6) where (U|P,i,n) is a capital recovery factor which reads: "to find U, given P=1, for an interest rate i over n periods." Compound interest factors are as tabulated in Appendix A. The number of repayment periods n will clearly influence the amounts of payments in this uniform payment case. Uniform payment bonds or mortgages are based on this form of repayment. Usually, there is an origination fee associated with borrowing for legal and other professional services which is payable upon the receipt of the loan. This fee may appear in the form of issuance charges for revenue bonds or percentage point charges for mortgages. The borrower must allow for such fees in addition to the construction cost in determining the required original amount of borrowing. Suppose that a sum of Po must be reserved at t=0 for the construction cost, and K is the origination fee. Then the original loan needed to cover both is: (7.7) If the origination fee is expressed as k percent of the original loan, i.e., K = kQ0, then: (7.8) Since interest and sometimes parts of the principal must be repaid periodically in most financing arrangements, an amount Q considerably larger than Q0 is usually borrowed in the beginning to provide adequate reserve funds to cover interest payments, construction cost increases and other unanticipated shortfalls. The net amount received from borrowing is deposited in a separate interest bearing account from which funds will be withdrawn periodically for necessary payments. Let the borrowing rate per period be denoted by i and the interest for the running balance accrued to the 215 project reserve account be denoted by h. Let At be the net operating cash flow for - period t (negative for construction cost in period t) and be the net financial cash flow in period t (negative for payment of interest or principal or a combination of both). Then, the running balance Nt of the project reserve account can be determined by noting that at t=0, (7.9) and at t = 1,2,...,n: (7.10) where the value of At or t may be zero for some period(s). Equations (7.9) and (7.10) are approximate in that interest might be earned on intermediate balances based on the pattern of payments during a period instead of at the end of a period. Because the borrowing rate i will generally exceed the investment rate h for the running balance in the project account and since the origination fee increases with the amount borrowed, the financial planner should minimize the amount of money borrowed under this finance strategy. Thus, there is an optimal value for Q such that all estimated shortfalls are covered, interest payments and expenses are minimized, and adequate reserve funds are available to cover unanticipated factors such as construction cost increases. This optimal value of Q can either be identified analytically or by trial and error. Finally, variations in ownership arrangements may also be used to provide at least partial financing. Leasing a facility removes the need for direct financing of the facility. Sale-leaseback involves sale of a facility to a third party with a separate agreement involving use of the facility for a pre-specified period of time. In one sense, leasing arrangements can be viewed as a particular form of financing. In return for obtaining the use of a facility or piece of equipment, the user (lesser) agrees to pay the owner (lesser) a lease payment every period for a specified number of periods. Usually, the lease payment is at a fixed level due every month, semi-annually, or annually. Thus, the cash flow associated with the equipment or facility use is a series of uniform payments. This cash flow would be identical to a cash flow resulting from financing the facility or purchase with sufficient borrowed funds to cover initial construction (or purchase) and with a repayment schedule of uniform amounts. Of course, at the end of the lease period, the ownership of the facility or equipment would reside with the lesser. However, the lease terms may include a provision for transferring ownership to the lesser after a fixed period. Example 7-2: A coupon bond cash flow and cost A private corporation wishes to borrow $10.5 million for the construction of a new building by issuing a twenty-year coupon bond at an annual percentage interest rate of 10% to be paid semi-annually, i.e. 5% per interest period of six months. The principal will be repaid at the end of 20 years. The amount 216 borrowed will cover the construction cost of $10.331 million and an origination fee of $169,000 for issuing the coupon bond. The interest payment per period is (5%) (10.5) = $0.525 million over a life time of (2) (20) = 40 interest periods. Thus, the cash flow of financing by the coupon bond consists of a $10.5 million receipt at period 0, -$0.525 million each for periods 1 through 40, and an additional -$10.5 million for period 40. Assuming a MARR of 5% per period, the net present value of the financial cash flow is given by: [FPV]5%) = 10.5 - (0.525)(P|U, 5%, 40) - (10.5)(P|F, 5%, 40) = 0 This result is expected since the corporation will be indifferent between borrowing and diverting capital from other uses when the MARR is identical to the borrowing rate. Note that the effective annual rate of the bond may be computed according to Eq.(7.4) as follows: ie = (1 + 0.05)2 - 1 = 0.1025 = 10.25% If the interest payments were made only at the end of each year over twenty years, the annual payment should be: 0.525(1 + 0.05) + 0.525 = 1.076 where the first term indicates the deferred payment at the mid-year which would accrue interest at 5% until the end of the year, then: [FPV]10.25% = 10.5 - (1.076)(P|U, 10.25%, 20) - (10.5)(P|F, 10.25%, 20) = 0 In other words, if the interest is paid at 10.25% annually over twenty years of the loan, the result is equivalent to the case of semi-annual interest payments at 5% over the same lifetime. Example 7-3: An example of leasing versus ownership analysis Suppose that a developer offered a building to a corporation for an annual lease payment of $10 million over a thirty year lifetime. For the sake of simplicity, let us assume that the developer also offers to donate the building to the corporation at the end of thirty years or, alternatively, the building would then have no commercial value. Also, suppose that the initial cost of the building was $65.66 million. For the corporation, the lease is equivalent to receiving a loan with uniform payments over thirty years at an interest rate of 15% since the present value of the lease payments is equal to the initial cost at this interest rate: If the minimum attractive rate of return of the corporation is greater than 15%, then this lease arrangement is advantageous as a financing scheme since the net present value of the leasing cash flow 217 would be less than the cash flow associated with construction from retained earnings. For example, with MARR equal to 20%: [FPV]20% = $65.66 million - ($10 million)(P|U, 20%, 30) = $15.871 million On the other hand, with MARR equal to 10%: [FPV]10% = $65.66 million - ($10 million)(P|U, 20%, 30) = $28.609 million and the lease arrangement is not advantageous. Example 7-4: Example evaluation of alternative financing plans. Suppose that a small corporation wishes to build a headquarters building. The construction will require two years and cost a total of $12 million, assuming that $5 million is spent at the end of the first year and $7 million at the end of the second year. To finance this construction, several options are possible, including: • • • Investment from retained corporate earnings; Borrowing from a local bank at an interest rate of 11.2% with uniform annual payments over twenty years to pay for the construction costs. The shortfalls for repayments on loans will come from corporate earnings. An origination fee of 0.75% of the original loan is required to cover engineer's reports, legal issues, etc; or A twenty year coupon bond at an annual interest rate of 10.25% with interest payments annually, repayment of the principal in year 20, and a $169,000 origination fee to pay for the construction cost only. The current corporate MARR is 15%, and short term cash funds can be deposited in an account having a 10% annual interest rate. The first step in evaluation is to calculate the required amounts and cash flows associated with these three alternative financing plans. First, investment using retained earnings will require a commitment of $5 million in year 1 and $7 million in year 2. Second, borrowing from the local bank must yield sufficient funds to cover both years of construction plus the issuing fee. With the unused fund accumulating interest at a rate of 10%, the amount of dollars needed at the beginning of the first year for future construction cost payments is: P0 = ($5 million)/(1.1) + ($7 million)/(1.1)2 = $10.331 million Discounting at ten percent in this calculation reflects the interest earned in the intermediate periods. With a 10% annual interest rate, the accrued interests for the first two years from the project account of $10.331 at t=0 will be: Year 1: I1 = (10%)(10.331 million) = $1.033 million Year 2: I2 = (10%)(10.331 million + $1.033 million - $5.0 million) = 0.636 million 218 Since the issuance charge is 0.75% of the loan, the amount borrowed from the bank at t=0 to cover both the construction cost and the issuance charge is Q0 = ($10.331 million)/(1 - 0.0075) = $ 10.409 million The issuance charge is 10.409 - 10.331 = $ 0.078 million or $78,000. If this loan is to be repaid by annual uniform payments from corporate earnings, the amount of each payment over the twenty year life time of the loan can be calculated by Eq. (7.6) as follows: U = ($10.409 million)[(0.112)(1.112)20]/[(1.112)20 - 1] = $1.324 million Finally, the twenty-year coupon bond would have to be issued in the amount of $10.5 million which will reflect a higher origination fee of $169,000. Thus, the amount for financing is: Q0 = $10.331 million + $0.169 million = $10.5 million With an annual interest charge of 10.25% over a twenty year life time, the annual payment would be $1.076 million except in year 20 when the sum of principal and interest would be 10.5 + 1.076 = $11.576 million. The computation for this case of borrowing has been given in Example 7-2. Table 7-2 summarizes the cash flows associated with the three alternative financing plans. Note that annual incomes generated from the use of this building have not been included in the computation. The adjusted net present value of the combined operating and financial cash flows for each of the three plans discounted at the corporate MARR of 15% is also shown in the table. In this case, the coupon bond is the least expensive financing plan. Since the borrowing rates for both the bank loan and the coupon bond are lower than the corporate MARR, these results are expected. TABLE 7-2 Cash Flow Illustration of Three Alternative Financing Plans (in $ millions) Year Source Retained Earnings Bank Loan Coupon Bond 0 0 1 1 1 2 2 2 3-19 20 [APV]15% Back to top Principal Issuing Cost Earned Interest Contractor Payment Loan Repayment Earned Interest Contractor Payment Loan Repayment Loan Repayment Loan Repayment - 5.000 - 7.000 - $10.409 - 0.078 1.033 - 5.000 - 1.324 0.636 - 7.000 - 1.324 - 1.324 - 1.324 $10.500 - 0.169 1.033 - 5.000 - 1.076 0.636 - 7.000 - 1.076 -1.076 - 11.576 - 9.641 - 6.217 - 5.308 7.4 Secured Loans with Bonds, Notes and Mortgages 219