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Const. Mgmt. Chp. 07 - Financing of Constructed Facilities

Const. Mgmt. Chp. 07 - Financing of Constructed Facilities

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Published by Faiz Ahmad

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Published by: Faiz Ahmad on Sep 26, 2009
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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 benefitsonly over the long term use of the facility. Thus, costs occur earlier than the benefits, andowners of facilities must obtain the capital resources to finance the costs of construction. Aproject cannot proceed without adequate financing, and the cost of providing adequatefinancing can be quite large. For these reasons, attention to project finance is an importantaspect of project management. Finance is also a concern to the other organizations involvedin a project such as the general contractor and material suppliers. Unless an ownerimmediately and completely covers the costs incurred by each participant, theseorganizations 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 netcash 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 alterthe basic financing problem.In essence, the project finance problem is to obtain funds to bridge the time betweenmaking expenditures and obtaining revenues. Based on the conceptual plan, the costestimate and the construction plan, the cash flow of costs and receipts for a project can beestimated. Normally, this cash flow will involve expenditures in early periods. Coveringthis negative cash balance in the most beneficial or cost effective fashion is the projectfinance problem. During planning and design, expenditures of the owner are modest,whereas substantial costs are incurred during construction. Only after the facility iscomplete do revenues begin. In contrast, a contractor would receive periodic paymentsfrom the owner as construction proceeds. However, a contractor also may have a negativecash balance due to delays in payment and
of profits or cost reimbursements onthe part of the owner.Plans considered by owners for facility financing typically have both long and short termaspects. 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, awider variety of financing options exist, including borrowing, grants, corporate investmentfunds, payment delays and others. Many of these financing options involve theparticipation of third parties such as banks or bond underwriters. For private facilities suchas office buildings, it is customary to have completely different financing arrangementsduring the construction period and during the period of facility use. During the latterperiod, 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 stagesof a project, so the practice of financial planning is often complicated.On the other hand, the options for borrowing by contractors to bridge their expendituresand 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 of construction. Contractors who areengaged 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 whichowners prescribe functional requirements and a contractor handles financing. Contractorsare 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, withdue 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 andsolvency 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 facilityconstruction. As one example, many municipal projects are financed in the United Stateswith
tax exempt bonds
for which interest payments to a lender are exempt from incometaxes. As a result, tax exempt municipal bonds are available at lower interest charges.Different institutional arrangements have evolved for specific types of facilities andorganizations.A private corporation which plans to undertake large capital projects may use its retainedearnings, seek equity partners in the project, issue bonds, offer new stocks in the financialmarkets, or seek borrowed funds in another fashion. Potential sources of funds wouldinclude pension funds, insurance companies, investment trusts, commercial banks andothers. Developers who invest in real estate properties for rental purposes have similarsources, plus quasi-governmental corporations such as urban development authorities.Syndicators for investment such as real estate investment trusts (REITs) as well asdomestic and foreign pension funds represent relatively new entries to the financial marketfor building mortgage money.Public projects may be funded by tax receipts, general revenue bonds, or special bondswith income dedicated to the specified facilities. General revenue bonds would be repaidfrom general taxes or other revenue sources, while special bonds would be redeemed eitherby 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 localagencies.Despite the different sources of borrowed funds, there is a rough equivalence in the actualcost of borrowing money for particular types of projects. Because lenders can participate inmany different financial markets, they tend to switch towards loans that return the highestyield 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 issuingcosts.As a general principle, however, the costs of funds for construction will vary inversely withthe risk of a loan. Lenders usually require security for a loan represented by a tangibleasset. If for some reason the borrower cannot repay a loan, then the borrower can takepossession of the loan security. To the extent that an asset used as security is of uncertainvalue, then the lender will demand a greater return and higher interest payments. Loansmade 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 re-assembling theproject team. Moreover, a default on a facility may result if a problem occurs such asfoundation problems or anticipated unprofitability of the future facility. As a result of theseuncertainties, construction lending for unfinished facilities commands a premium interestcharge of several percent compared to mortgage lending for completed facilities.Financing plans will typically include a reserve amount to cover unforeseen expenses, costincreases or cash flow problems. This reserve can be represented by a special reserve or acontingency amount in the project budget. In the simplest case, this reserve might representa 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 maybe established. The cost of these reserve funds is the difference between the interest paid tobondholders 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 issuemust be met. A typical seven month schedule to issue revenue bonds would include thevarious steps outlined in Table 7-1.[1]In many cases, the speed in which funds may beobtained will determine a project's financing mechanism.
Illustrative Process and Timing for Issuing Revenue BondsActivities Time of ActivitiesAnalysis of financial alternativesPreparation of legal documentsPreparation of disclosure documentsForecasts of costs and revenuesBond RatingsBond MarketingBond Closing and Receipt of FundsWeeks 0-4Weeks 1-17Weeks 2-20Weeks 4-20Weeks 20-23Weeks 21-24Weeks 23-26
Example 7-1: Example of financing options
 Suppose that you represent a private corporation attempting to arrange financing for a newheadquarters building. These are several options that might be considered:
Use corporate equity and retained earnings:
The building could be financed bydirectly committing corporate resources. In this case, no other institutional parties

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