Lecture

1.040/1.
401
Project Management
Spring 2007
Project Financing & Evaluation
Dr. SangHyun Lee

lsh@mit.edu
Department of Civil and Environmental Engineering

Massachusetts Institute of Technology
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
 Your past project experience (strongly recommended if you have any)
 Size of project is not important!
 Project main figures
 Main managerial aspects
 Project management practices
 Problems, strengths, weaknesses, risks
 Your learning
 Emerging construction technologies (e.g., 4D CAD, Virtual Reality, Sensing, …)
 Volunteers for next week?
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
 Don’t memorize course content. Understand it.
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
Session Objective
 The role of project financing
 Mechanisms for project financing
 Measures of project profitability

Project Management Phase
DESIGN DEVELOPMENT CLOSEOUT OPERATIONS

FEASIBILITY
PLANNING
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
More details on:

 Hendrickson PM for Construction on-line textbook
 Chapter 7
Outline
 Session Objective & Context
 Project Financing
 Owner
 Project
 Contractor
 Present value
 Rates
 NPV
 Missing factors
Financing – Gross Cashflows
years 1 2 3 4 5 6 7 8 9 10
OWNER
investment ($10,000,000) ($20,000,000)
operation incomes $2,000,000 $4,000,000 $6,000,000 $6,000,000 $6,000,000 $6,000,000 $6,000,000
owner cashflow $0 ($10,000,000) ($20,000,000) $2,000,000 $4,000,000 $6,000,000 $6,000,000 $6,000,000 $6,000,000 $6,000,000
owner cum cashflow $0 ($10,000,000) ($30,000,000) ($28,000,000) ($24,000,000) ($18,000,000) ($12,000,000) ($6,000,000) $0 $6,000,000
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
Owner investment = contractor revenue
$10,000,000
$5,000,000
$0
($5,000,000) 1 2 3 4 5 6 7 8 9 10 11
($10,000,000) owner cum cashflow

($15,000,000) contractor cum cashflow
($20,000,000)
($25,000,000)
($30,000,000)
($35,000,000)
Design/Preliminary Construction
years 1 2 3 4 5 6 7 8 9 10
OWNER
investment ($10,000,000) ($20,000,000)
owner cashflow $0 ($10,000,000) ($20,000,000) $2,000,000 $4,000,000 $6,000,000 $6,000,000 $6,000,000 $6,000,000 $6,000,000
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
($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
$10,000,000
$5,000,000
$0
($5,000,000) 1 2 3 4 5 6 7 8 9 10 11

($20,000,000)
($25,000,000)
($30,000,000)
($35,000,000)
Design/Preliminary Construction
years 1 2 3 4 5 6 7 8 9 10
OWNER
investment ($10,000,000) ($20,000,000)
owner cashflow $0 ($10,000,000) ($20,000,000) $2,000,000 $4,000,000 $6,000,000 $6,000,000 $6,000,000 $6,000,000 $6,000,000
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
($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
$10,000,000
$5,000,000
$0
($5,000,000) 1 2 3 4 5 6 7 8 9 10 11
• Early expenditure
• Takes time to get revenue
($20,000,000)
($25,000,000)
($30,000,000)
($35,000,000)
Project Financing
Aims to bridge this gap in the most beneficial way!

Critical Role of Financing
 Makes projects possible

 Has major impact on
 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)
How Does Owner Finance a Project?
 Public
 Private
 “Project” financing
Outline
 Owner
 Project
 Contractor
 Present value
 Rates
 NPV
 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
construction operation time

w/o tangible w/ tangible
Outline
 Owner
 Project
 Contractor
 Present value
 Rates
 NPV
 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
 Small projects not much benefit
 Investment in project through special purpose corporations
 Often joint venture between several parties
 Need capacity for independent operation
 Benefits
 Off balance sheet (liabilities do not belong to parent)
 Limits risk
 External investors: reduced agency cost (direct investment in project)
 Drawback
 Tensions among stakeholders
Outline
 Owner
 Project
 Contractor
 Present value
 Rates
 NPV
 Missing factors
Contractor Financing I
 Payment schedule
 Break out payments into components
 Advance payment
 Periodic/monthly progress payment (itemized breakdown structure)
 Milestone payments
 Often some compromise between contractor and owner
 Architect certifies progress
 Agreed-upon payments
 retention on payments (usually, about 10%)
 Often must cover deficit during construction
 Can be many months before payment received
S-curve Work
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 Revenue Projection Contractor Revenue Projection
120 140
100 120
100
80
Revenue
Revenue
80
60
60
40
40
20
20
0 0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18
Month Month
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
 Agreed upon in contract

 Often structure proposed by owner
 Should be checked by owner (fair-cost estimate)
 Often based on “Masterformat” Cost Breakdown Structure
(Owner standard CBS)
 Certified by third party (Architect/engineer)
Outline
 Owner
 Project
 Contractor
 Additional Issues
 Present value
 Rates
 NPV
 Missing factors
Latent Credit
 Many people forced to serve as lenders to owner due
to delays in payments
 Designers
 Contractors
 Consultants
 CM
 Suppliers
 Implications
 Good in the short-term
 Major concern on long run effects
Role of Taxes
 Tax deductions for

 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
 Project Financing
 Owner
 Project
 Contractor
 Financial Evaluation
 Present value
 Rates
 NPV
 Missing factors
Develop or Not Develop
 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 Evaluation Example:
 Project A  Project B
 Construction=3 years  Construction=6 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/commissioning 1,300,000.00
Contingencies 200,000.00
GROSS MARGIN 900,000.00
Time factor?
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
 Owner
 Project
 Contractor
 Additional issues
 Time value of money
 Present value
 Rates
 NPV
 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
0 1 $x(1+i) 2 $x(1+i)2 … n $x(1+i)n
$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
 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 extra expense
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
 Send your resume (or brief your experience) by this
Sunday
Outline
 Owner
 Project
 Contractor
 Present value
 Rates
 NPV
 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)
 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
 The loan l is the present value of r
 l = PV(r)
Future to Present Revenue
If I know this is coming…
x
I can borrow this from the bank now

PV(x) t
0 I’ll pay this back to the bank later
-x
The net result is that I can convert a sure x at time t

PV(x) into a (smaller) PV(x) now! t
Present Value (Cost)
 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
 The size of the deposit (immediate cost) x is the present value of c.
Future to Present Cost
0 t
If I know this cost is coming… -x
I retrieve this back from the bank later

I can deposit this in the bank now x
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
 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
 Owner
 Project
 Contractor
 Present value
 Rates
 NPV
 Missing factors
Rates
 Difference between PV (v) and FV ( =v(1+i)t ) depends on i and t.
Rates
 Difference between PV (v) and FV ( =v(1+i)t ) depends on i and t.
 Interest Rate
 Contractual arrangement between a borrower and a lender
 Discount Rate (real change in value to a person or group)
 Worth of Money + Risk
 Discount Rate > Interest Rate
 Minimum Attractive Rate of Return (MARR)
 Minimum discount rate accepted by the market corresponding to the risks
of a project (i.e., minimum standard of desirability)
Choice of Discount Rate
r = rf + ri + rr
Where:
r is the discount rate

rf the risk free interest rate. Normally government bond
ri Rate of inflation. It is measured by either by consumer price
index or GDP deflator.
rr Risk factor consisting of market risk, industry risk, firm
specific risk and project risk
Market Risk
rr = Industry Risk
Firm specific Risk
Project Risk
GDP = Gross Domestic Product

Outline
 Owner
 Project
 Contractor
 Present value
 Rates
 Interest Formulas
 NPV
 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

Interest Formulas: Payment
 Single Payment Compound Amount Factor (F=P×Factor)

 Factor that will make your present value future value in single payment
 (F/P, i, n) = (1 + i )n
0 1 2 … n
F
P
 Single Payment Present Value Factor (P=F×Factor)

 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 1 … n-1 n
P
F
- 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?
- Example

0 n
P=? F=$100,000
 (P/F, 0.12, 5) or (F/P, 0.12, 5)?

- Example

 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
 Uniform Series Compound Amount Factor (F=A×Factor)

 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
A A A A
 Annuity occurs at the end of the interest period


 (F/A, i, n) =[(1+i)n - 1]/ i
F=A
F
0 1 2 … n
A A A A

 (F/A, i, n) =[(1+i)n - 1]/ i
F = A+A(1+i)
F
0 1 2 … n
A A A A

 (F/A, i, n) =[(1+i)n - 1]/ i
F = A + A(1+i) + … + A(1 + i )n-1
0 1 2 … n
A A A A
 Uniform Series Sinking Fund Factor (A=F×Factor)

 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)
0 1 2 … n
A A A A
F
 Uniform Series Present Value Factor (P=A×Factor)

 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
A A A A

 (P/A, i, n) = [ (1 + i )n -1 ] / [ i (1 + i )n ]
P = A/ (1 + i )
0 1 2 … n
A A A A

 (P/A, i, n) = [ (1 + i )n -1 ] / [ i (1 + i )n ]
P = A/(1 + i ) + A/(1 + i )2
0 1 2 … n
A A A A

 (P/A, i, n) = [ (1 + i )n -1 ] / [ i (1 + i )n ]
P = A/(1 + i ) + A/(1 + i )2 + … + A/(1 + i )n
0 1 2 … n
A A A A
Verify it!
 Uniform Series Capital Recovery Factor (A=P×Factor)

 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 1 2 … n
A A A A
P
Verify it!
- 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?
- Example

 Down Payment = 5,000,000 * 0.2 = 1,000,000
 P = 5,000,000 – 1,000,000 = 4,000,000
 A = P * (which factor?)
- Example

 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?
 A - Annual Equivalent
 P - Present Equivalent
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
 P = -20,000 + 4,000 * (P/F, 0.15, 5)
= -20,000 + 4,000 * (0.4972)
= -18,011
Outline
 Owner
 Project
 Contractor
 Present value
 Rate
 NPV
 Missing factors
Net Present Value
 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
 Treat revenues as positive and costs as negative
Calculation of Net Present Value
Total Revenue (R) (+) Various Costs (C) (-)
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
 Accept a project which has 0 or positive NPV

Alternatively,
 Use NPV to choose the best among a set of
(mutually exclusive) alternative projects
 Mutually exclusive projects: the acceptance of a project precludes
the acceptance of one or more alternative projects.
Project Evaluation Example
Revisit: Which one is better?
 Project A  Project B
 Construction=3 years  Construction=6 years
 Cost = $1M/year  Cost = $1M/year
 Sale Value = $4M  Sale Value = $8.5M
 Total Cost?  Total Cost?
 Profit?  Profit?
Drawing out the examples
 Project A
$4M
0 1 2 3
$1M $1M $1M
 Project B $8.5M
0 1 6
$1M $1M $1M $1M $1M $1M
• Assume 10% discount rate

• Link
Or Using Interest Formulas
 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)
• Assume 10% discount rate

Four Independent Projects
 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
NPV1 – Cash Flow Year 0 1 2 3 4 5
-$77 M
[NPV2]20%
= -75.3 + (28)(P/A, 0.2, 5) = -75.3 + 83.7
= 8.4
$28 M each year
NPV2 – Cash Flow Year 0 1 2 3 4 5
-$75.3 M
Solution
[NPV3]20%
= -39.9 + (28)(P/A, 20%, 4) - (80)(P/F, 20%, 5)
= -39.9 + 72.5 - 32.2
= 0.4 $28 M each year
NPV3 – Cash Flow

Year 0 1 2 3 4 5
-$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
NPV4 – Cash Flow

Year 0 1 2 3 4 5
-$40 M
-$60 M
Source: Hendrickson and Au, 1989/2003
Solution
[NPV1] = 17.4
[NPV2] = 8.4
[NPV3] = 0.4
[NPV4] = -1.6

Discount Rate in NPV
 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.
 Its choice can easily change the ranking of projects.
 Example
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%)
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
 Owner
 Project
 Contractor
 Present value
 Rate
 NPV
 IRR & payback period
 Missing factors
Internal Rate of Return (IRR)
 Defined as the rate of return that makes the NPV of the project
equal to zero
 To see whether the project’s rate of return is equal to or higher
than the rate of the firm to expect to get from the project
IRR Calculation Example
 NPV = -20,000 + 5,600 (P/A, i, 5) + 4,000 (P/F, i, 5)

 Link
Relationship between NPV & IRR
IRR
IRR Investment Rule
> Accept
r- =
r* Indifferent
< Reject
- r = IRR,
* r = MARR
“Accept a project with IRR larger than MARR”

Alternatively,
“Maximize IRR across mutually exclusive projects.”

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
NPV
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
 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
 Payback period (“Time to return”)

 Minimal length of time over which benefits repay costs
 Typically only used as secondary assessment
Payback Period
 Payback period (“Time to return”)

 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
 Financing has major impact on project selection

 Suppose that one had to choose between 2 investment
projects
 How can one compare them?
Comparing Projects
 Financing has major impact on project selection

 Suppose that one had to choose between 2 investment
projects
 How can one compare them?
 Use NPV
 Verify IRR
 Check payback period
Other Methods
 Benefit-Cost ratio (benefits/costs)

 Discounting still generally applied
 Accept if >1 (benefits > costs)
 Common for public projects
 Does not consider the absolute size of the benefits
 Cost-effectiveness
 Looking at non-economic factors
 Discounting still often applied for non-economic
 $/Life saved
 $/Life quality
Inflation & Deflation
 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 → discount rate excluding inflation
i  i  j  ij
If i, A(y=0) will be A*(1+i) after one year.
i' → discount rate including inflation
Then, if j, A will be A*(1+i)*(1+j). j → annual inflation rate
' i → discount rate excluding inflation
i  i  j  ij
If i, A(y=0) will be A*(1+i) after one year.
i' → discount rate including inflation
Then, if j, A will be A*(1+i)*(1+j). j → annual inflation rate
When the inflation rate j is small, these relations can be approximated by:
i'  i  j or i  i'  j
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 (then-current) dollars
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.
 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)
 Whether taking into account inflation or not, NPV could be different.
Impact of Inflation: Boston Central Artery
Price Price Project Project Project
Year
Index Index Expenses Expenses Expenses
t
1982 $ 2002 $ ($ K) (1982 $ k) (2002 $ K)
1982 100 53
1983 104 55
1984 111 59
1985 118 62
1986 122 65 33,000 27,000 51,000
1987 123 65 82,000 67,000 126,000
1988 130 69 131,000 101,000 190,000
1989 134 71 164,000 122,000 230,000
1990 140 74 214,000 153,000 289,000
1991 144 76 197,000 137,000 258,000
1992 146 77 246,000 169,000 318,000
1993 154 82 574,000 372,000 703,000
1994 165 88 854,000 517,000 975,000
1995 165 88 852,000 515,000 973,000
1996 165 87 764,000 464,000 877,000
1997 175 93 1,206,000 687,000 1,297,000
1998 172 91 1,470,000 853,000 1,609,000
1999 176 94 1,523,000 863,000 1,629,000
2000 181 96 1,329,000 735,000 1,387,000
2001 183 97 1,246,000 682,000 1,288,000
2002 189 100 1,272,000 674,000 1,272,000
2003 195 103 1,115,000 572,000 1,079,000
2004 202 107 779,000 386,000 729,000
2005 208 110 441,000 212,000 399,000
2006 215 114 133,000 62,000 117,000
Sum 14,625,000,000 8,370,000 15,797,000

Outline
 Owner
 Project
 Contractor
 Financial Evaluation
 Present value
 Rates
 NPV
 Missing factors
What are we Assuming Here?
 That only quantifiable monetary benefits matter
 Certainty about future cash flows

 Main uncertainties:
 Financial concerns
 Currency fluctuations (international projects)
 Inflation/deflation
 Taxes variations
 Project risks
Project Management Phase
DESIGN DEVELOPMENT CLOSEOUT OPERATIONS

FEASIBILITY
PLANNING
Financing & Evaluation
Risk
Risk Management
 Case Study

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1.040/1.

Project Financing & Evaluation

Dr. SangHyun Lee

Department of Civil and Environmental Engineering

 STELLAR access: to be announced

 STELLAR access: to be announced

 The role of project financing

 Mechanisms for project financing

 Measures of project profitability

DESIGN DEVELOPMENT CLOSEOUT OPERATIONS

Financing & Evaluation

More details on:

Owner investment = contractor revenue

($10,000,000) owner cum cashflow

Owner investment = contractor revenue

($10,000,000) owner cum cashflow

Owner investment = contractor revenue

Aims to bridge this gap in the most beneficial way!

 Makes projects possible

construction operation time

 Owner keeps an eye out for

Contractor Revenue Projection Contractor Revenue Projection

 Owner keeps an eye out for

 Agreed upon in contract

 Tax deductions for

 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

GROSS MARGIN 900,000.00

 Suppose we invest $x in a bank offering interest rate i

0 1 $x(1+i) 2 $x(1+i)2 … n $x(1+i)n

 Given a source of reliable investments, we are

 This indifferences arises because we can

 How is it that some future revenue r at time t has a “present

I can borrow this from the bank now

The net result is that I can convert a sure x at time t

 How is it that some future cost c at time t has a “present value”?

If I know this cost is coming… -x

I retrieve this back from the bank later

 Given a reliable source offering annual return i (i.e., interest) we

r is the discount rate

GDP = Gross Domestic Product

 i = Effective interest rate per interest period (discount rate or MARR)

 n = Number of compounding periods

 A = Annuity (i.e., a series of payments of set size) at end-of-period

 Single Payment Compound Amount Factor (F=P×Factor)

 Single Payment Present Value Factor (P=F×Factor)

 If you wish to have $100,000 at the end of five years

 If you wish to have $100,000 at the end of five years

 (P/F, 0.12, 5) or (F/P, 0.12, 5)?

 If you wish to have $100,000 at the end of five years

 P = 100,000 × (P/F, 0.12, 5)

 P = 100,000 × 0.5674 = $56,740

 Uniform Series Compound Amount Factor (F=A×Factor)

 (F/A, i, n) =[(1+i)n - 1]/ i

 Annuity occurs at the end of the interest period

 Uniform Series Compound Amount Factor (F=A×Factor)

 (F/A, i, n) =[(1+i)n - 1]/ i

 Uniform Series Compound Amount Factor (F=A×Factor)

 (F/A, i, n) =[(1+i)n - 1]/ i

 Uniform Series Compound Amount Factor (F=A×Factor)

 (F/A, i, n) =[(1+i)n - 1]/ i

F = A + A(1+i) + … + A(1 + i )n-1