The final course of the specialization expands the knowledge of a construction project manager to include an understanding of economics and the mathematics of money, an essential component of every construction project. Topics covered include the time value of money, the definition and calculation of the types of interest rates, and the importance of Cash Flow Diagrams.
Borrowing vs Partnering Case Study: Revenue generating case
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Do curso por Columbia University
Construction Finance
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Risk In Project Finance
Eduardo Gamez discusses risk in project financing outlining the different entities involved in a transaction for a project.
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Ibrahim Odeh, Ph.D., MBAInstructor, Department of Civil Engineering and Engineering Mechanics, Columbia University
Director of Research and Founder, Global Leaders in Construction Management
Here the two organization charts, for the left hand side you see borrowing.
And in the borrowing scenario, the lender is lending money to or
to the project owner to develop an asset.
Now the return for that lender is not tied to the project's success.
That lender may not care if the project finish in a year, in two year, or
if it drags over a ten year period.
It may not care if the project costs was unitary plan, or twice, or three times.
All they know is they sign a lending agreement of x
amount of money on the next amount of time and
the return is base on those parameters.
Now in the partnership side,
[COUGH] you have two new entities to that organization.
One, you have the developer partner who owns to contract with that designer,
the builders, and the operation maintenance in which every case,
if that entoty is there.
The investor in this case or the lender,
is contract through developer partner.
Now the return on investment for
that investor is tied to the success of the project.
So for instance, if the project is not accepted by the owner in year two, but
it drags for another year that investor will not see returns for another year.
And this may amount to a significant amount of risk and unwanted debt.
And so in this case, the investor is motivated as
much as used project owner to incentivize or
to motivate the developer to finish the project early.
To finish it on time, to finish it on budget,
because their return is tied to the project organization,
so I hope that's clear.
From the investor point of view,
the project financing again has two different categories.
One, you could be a lender, just like we saw before, directed to the project owner.
And as a lender, the project viability have to pass certain criteria.
And there's ratios for each one of these criteria,
ratios in terms efficiencies, in terms of productivity,
debt service ratios, assets over equity ratios,
loan life and project life cycle or life ratio, and so forth.
Now, [COUGH] when you're a lender, your fixed funds are your final exposure,
how much you're lending, and how much that you're lending it for?
So you're cost and you're schedule are fixed,
those are not your risk as a lender.
Therefore, it's easier for the lender to anticipate what the margins and
what the fees will be for a transaction.
Now for an investor, it's quite different.
An investor, as we saw in the organization before,
gets fully involved in the project.
It ties its assets to the success of the product.
So the product viability for them relies on what is the net present
value on the project, what is the internal rate of return of the project?
And what's the payback period, when does that payback period start,
is it tied to acceptance, is it tied to a certain milestone in the product?
So you have to be very clear on that, and
those are the type of things that an investor look for in a contract.
Now, under this scenario, the uncertainties lie
on what the final cost of the project is, and when is the project ending?
So the life of the debt gets extended if the project drags on.
And therefore, the gross margin and the fees that
the investor gets depend heavily on the performance of the developer.
So that in a typical transaction like that,
the investor has the power even though the owner contracts with the developer.
The investor has the power to replace, the developer if they don't see that their
interests are aligned, and they do that in consultation with the project owner.
But more likely the no, they will work with
the developer to make sure they have all the tools.
And they're successful in delivering the project as it was anticipated.
So I wanted to give you two examples,
two quick examples of two types of transactions.
So the first one is a program, $1.5 billion program of
800 projects that is being implemented in 15 years.
Now this case, the program is being done with revenue
that is being generated on a monthly collection.
So it may be a tax or
it may be the utility revenue,
so what we see here is that in the timeline.
We have that revenue curve and we have the cost curve and typically,
this is what it looks like.
You have a revenue that is over the cost and
you know that you can cover all that execution.
Now, we can not forget that overtime
those cost have escalation, have inflation tight to it.
So you have to make sure that those are included in it.
And more importantly,
we have to understand that there is some certainty tight to the cost.
So unless you know exactly all the contract amount for
all those 800 projects, you don't know the exact cost.
By year 2 you may know 10, 100 contract, and then the rest will be in planning.
And then the next year, you'll know more about them, and
some of the price will be closed out and so forth.
So there is uncertainty in that, when you add the uncertainty and the risk,
you may be looking at something like this where the cost plus risk plus
inflation plus uncertainty is close, and sometimes passes the revenue.
Now in this case, take a quick look that in this area.
In this area here, even though we're not at the very end,
we don't have more revenue than cost on the program.
In this area here, this pink area, the cost at a certain point of time was
higher than the revenue that was being collected.
So it's important to not only look at the program as a whole package.
But in this case, is to look at the timeline of the project and
make sure that along the timeline, you're always positive and you always have
enough revenue, enough cumulative savings in the bank to pay for the project.
So [COUGH] in this case, that may come in to effect
when you're calculating your net present value and
your internal rate of return at the very beginning of
the project through discounting all your cost.
Now, if you start discounting your risk and just the cost,
then you have a risk adjusted Net present value and
a risk adjusted are in turn of rate or return.
And that will give you a true or
a better scenario of how a project may be looking.
The other side of the equation is the revenue, so
the revenue is tied to collections.
And you don't know exactly how much those collections are until you actually
collect them.
And so sometimes, we find cases like this particular program,
where the revenues is forecasted as straight line.
And then you have some variability in the actual collections,
but what is interesting here is that,
Is that here the revenue collections in cumulative
basis are lower than the forecast.
So the forecast gets adjusted, and
if you planned the project with a very short gap between revenues and
cost, you may be overlooking the trouble.
So you have to acknowledge that there's two sides of the uncertainty when you're
looking at this time for projects.
The revenue side of things has an uncertainty and
the cost side of things have an uncertainty.
So if you think about this and say, bank account.
You have revenue coming in, you have cost going out, and then you have a balance.
This is what this graph looks like is a cash flow.
So the balance has also uncertainties and you have to look at the two streams
where the risk adjusted cash flow makes sense, and you have to plan for this.
So sometimes, you have like here in the beginning where it says actuals,
that the bank account is building up.
But then you start to spend more than the money that is coming in and
it starts going down.
Now in the areas where the orange line goes under the x
axis is areas where you're starting to spend more than the money that
is in the bank through the community collections.
So those are key areas that if you don't track the risk
adjusted cash flow, you will not be able see.
If you only focused in the blue area of the graph,
you will say this scenario, this program is perfect.
But if you adjust that by risk and uncertainties,
then you start seeing pocket of areas of the life cycle of the program,
where you may be in trouble and you have to plan ahead for it.
So you'd have to be aware of them.
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