Haramaya University

Haramaya Institute of Technology

Department of Civil Engineering

Ayele.B (M.Sc. in Construction Technology and Management)

(B.Sc. in Civil Engineering)
Email: ayele.bereda@haramaya.edu.et
Construction Management ( CEng 5204 )
Section-2-Lecture-3-Project Finance and Risk Management
 Project Finance
 PROJECT FINANCE AND CONTRACT PRICING

 A project's cash flow is basically the difference between the project's income and its
expense.

 The difference between a company's total income and its total expense over a
period of time is the company cash flow.
 Project Finance
 Contract Cash Flow
 At the project level, a project’s cash flow is the difference between the project’s expense
and income.
 Cash flow = Cash in – Cash out = Income – Expense
 Forecasting cash flow is necessary for a construction company for the following reasons:
 To ensure that sufficient cash is available to meet the demands.
 It shows the contractor the maximum amount of cash required and when it will be
required.
 Project Finance
 It provides a reliable indicator to lending institutions that loans made can be repaid
according to an agreed program.

 It ensures that cash resources are fully utilized to the benefit of the owner and
investors in the company.

 The three main ingredients in determination of cash flow are:

 Expenses (cash out) which represents the aggregate of the payments which the
contractor will make over a period of time for all resources used in the project such
as labor, equipment, material, and subcontractors.
 Project Finance
 Income (cash in) that represents the receipts a contractor will receive over a period
of time for the work he/she has completed.
 Timing of payments: in cash flow analysis, we are interested in the timing of
payments related to the work done by the contractor.
 Construction Project Costs
 The sum of a project's direct costs and its allocated indirect costs is termed the
project cost.
 The costs that spent on a specific activity or project can be classified as;
 Project Finance
• Fixed cost: costs that spent once at specific point of time (e.g., the cost of
purchasing equipment, etc.)
• Time-related cost: costs spent along the activity duration (e.g., labor wages,
equipment rental costs, etc.)
• Quantity-proportional cost: costs changes with the quantities (e.g., material cost).
 Project direct costs
 A breakdown of direct costs includes labor costs, material costs, equipment costs,
and subcontractor costs.
 Project Finance
 Project indirect costs
• The indirect costs always classified to: project (site) overhead; and General (head-office) overhead.

• Project overhead:-These include the costs of site utilities, supervisors, housing and feeding of project
staff, parking facilities, offices workshops, stores, and first aid facility. Site overhead costs are
estimated to be between 5% - 15% of project total direct cost.

• General overhead:-They represent the cost of the head-office expenses, mangers, directors, design
engineers, schedulers, etc. It can be estimated to be between 2% - 5% of the contract direct cost.

• When studying cash flow, it is very important to determine the actual dates when the expenditures
(cost) will take place.
 Project Finance
Example 1: Consider the construction of 8-week foundation activity with operation cost of
$8,800 . The operation cost is broken down into the following elements:

• Labor $1,600 paid weekly

• Plant $4,000 paid weekly after 4 weeks credit facility

• Materials $800 paid weekly after 5 weeks credit facility

• Subcontractors $2,400 paid weekly after 3 weeks credit facility

 Determine the expenses (cash out) of this activity.

 Project Finance
• Solution
Project Finance
• S-Curve
• The curve represents the cumulative expenditures of a project direct and indirect costs over time is
called the S-curve as it take the S-shape.
• In many contracts, the owner requires the contractor to provide an S-curve of his estimated progress
and costs across the life of the project.
• This S-shaped of the curve results because early in the project, activities are mobilizing and the
expenditure curve is relatively flat.
• As many other activities come on-line, the level of expenditures increases and the curve has a steeper
middle section.
• Toward the end of a project, activities are winding down and expenditures flatten again.
• The S-Curve is one of the most commonly techniques to control the project costs.
 Project Finance
• The curve represents the cumulative expenditures of a project direct and indirect costs over
time is called the S-curve as it take the S-shape as shown below.
 Project Finance
 An S-curve for a project can be developed using the following steps:

• Constructing a simple bar chart for all the tasks of the project.

• Assigning costs to each task using task duration.

• Plotting the cumulative amounts of expenditures versus time by smoothly

connecting the projected amounts of expenditures over time.
 Project Finance
• Example 2:-Consider the project shown in figure below. The costs of activities are
assumed as shown in table below. The indirect costs of tasks are calculated
considering a daily cost of $500 . It is required to draw the S-curve of the total cost
of the project.
Project Finance
Cost data
Project Finance
• Solution:-The S-curve is calculated based on the project's bar chart and the
expenditures of each activity. the eleven activities of this project are scheduled
across a 32-day time span.

• A bar chart representation of these activities is drawn in figure below showing the
total costs associated with each activity above each activity's bar. The figure shows
the total expenditures and the cumulative bi-daily expenditures across the life of
the project. The S-curve of the cumulative expenditures over time is plotted in
figure.
Project Finance
Project Finance
 Project Finance
 Project Income (Cash-in)

• The flow of money from the owner to the contractor is in the form of progress
payments, advance payment and retention money.

• As opposed the expenses presented in figure above with smooth profile, the
revenue will be a stepped curve. Also, when the contractor collects his/her money it
is named project income (cash in) as shown in figure below.
Project Finance
 Project Finance
 Calculating Contract Cash Flow
 Having determined the contract expenses and income as presented in the previous
section, it is possible to calculate the contract cash flow.

 If we plotted the contract expense and income curves against each other, then the
cash flow is the difference between the points of both curves.
 Project Finance
• The hatched area in the figure below represents the difference between the
contractor’s expense and income curves, i.e., the amount that the contractor will
need to finance.
 Project Finance
• The contractor may request an advanced or mobilization payment from the owner.
This shifts the position of the income profile so that no overdraft occurs as shown in
figure below.
 Project Finance
• In case of less number of payments (two or three payments) along the contract
period, this will lead to increase the overdraft as shown in figure below
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• The cash flow calculations are made as described in the following steps:
• Perform project schedule and determine project and activities timing.
• Draw bar chart based on early or late timings.
• Calculate the cost per time period.
• Calculate the cumulative cost.
• Adjust the cost according the method of paying it to produce the expenses.
• Calculate the cumulative revenue (revenue = cost x (1 + markup)).
• Adjust the revenue based on the retention and delay of owner payment to
determine the income.
• Calculate the cash flow (cash flow = income – expense) at the contract different
times.
 Project Finance
Exercise 1:In this project, the markup equals 5% and the contractor will pay his expenses
immediately. Retention is 10% and will be paid back with the last payment. The calculations will
be made every 8 days, i.e., the contractor will receive his/her payment every 8-days (time
period). Owner’s payment is delayed one period, while the contractor will submit the first invoice
after the first period. No advanced payment is given to the contractor.
Project Finance
 Project Finance
• The project revenue of each activity is calculated as revenue = cost (1 + markup) .
• By summing up the activities cost and revenue, then
the contract total cost = $150,000
and the total revenue = $157,500
 By considering that both the cost and the revenue are evenly distributed over the
activities durations.
 The calculations will be made every 8-days period and the project duration is
divided into four periods each one equals 8 days.
 In addition, one period is added after project completion because of payment
delayed by one period (8days).
 Project Finance
• Summing up the costs it became direct expenses to the contractor as there is no
delay in paying them.

• The expected owner payments are then added up to from the project revenue.

• The retention is subtracted from the owner payment and will be paid back to the
contractor with the last payment.
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• The calculations in the last row are the difference between the project income and
project expense. Having two values in some periods shows the sudden change of
the cash flow as the contractor receives more payments from the owner.

• For example, in the second period, just before the contractor receive his/her
payment the cash flow was (0 – 98,000 = - 98,000 $).

• As the contractor receives a payment of $43,470, the cash flow improves and
becomes = -54,530 (43,470- 98,000).
 Project Finance
• The maximum overdraft money (maximum cash) is $98,000 and will be needed at
the 16th day of the project. Thus shows the importance of studying the contract
cash flow.

• Accordingly, the contractor can made his arrangements to secure the availability of
this fund on the specified time.
 Project Finance
• Minimizing Contractor Negative Cash Flow
• It is very essential to the contractor to minimize his/her negative cash flow because
this may hinder him/her during performing the contract due to lack of financial
resources.

• Among the procedures the contractor may follow to minimize negative cash flow is:

• Adjustment of work schedule to late start timing in order to delay payments. In this
case, the contractor should be aware that in this case in delay might happen will
affect the project completion time and may subject him/her to liquidated damages.
 Project Finance
• Minimizing Contractor Negative Cash Flow
• Reduction of delays in receiving revenues.
• Asking for advanced or mobilization payment.
• Achievement of maximum production in the field to increase the monthly
payments.
• Increasing the mark up and reducing the retention.
• Adjust the timing of delivery of large material orders to be with the submittal of the
monthly invoice.
• Delay in paying labor wages, equipment rentals, material suppliers and
subcontractors.
 Project Finance
 Project Cash Flow
 The project cash flow deals with the whole life of the project not the construction
period only. Thus, project cash flow studies the project finance from the feasibility
studies phase till the operation phase.

 At the early stage of a project, the project experience negative cash flow as there is
no income in these stages. In the operation stage, the revenue will increase than the
expenses. Atypical project cash flow is shown in figure below.
 Project Finance
• When comparing the economics of projects, the cumulative cash flow provides
indicators for such comparison as payback period, profit, and the maximum capital.
These indicators called the profitability indicators.
Typical project cash flow
 Project Finance
 Project Profitability Indicators

• Profit:-It is the difference between total payments and total revenue without the
effect of time on the value of money. When comparing alternatives, the project
with the maximum profit is ranked the best.

• Maximum capital:-It is the maximum demand of money, i.e., the summation of all
negative cash (expenditures). The project with minimum capital required is ranked
the best.
 Project Finance
• Payback period:-It is the length of time that it takes for a capital budgeting project
to recover its initial cost, where the summation of both cash out and cash in equals
zero.

• When comparing alternatives, the project with the shortest payback period is
ranked the best.
 Project Finance
• Example:-Two projects A and B have annual net cash flows as show in Table below.
Assume all cash flows occur at the year-end. Establish the ranking of the projects in
order of attractiveness to the company using:

a. Maximum capital needed

b. Profit

c. Payback period
Project Finance
 Project Finance
• The cumulative cash flow of projects A and B are shown in Figure below.

Cumulative net cash flow

 Project Finance
 From the figure the following indicators are drawn:

• Maximum capital: project A ($ 80,000) is better than project B ($ 110,000) because

it needs less capital.

• Profit: Project B ($ 80,000) is more profitable than project A ($ 65,000).

• Payback period: Project A (5 years) is better than project B (6 years) because Project
A has shorter payback period.
 Project Finance
 Discounted Cash Flow
• The value of money is dependent on the time at which it is received. A sum of
money on hand today is worth more than the same sum of money to be received in
the future because the money on hand today can be invested to earn interest to
gain more than the same money in the future.

 Refer Your lecture material, and Engineering Economics course materials for PV,
NPV, and Internal Rate of Return (IRR) concepts.
 Risk Management
 Risk Management
• Risk is a measure of the probability and consequence of not achieving a defined
project goal.
• Uncertainty and risks usually leads to project completion delays and cost overruns.
• Uncertainty is the gap between the information required to estimate an outcome
and the information already possessed by the decision maker. Risk has two primary
components for a given event:
• A probability of occurrence of that event
• Impact (or consequence) of the event occurring (amount at stake)
Thus, the early assessment of the risks and uncertainties which would affect the
construction of a project may improve the performance in terms of time and money.
 Risk Management
• Risk management is a major step in project planning; however, it is a complex
process since the variables are dynamic and dependent on variety of conditions such
as: project size, project complexity, location, time of the year, etc. In order to offset
the effect of risks time and/or cost contingencies should be added to cover
unforeseen occurrences.

• Risk management is defined as the process for systematically identifying, analyzing,

and responding to risk events throughout the life of a project to obtain the optimum
or acceptable degree of risk elimination or control.
 Risk Management
 Accordingly, the major steps of risk management are:

• Identification of risks;

• Responses to avoid, reduce, or transfer risk;

• Analysis and assessment of residual risks after the risk responses; and

• Adding time and /or cost contingency for residual risks in the project estimates.

 In general, in risk allocation, the risk should be carried out by the party (client or
contractor) who is best able to make the assessment of the risk or uncertainty.
 Risk Management
 Risk Identification :-Construction risk is defined as the possibility of undesirable
extra cost or delay due to factors having uncertain future outcome.

• The purpose is to identify all risks to the project/contract and provide a preliminary
assessment of their consequences.

• Identify every factor that may harm the project as potential risk. For example, one
may state “If the lay-down area is not optimized then productivity will be too low;”
“segmental liners may not be available prior to construction thus delaying project”.
 Risk Management
• In identifying risks, a number of approaches can be used including: standard
checklists; comparison to other projects; expert interviews; and brainstorming
sessions.

 Main categories of sources of risks are listed along with some examples of each
category as follow:
 Risk Management
Administrative:  Construction:
Delay in possesses of site;  limited work space;
Limited working hours;  Changes in soil condition than the soil
Limited access to the site; and report;
Troubles with public services  Construction method used;
 Logistical:  Availability of skilled labor;
Shortage or late supply of different  Equipment breakdown; and
resources;  Effect of varied weather and environmental
Site remoteness problems; and conditions on construction.
Difficulties in communications with
different parties involved.
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 Physical:
 Periods of high tides, temperature, etc;
 Placing fill in dry season; and
 Diverting water canals in time of low flow.
 Design:
 Design incomplete;
 Design changes; and
 Design errors.
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 Financial:

 Inflation which results in reducing the purchasing power of the currency;

 New restrictions applied on importing materials and equipments;

 Exchange rate fluctuation;

 Changes in taxes;

 Availability of funds; and

 Delay payments by client.

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 Political:

 Change of local laws and regulations;

 Inflation which result in reducing the purchasing power of the currency;

 Effect of wars and revolutions; and

 Necessity to use local resources.

Risk Management
 Management:
 Scheduling errors;
 Space congestion;
 Errors in bill of quantities; and
 Estimating of cost and duration based on standard figures.
 Contractual:
 Contract type and its suitability for undertaken work;
 Co-ordination of work; and
 Liability towards others.
 Risk Management
 Disasters:

 Floods and storms;

 Fires;

 Earthquakes;

 Accidents;

 Diseases; and

 Other acts of GOD.

 Risk Management
 Response to Risk and Uncertainties

• Having identified a list of possible risks and uncertainties that a project may face,
management should develop responses to avoid, reduce or transfer these risks.

• The following list of actions may be taken to reduce or transfer risks:

 Using construction methods which have high degree of success;

 Using extra resources to enhance the construction program to absorb possible

delay;
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 Securing alternative suppliers and advanced delivery dates for materials;

 Providing temporary roads to give flexibility of operations;

 Allowing free housing near construction site for labors to reduce problems arising from
remoteness of job site;

 Locating site facilities away of the working space to give sufficient area for construction
works;

 Assuming realistic reduced resources output;

 Maintaining good roads to provide assumed production rates for hauling equipment;
 Risk Management
 Using equipment for which spare parts are easily available to reduce shortage of
spare parts;
 Providing facilities for mechanical maintenance of equipment; and
 Purchasing insurance to cover the risk of site injuries.
 The previously mentioned items are some examples of the actions that may be
taken to reduce or transfer the effect of risks.
 However, some risks will not be eliminated. To deal with residual risks, a detailed
risk analysis may be required.
 Risk Management
 Time contingency
 In addition to the above-mentioned responses to risks, time contingency is one of
the contractor’s responses to risks and uncertainties.

 Time contingency is an extra time that added to the contract time to offset the
effect of some risks that are known to the contractor in advance such as late
delivery of materials.

 This extra time may be added in two ways:

 Risk Management
• A general allowance is added to the overall contract duration when most the
activities will be affected by the risk.

• For example, effect of bad weather which will affect all running activities.

• Allowance is added to a particular activity affected by the risk.

 Risk Management
 Cost contingency

 Also, the contractor has to assess the risks he/she is going to retain and include
appropriate cost contingency allowance to the contract estimate.

 This allowance can be added as a fixed percentage of money from the direct cost based
on the contractor experience.

 However, this allowance might not be appropriate for the specific risks.

 This method can be used when there is no means for performing risk analysis. The second
method is to make a detailed analysis of risks as presented in the next subsection.
 Risk Management
• Example:-In a specific project the following risks were identified.

• Client’s delays;

• Troubles encountered with public services;

• Late supply of materials; and

• Equipment breakdown.

As a contractor, give your views on the possible responses to deal with them.
 Risk Management
Solution
Contractor’s response to the risks:
• Client’s delay: the contractor should supply an activity schedule to warn the client
and to be an evidence for the delay.
• Troubles encountered with public services: the contractor should use maps of new
tools to locate public services. Also, he may use trial pits.
• Late supply of materials: the contractor should secure advanced delivery dates and
alternative suppliers.
• Equipment breakdown: the contractor should supply the site with a complete
workshop for maintenance of equipment.
 Risk Management
• Risk Analysis

• After applying the responses to risks mention in the previous section, there are still
some residual risks that need risk analysis to assess their impact on the project time
and cost.

• This risk analysis is the process which incorporates uncertainty in a quantitative

manner, using probability theory, to evaluate the potential impact of risk.

• The basic steps of risk analysis are:

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• Estimate range of risk variables;

• Choose the appropriate probability distribution which best fit risk variables;

• Define the affected activities by these risk variables; and

• Use a simulation model to evaluate the impact of risks (Monte Carlo Simulation).

This, risk analysis usually includes: sensitivity analysis; and probability analysis.
 Risk Management
 Sensitivity analysis

• Sensitivity analysis is used to identify those variables which contribute most to the
risk of the contract (time and/or cost). The purpose of this analysis is to eliminate
those risk variables which have minor impact on the performance criteria and hence
reduce problem size and effort.
 Risk Management
 Probability analysis

• The purpose of the probability analysis is to determine the effect of those risk
variables which have a significant impact on the performance criteria of the project.
 Risk Management
• Pricing Policy

• Having all contract costs (direct and indirect), and markup components (profit
margin, risk allowance and financial charge), it is time to finalize the bid price.

• While, the direct cost are associated directly to the contract activities, indirect cost
and markup are not associated with specific activities but with the whole contract.

• Accordingly, pricing policy is the method by which the indirect costs and markup will
be distributed among the items of the bill of quantities, so that the bid price is
ready to be submitted to the client.
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• Balanced bid (straight forward method)

• In this method the indirect cost and the markup will be distributed among different
items based on their direct cost; i.e., the more the direct cost of an item, the more
its share from indirect cost and markup. The resulting bid price is called a balanced
bid.
• The share of specific item = Direct cost of this item x (total indirect cost + markup)
Total contract direct cost
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• Example 1:-Assume that the direct cost for an item (a) is 400,000 birr and that item
is included in a contract whose price is 3,500,000 birr and its total direct cost is
2,800,000 birr. Calculate the price for item (a) considering a balanced bid.
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• Solution

• Bid price = direct cost + indirect cost + markup

• Indirect cost + markup (for the whole contract) = Bid price - direct cost = 3,500,000 -
2,800,000 = 700,000 birr

• Then, Indirect cost + markup for activity (a)

• (400,000/2,800,000)*(700,000) = 100,000 birr, Then, price of activity a = its direct

cost + indirect cost = 400,000 + 100,000 = 500,000 birr
 Risk Management
• Unbalanced bid (Loading of Rates)

• The contract price is said to be unbalanced if the contractor raises the prices on
certain bid items (usually the early items on the bill of quantities) and decreases the
prices on other items so that the tender price remain the same.

• This process is also called the loading of rates. The contractor usually loads the
prices of the first items to ensure more cash at the beginning of the contract and to
reduce the negative cash flow and accordingly reduces borrowing of money.
 Risk Management
• Loading of rates may be risky to both the contractor and the owner.

• If the contractor raised the price for an item and the quantity of this item increased
than that was estimated in the bill of quantities then, this situation is more risky to
the owner as it will cost the owner more money.

• On the other hand, if the contractor reduced the price of a specific item and the
quantity of that item increased, thus situation will be more risky to the contractor.
 Risk Management
• Example 2-Consider a small contract comprises of five sequential activities of equal
duration. The quantity of work in each activity, the direct cost rate, and total cost
rate for balanced and unbalanced bid are given in table on the next slide.

• Compare the cash flow curves for both balanced and unbalanced bids; Determine
the effect of unbalanced bid on the contractors profit if:

• Quantity of activity (B) is increased by 50%.

• Quantity of activity (C) is increased by 50%.

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• Solution

• Assume each activity with one time unit duration then, the cash flow will be as
given in table below

• Also, cash flow curves for both balanced and unbalanced curves are shown In figure
below

• It shows that in the unbalanced bid, the contractor will receive more money in the
early stages of the contract.
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Cash flow calculations

contract total direct cost = 100 (4 + 8 + 16 + 16 + 8) = 5200

- Contract price = 6500
- Contract markup = 6500 – 5200 = 1300 = 25% of direct cost
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Cash flow for balanced and unbalanced bids

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• Table below shows the effect of tender price if the quantity of activity “B” increased
by 50%.

• The price of the unbalanced bid (7200) is grater than that of the balanced bid (7000)
which means more profit to the contractor and more risk to the owner.

• In another way: Total direct cost = 5200 + 50 x 8 = 5600

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• Indirect cost & markup for balanced bid = 7000 – 5600 = 1400 = 25% of direct cost

• Indirect cost & markup for unbalanced bid = 7200 – 5600 = 1600 = 29% of direct
cost

• This increase means that the profit of the contractor has been increased and thus
represents risk to the owner.
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Effect of change in quantity of activity B
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• Table below shows the effect of tender price if the quantity of activity “C” increased
by 50%.
• The price of the unbalanced bid (7400) is less than that of the balanced bid (7500)
which means less profit and more risk to the contractor.
• In another way: Total direct cost = 5200 + 50 x 16 = 6000
• Indirect cost & markup for balanced bid = 7500 – 6000 = 1500 = 25% of direct cost
• Indirect cost & markup for unbalanced bid = 7400 – 6000 = 1400 = 23% of direct
cost
 Risk Management
• This decrease means that the profit of the contractor has been decreased and thus
represents risk to the contractor.
Effect of change in quantity of activity C
End of Project Financing and Risk Management
Any Question?