Chapter 2
Project Financing
Dr. Nabil I El Sawalhi
Associate Professor of
Construction Management
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Critical Role of Financing
• Makes projects possible
• Difficulty of Financing is a major driver
towards alternate delivery methods
– Flexibility on owner financing
– Flexibility for contractor financing
• Has major impact on
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Riskiness of construction
Claims
Types of construction undertaken
Prices offered by Contractors
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• 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.
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• The project finance problem is to obtain funds to bridge
the time between making expenditures and obtaining
revenues.
• 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.
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Institutional Arrangements for
Facility Financing
• Financing arrangements differ sharply by type of
owner and by the type of facility construction.
• municipal projects are financed in the United
States with tax exempt bonds for which interest
payments to a lender are exempt from income
taxes.
• Different institutional arrangements have
evolved for specific types of facilities and
organizations.
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Private finance
• A private corporation 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.
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Public finance
• 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
• Grants from government are also an important
source of funds for state, county, city or other
local agencies.
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Cost of borrowing money
• 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.
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security for 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.
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Lending contract
• Secured lending involves a contract between a
borrower and lender, where the lender can be
an individual, a financial institution or a trust
organization.
• Notes and mortgages represent formal contracts
between financial institutions and owners.
• Usually, repayment amounts and timing are
specified in the loan agreement.
• Public facilities are often financed by bond
issues for either specific projects or for groups of
projects
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Overdraft Accounts
• Overdrafts can be arranged with a banking
institution to allow accounts to have either a
positive or a negative balance.
• With a positive balance, interest is paid on the
account balance, whereas a negative balance
incurs interest charges.
• Usually, an overdraft account will have a
maximum overdraft limit imposed. Also, the
interest rate available on positive balances is
less than the interest rate charged for borrowing.
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Project versus Corporate
Finance
• A construction project is only a portion of the
general capital budgeting problem faced by an
owner.
• Unless the project is very large in scope relative
to the owner, a particular construction project is
only a small portion of the capital budgeting
problem.
• Numerous construction projects may be lumped
together as a single category in the allocation of
investment funds.
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• Financing is usually performed at the
corporate level using a mixture of long
term corporate debt and retained earnings.
• A typical set of corporate debt instruments
would include the different bonds and
notes .
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Construction Financing for
Contractors
• The cash flow profile of expenses and
incomes for a construction project typically
follows the work in progress for which the
contractor will be paid periodically.
• The markup by the contractor above the
estimated expenses is included in the total
contract price and the terms of most
contracts generally call for monthly
reimbursements of work completed less
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retainage.
• In times of economic uncertainty, the
fluctuations in inflation rates and market
interest rates affect profits significantly.
The total contract price is usually a
composite of expenses and payments in
then-current dollars at different payment
periods.
• In this case, estimated expenses are also
expressed in then-current dollars.
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• During periods of high inflation, the
contractor's profits are particularly
vulnerable to delays caused by
uncontrollable events for which the owner
will not be responsible.
• Hence, the owner's payments will not be
changed while the contractor's expenses
will increase with inflation.
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Project Financing and Evaluation
• Project Financing
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Public
Private
Project
Contractor
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Public Financing
• Sources of funds
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General purpose or special-purpose bonds
Tax revenues
Capital grants subsidies
International subsidized loans
• Public owners face restrictions in funding projects and this
leads to Major motivation for public/private partnerships
• Owners tend to group small construction projects to
lower the fixed financing costs
 Social benefits important justification to encourage financing
such as benefits to region, quality of life, unemployment
relief
• The public finance is exempted from taxes
• MARR (Min Acceptable Rate of Return) much lower (e.g.
10%), often standardized
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Private Financing
• Major mechanisms
– Debt
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Borrow money
Retained earnings
Bonds
– Equity
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Offering equity shares
Must encourage investors with sufficiently high rate of return
Because higher costs and risks, require higher
returns
MARR varies per firm, often high (e.g. 20%)
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Contractor Financing I
• Payment schedule
– Break out payments into components
– Often some compromise between contractor and
owner
– Architect certifies progress
• Contractor applies for agreed -upon payments
• Often must cover deficit during construction (<<than total
cost)
– Often schedule may not capture costs (equipment)
– Can be many months before payment received
– % Retainage standard
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Contractor Financing II
• Owner keeps eye out for
– Front-end loaded bids (discounting)
– Unbalanced bids
• Frequently borrow from
– Reserve
– Banks (Need to demonstrate low risk)
• Interaction with owners
– Some owners may assist in funding
• Help secure lower priced loan for contractor
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– Sometimes assist owners
in funding!
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Contractor Financing III
• 3-way agreements sometimes sought between
– Contractor
– Owner
– Bank
– Basically, bank pays contractor according to
progress
• Payment request submitted with progress report
monthly by contractor
• Owner then submits “draw request” to bank
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Assignment # 1
• Define the followings in not more that 5
lines:
• Equity
• share
• Inflation
• Bond
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