7.8 Shifting Financial Burdens
The different participants in the construction process have quite distinct perspectives on financing. In the realm of project finance, the revenues to one participant represent an expenditure to some other participant. Payment delays from one participant result in a financial burden and a cash flow problem to other participants. It is common occurrence in construction to reduce financing costs by delaying payments in just this fashion. Shifting payment times does not eliminate financing costs, however, since the financial burden still exists.
Traditionally, many organizations have used payment delays both to shift financing expenses to others or to overcome momentary shortfalls in financial resources. From the owner's perspective, this policy may have short term benefits, but it certainly has long term costs. Since contractors do not have large capital assets, they typically do not have large amounts of credit available to cover payment delays. Contractors are also perceived as credit risks in many cases, so loans often require a premium interest charge. Contractors faced with large financing problems are likely to add premiums to bids or not bid at all on particular work. For example, A. Maevis noted:
...there were days in New York City when city agencies had trouble attracting bidders; yet contractors were beating on the door to get work from Consolidated Edison, the local utility. Why? First, the city was a notoriously slow payer, COs (change orders) years behind, decision process chaotic, and payments made 60 days after close of estimate. Con Edison paid on the 20th of the month for work done to the first of the month. Change orders negotiated and paid within 30 days-60 days. If a decision was needed, it came in 10 days. The number of bids you receive on your projects are one measure of your administrative efficiency. Further, competition is bound to give you the lowest possible construction price.
Even after bids are received and contracts signed, delays in payments may form the basis for a successful claim against an agency on the part of the contractor.
The owner of a constructed facility usually has a better credit rating and can secure loans at a lower borrowing rate, but there are some notable exceptions to this rule, particularly for construction projects in developing countries. Under certain circumstances, it is advisable for the owner to advance periodic payments to the contractor in return for some concession in the contract price. This is particularly true for large-scale construction projects with long durations for which financing costs and capital requirements are high. If the owner is willing to advance these amounts to the contractor, the gain in lower financing costs can be shared by both parties through prior agreement.
Unfortunately, the choice of financing during the construction period is often left to the contractor who cannot take advantage of all available options alone. The owner is often shielded from participation through the traditional method of price quotation for construction contracts. This practice merely exacerbates the problem by excluding the owner from participating in decisions which may reduce the cost of the project.
Under conditions of economic uncertainty, a premium to hedge the risk must be added to the estimation of construction cost by both the owner and the contractor. The larger and longer the project is, the greater is the risk. For an unsophisticated owner who tries to avoid all risks and to place the financing burdens of construction on the contractor, the contract prices for construction facilities are likely to be increased to reflect the risk premium charged by the contractors. In dealing with small projects with short durations, this practice may be acceptable particularly when the owner lacks any expertise to evaluate the project financing alternatives or the financial stability to adopt innovative financing schemes. However, for large scale projects of long duration, the owner cannot escape the responsibility of participation if it wants to avoid catastrophes of run-away costs and expensive litigation. The construction of nuclear power plants in the private sector and the construction of transportation facilities in the public sector offer ample examples of such problems. If the responsibilities of risk sharing among various parties in a construction project can be clearly defined in the planning stage, all parties can be benefited to take advantage of cost saving and early use of the constructed facility.
Example 7-13: Effects of payment delays
Table 7-9 shows an example of the effects of payment timing on the general contractor and subcontractors. The total contract price for this project is $5,100,000 with scheduled payments from the owner shown in Column 2. The general contractor's expenses in each period over the lifetime of the project are given in Column 3 while the subcontractor's expenses are shown in Column 4. If the general contractor must pay the subcontractor's expenses as well as its own at the end of each period, the net cash flow of the general contractor is obtained in Column 5, and its cumulative cash flow in Column 6.
TABLE 7-9 An Example of the Effects of Payment Timing
Note: Cumulative cash flow includes no financing charges.
In this example, the owner withholds a five percent retainage on cost as well as a payment of $100,000 until the completion of the project. This $100,000 is equal to the expected gross profit of the contractor without considering financing costs or cash flow discounting. Processing time and contractual agreements with the owner result in a delay of one period in receiving payments. The actual construction expenses from the viewpoint of the general contractor consist of $100,000 in each construction period plus payments due to subcontractors of $900,000 in each period. While the net cash flow without regard to discounting or financing is equal to a $100,000 profit for the general contractor, financial costs are likely to be substantial. With immediate payment to subcontractors, over $1,000,000 must be financed by the contractor throughout the duration of the project. If the general contractor uses borrowing to finance its expenses, a maximum borrowing amount of $1,200,000 in period five is required even without considering intermediate interest charges. Financing this amount is likely to be quite expensive and may easily exceed the expected project profit.
By delaying payments to subcontractors, the general contractor can substantially reduce its financing requirement. For example, Table 7-10 shows the resulting cash flows from delaying payments to subcontractors for one period and for two periods, respectively. With a one period delay, a maximum amount of $300,000 (plus intermediate interest charges) would have to be financed by the general contractor. That is, from the data in Table 7-10, the net cash flow in period 1 is -$100,000, and the net cash flow for each of the periods 2 through 5 is given by:
$950,000 - $100,000 - $900,000 = -$ 50,000
Finally, the net cash flow for period 6 is:
$1,300,000 - $900,000 = $400,000
Thus, the cumulative net cash flow from periods 1 through 5 as shown in Column 2 of Table 7-10 results in maximum shortfall of $300,000 in period 5 in Column 3. For the case of a two period payment delay to the subcontractors, the general contractor even runs a positive balance during construction as shown in Column 5. The positive balance results from the receipt of owner payments prior to reimbursing the subcontractor's expenses. This positive balance can be placed in an interest bearing account to earn additional revenues for the general contractor. Needless to say, however, these payment delays mean extra costs and financing problems to the subcontractors. With a two period delay in payments from the general contractor, the subcontractors have an unpaid balance of $1,800,000, which would represent a considerable financial cost.
TABLE 7-10 An Example of the Cash Flow Effects of Delayed Payments
7.9 Construction Financing for Contractors
For a general contractor or subcontractor, 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 retainage. At time period 0, which denotes the beginning of the construction contract, a considerable sum may have been spent in preparation. The contractor's expenses which occur more or less continuously for the project duration are depicted by a piecewise continuous curve while the receipts (such as progress payments from the owner) are represented by a step function as shown in Fig. 7-1. The owner's payments for the work completed are assumed to lag one period behind expenses except that a withholding proportion or remainder is paid at the end of construction. This method of analysis is applicable to realistic situations where a time period is represented by one month and the number of time periods is extended to cover delayed receipts as a result of retainage.
Figure 7-1 Contractor's Expenses and Owner's Payments
While the cash flow profiles of expenses and receipts are expected to vary for different projects, the characteristics of the curves depicted in Fig. 7-1 are sufficiently general for most cases. Let Et represent the contractor's expenses in period t, and Pt represent owner's payments in period t, for t=0,1,2,...,n for n=5 in this case. The net operating cash flow at the end of period t for t 0 is given by:
where At is positive for a surplus and negative for a shortfall.
The cumulative operating cash flow at the end of period t just before receiving payment Pt (for t 1) is:
where Nt-1 is the cumulative net cash flows from period 0 to period (t-1). Furthermore, the cumulative net operating cash flow after receiving payment Pt at the end of period t (for t 1) is:
The gross operating profit G for a n-period project is defined as net operating cash flow at t=n and is given by:
The use of Nn as a measure of the gross operating profit has the disadvantage that it is not adjusted for the time value of money.
Since the net cash flow At (for t=0,1,...,n) for a construction project represents the amount of cash required or accrued after the owner's payment is plowed back to the project at the end of period t, the internal rate of return (IRR) of this cash flow is often cited in the traditional literature in construction as a profit measure. To compute IRR, let the net present value (NPV) of At discounted at a discount rate i per period be zero, i.e.,
The resulting i (if it is unique) from the solution of Eq. (7.21) is the IRR of the net cash flow At. Aside from the complications that may be involved in the solution of Eq. (7.21), the resulting i = IRR has a meaning to the contractor only if the firm finances the entire project from its own equity. This is seldom if ever the case since most construction firms are highly leveraged, i.e. they have relatively small equity in fixed assets such as construction equipment, and depend almost entirely on borrowing in financing individual construction projects. The use of the IRR of the net cash flows as a measure of profit for the contractor is thus misleading. It does not represent even the IRR of the bank when the contractor finances the project through overdraft since the gross operating profit would not be given to the bank.
Since overdraft is the most common form of financing for small or medium size projects, we shall consider the financing costs and effects on profit of - the use of overdrafts. Let be the cumulative cash flow before the owner's payment in period t including interest and be the cumulative net cash flow in period t including interest. At t = 0 when there is no accrued interest, = F0 and = N0. For t in period t can be obtained by considering the contractor's expensesI Et to be dispersed uniformly during the period.
The inclusion of enterest on contractor's expenses Et during period t (for G 1) is based on the rationale that the S-shaped curve depicting the contractor's expenses in Figure 7-1 is fairly typical of actual situations, where the owner's payments are typically made at the end of well defined periods. Hence, interest on expenses during period t is approximated by one half of the amount as if the expenses were paid at the beginning of the period. In fact, Et is the accumulation of all expenses in period t and is treated - as an expense at the end of the period. Thus, the interest per period (for t 1) is the combination of interest charge for Nt-1 in period t and that for one half of Et in the same period t. If is negative and i is the borrowing rate for the shortfall,
If is positive and h is the investment rate for the surplus,
Hence, if the cumulative net cash flow is negative, the interest on the overdraft for each period t is paid by the contractor at the end of each period. If Nt is positive, a surplus is indicated and the subsequent interest would be paid to the contractor. Most often, Nt is negative during the early time periods of a project and becomes positive in the later periods when the contractor has received payments exceeding expenses.
Including the interest accrued in period t, the cumulative cash flow at the end of period t just before receiving payment Pt (for t 1) is:
Furthermore, the cumulative net cash flow after receiving payment Pt at the end of period t (for t 1) is:
The gross operating profit at the end of a n-period project including interest charges is:
where is the cumulative net cash flow for t = n.
Example 7-14: Contractor's gross profit from a project
The contractor's expenses and owner's payments for a multi-year construction project are given in Columns 2 and 3, respectively, of Table 7-11. Each time period is represented by one year, and the annual interest rate i is for borrowing 11%. The computation has been carried out in Table 7-11, and the contractor's gross profit G is found to be N5 = $8.025 million in the last column of the table.
TABLE 7-11 Example of Contractor's Expenses and Owner's Payments ($ Million)
Example 7-15: Effects of Construction Financing
The computation of the cumulative cash flows including interest charges at i = 11% for Example 7-14 is shown in Table 7-12 with gross profit = = $1.384 million. The results of computation are also shown in Figure 7-2.
TABLE 7-12 Example Cumulative Cash Flows Including Interests for a Contractor ($ Million)
Figure 7-2 Effects of Overdraft Financing
7.10 Effects of Other Factors on a Contractor's Profits
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.
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.
Example 7-16: Effects of Inflation
Suppose that both expenses and receipts for the construction project in the Example 7-14 are now expressed in then-current dollars (with annual inflation rate of 4%) in Table 7-13. The market interest rate reflecting this inflation is now 15%. In considering these expenses and receipts in then-current dollars and using an interest rate of 15% including inflation, we can recompute the cumulative net cash flow (with interest). Thus, the gross profit less financing costs becomes = = $0.4 million. There will be a loss rather than a profit after deducting financing costs and adjusting for the effects of inflation with this project.
TABLE 7-13 Example of Overdraft Financing Based on Inflated Dollars ($ Million)
Example 7-17: Effects of Work Stoppage at Periods of Inflation
Suppose further that besides the inflation rate of 4%, the project in Example 7-16 is suspended at the end of year 2 due to a labor strike and resumed after one year. Also, assume that while the contractor will incur higher interest expenses due to the work stoppage, the owner will not increase the payments to the contractor. The cumulative net cash flows for the cases of operation and financing expenses are recomputed and tabulated in Table 7-14. The construction expenses and receipts in then-current dollars resulting from the work stopping and the corresponding net cash flow of the project including financing (with annual interest accumulated in the overdraft to the end of the project) is shown in Fig. 7-3. It is noteworthy that, with or without the work stoppage, the gross operating profit declines in value at the end of the project as a result of inflation, but with the work stoppage it has eroded - further to a loss of $3.524 million as indicated by = -3.524 in Table 7-14.
TABLE 7-14 Example of the Effects of Work Stoppage and Inflation on a Contractor ($ Million)
Figure 7-3 Effects of Inflation and Work Stoppage
Example 7-18: Exchange Rate Fluctuation. Contracting firms engaged in international practice also face financial issues associated with exchange rate fluctuations. Firms are typically paid in local currencies, and the local currency may loose value relative to the contractor's home currency. Moreover, a construction contractor may have to purchase component parts in the home currency. Various strategies can be used to reduce this exchange rate risk, including:
- Au, T., and C. Hendrickson, "Profit Measures for Construction Projects," ASCE Journal of Construction Engineering and Management, Vol. 112, No. CO-2, 1986, pp. 273-286.
- Brealey, R. and S. Myers, Principles of Corporate Finance, McGraw-Hill, Sixth Edition, 2002.
- Collier, C.A. and D.A. Halperin, Construction Funding: Where the Money Comes From, Second Edition, John Wiley and Sons, New York, 1984.
- Dipasquale, D. and C. Hendrickson, "Options for Financing a Regional Transit Authority," Transportation Research Record, No. 858, 1982, pp. 29-35.
- Kapila, Prashant and Chris Hendrickson, "Exchange Rate Risk Management in International Construction Ventures," ASCE J. of Construction Eng. and Mgmt, 17(4), October 2001.
- Goss, C.A., "Financing: The Contractor's Perspective," Construction Contracting, Vol. 62, No. 10, pp. 15-17, 1980.