Construction Management - pdf - c09.pdf - po ang - Januszek66

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Chapter 9

Project Cash Flow

Scenario Testing

The Need

Construction company operations are project based. Cash ﬂows can be

estimated by attempting to assess ﬂows from (1) projects in progress,

(2) projects under contract but not yet begun, and (3) potential projects

which will start during the coming ﬁnancial accounting period. These

sources of income can be viewed as (1) Birds in the hand, (2) Birds in

the bush, and (3) Birds ﬂying in the sky. In other words, cash ﬂows can

be projected from projects in progress and projects which may, with

some probability, start in the coming period for which forecasts are

being made. The advent of spreadsheet analysis and high speed com-

puting has led to “scenario testing” of future cash ﬂow expectations.

Cash Flow Diagram

The Technology

Spreadsheets allow managers to run probabilistic cash ﬂow projections that take into

account the factors noted above. More advanced analysis can also factor in historical

evidence of payment trends and the potential impact of macroeconomic factors. These

techniques go beyond the typical best-, expected-, and worst-case scenario modeling and

may rely on Monte Carlo simulation, Markov modeling, or the use of “fuzzy” data sets to

build up statistically valid outcomes. At the most advanced level, when future cash ﬂows

are tied to a multitude of unknowns, probabilistic techniques may be employed in

combination with real-options theory to gain an improved view of the impact of a

ﬁnancial decision (e.g., accepting or declining a project or changing market strategy) on

value creation for a company. This level of analysis used to be in the economist’s realm,

butisnow commonplace in the ﬁnance and business development groups of corporations.

9.1

CASH FLOW PROJECTION

The projection of income and expense during the life of a project can be developed from sev-

eral time-scheduling aids used by the contractor. The sophistication of the method adopted

usually depends on the complexity of the project. In many contracts (e.g., public contracts

such as those used by state agencies), the owner requires the contractor to provide an S-curve

of estimated progress and costs across the life of the project. The contractor develops this

by constructing a simple bar chart of the project, assigning costs to the bars, and smoothly

connecting the projected amounts of expenditures over time.

Consider the highly simpliﬁed project (Fig. 9.1) in which four major activities are

scheduled across a four-month time span. Bars representing the activities are positioned

along a time scale indicating start and ﬁnish times. The direct costs associated with each

activity are shown above each bar. It is assumed that the monthly cost of indirect charges

(i.e., site ofﬁce costs, telephone, heat, light, and supervisory salaries, which cannot be

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Chapter 9

Project Cash Flow

Figure 9.1 Development of the S-curve.

charged directly to an activity) is $5,000. Assuming for simplicity that the direct costs are

evenly distributed across the duration of the activity, the monthly direct costs can be readily

calculated and are shown below the time line. The direct charges in the second month,

for example, derive from activities A, B, and C, all of which have a portion in the period.

The direct charge is simply calculated based on the portion of the activity scheduled in the

second month as:

Activity A : 1

2 ×

000

$25

000

Activity B : 1

2 ×

000

$20

000

Activity C : 1

3 ×

000

$20

000

$65

000

The ﬁgure shows the total monthly and cumulative monthly expenditures across the life of

the project. The S-curve is nothing more than a graphical presentation of the cumulative

expenditures over time. A curve is plotted below the time-scaled bars through the points of

cumulative expenditure. As 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 points are connected by a smooth curve since the

assumption is that the expenditures are relatively evenly distributed over each time period.

This curve is essentially a graphical portrayal of the outﬂow of monies (i.e., expense ﬂow)

for both direct and indirect costs.

9.2

CASH FLOW TO THE CONTRACTOR

The ﬂow of money from the owner to the contractor is in the form of progress payments.

As already noted, estimates of work completed are made by the contractor periodically

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9.2

Cash Flow to the Contractor

Figure 9.2 Expenses and income proﬁles.

(usually monthly) and are veriﬁed by the owner’s representative. Depending on the type

of contract (e.g., lump sum, unit price, etc.), the estimates are based on evaluations of the

percentage of total contract completion or actual ﬁeld measurements of quantities placed.

This process is best demonstrated by further consideration of the four-activity example just

described. Assume that the, contractor originally included a proﬁt or markup in his bid of

$50,000 (i.e., 25%) so that the total bid price was $250,000. The owner retains 10% of all

validated progress payment claims until one-half of the contract value (i.e., $125,000) has

been built and approved as an incentive for the contractor to complete the contract. The

retainage will be deducted from the progress payments on the ﬁrst $125,000 and eventually

paid to the contractor on satisfactory completion of the contract. The progress payments will

be billed at the end of the month, and the owner will transfer the billed amount minus any

retainage to the contractor’s account 30 days later. The amount of each progress payment

can be calculated as:

Pay

1.25(indirect expense

direct expense)

−

0.10[1.25(indirect expense

direct expense)]

The minus term for retainage drops out of the equation when 50% of the contract has been

completed. Because of the delay in payment of billings by the owner and the retainage

withheld, the revenue proﬁle lags behind the expense S-curve as shown in Figure 9.2.

The revenue proﬁle has a stair-step appearance since the progress payments are trans-

ferred in discrete amounts based on the preceding equation. The shaded area in Figure 9.2

between the revenue and expense proﬁles indicates the need on the part of the contractor

to ﬁnance part of the construction until such time as he is reimbursed by the owner. This

difference between revenue and expense makes it necessary for the contractor to obtain

temporary ﬁnancing. Usually, a bank extends a line of credit against which the contrac-

tor can draw to buy materials, make payments, and pay other expenses while waiting for

reimbursement. This is similar to the procedure used by major credit card companies in

which they allow credit card holders to charge expenses and carry an outstanding balance

for payment. Interest is charged by the bank (or credit card company) on the amount of

the outstanding balance or overdraft 1 .Itis, of course, good policy to try to minimize the

amount of the overdraft and, therefore, the interest payments. The amount of the overdraft is

1 Similar examples of this type of inventory ﬁnancing can be found in many cyclic commercial undertakings.

Automobile dealers, for instance, typically borrow money to ﬁnance the purchase of inventories of new car

models and then repay the lender as cars are sold. Clothing stores buy large inventories of spring or fall fashions

with borrowed money and then repay the lender as sales are made.

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Chapter 9

Project Cash Flow

Figure 9.3 Inﬂuence of front, or mobilization, payment on expense and income proﬁles.

inﬂuenced by a number of factors, including the amount of markup or proﬁt the contractor

has in his bid, the amount of retainage withheld by the owner, and the delay between billing

and payment by the owner.

Interest on this type of ﬁnancing is usually quoted in relationship to the prime rate.

The prime rate is the interest rate charged preferred customers who are rated as very

reliable and who represent an extremely small risk of default (e.g., General Motors,

Exxon, etc.). The amount of interest is quoted in the number of points (i.e., the num-

ber of percentage points) above the prime rate. The higher-risk customers must pay more

points than more risky borrowers. Construction contractors are normally considered high-

risk borrowers; if they default, the loan is secured only by some materials inventories

and partially completed construction. In the event that a manufacturer of household ap-

pliances defaults, the inventory of appliances is available to cover part of the loss to

the lender. Additionally, since construction contractors have a historically high rate of

bankruptcy, they are more liable to be charged higher interest rates in most of their ﬁnancial

borrowings.

Some contractors offset the overdraft borrowing requirement by requesting front, or

mobilization, money from the owner. This shifts the position of the revenue proﬁle so that

a reduced, or zero, overdraft occurs (Fig. 9.3). Since the owner is normally considered less

of a risk than the contractor, he can borrow short-term money at a lower interest rate. If

the owner agrees to this approach, he essentially takes on the interim ﬁnancing requirement

normally carried by the contractor. This can occur on cost-reimbursable contracts where

the owner has great conﬁdence in the contractor’s ability to complete the project. In such

cases it represents an overall cost savings to the owner, since otherwise he will ultimately

be back-billed for the contractor’s higher ﬁnancing rate if the contractor must carry the

overdraft.

9.3

OVERDRAFT REQUIREMENTS

In order to know how much credit must be made available at the bank, the contractor needs to

know what the maximum overdraft will be during the life of the project. With the information

given regarding the four-activity project, the overdraft proﬁle can be calculated and plotted.

For purposes of illustration, the interest rate applied to the overdraft will be assumed to

be one percent per month. That is, the contractor must pay the bank 1% per month for the

amount of the overdraft at the end of the month. More commonly, daily interest factors may

be employed for the purpose of calculating this interest service charge. Month-end balances

might otherwise be manipulated by proﬁtable short-term borrowings at the end of the

month. The calculations required to deﬁne the overdraft proﬁle are summarized in Table 9.1.

Table 9.1

Overdraft Calculations

Month

Direct cost

$25,000

$65,000

$75,000

$15,000

Indirect cost

5,000

Subtotal

30,000

70,000

80,000

20,000

Markup (25%)

7,500

17,500

20,000

5,000

Total billed

37,500

87,500

100,000

25,000

Retainage withheld

(10%)

3,750

8,750

Payment received

$33,750

$78,750

$100,000

$37,500

Total cost to date

30,000

100,000

180,000

200,000

Total amount billed

to date

37,500

125,000

225,000

250,000

Total paid to date

$33,750

112,000

212,500

250,000

Overdraft end of

month

30,000

100,300

147,553

90,279

(8,818) b

(46,318) b

Interest on overdraft

balance a

300

1,003

1,476

903

Total amount

30,300

101,303

149,029

91,182

(8,818)

ﬁnanced

a A simple illustration only. Most lenders would calculate interest charges more precisely on the amount/time involved employing daily interest factors.

b Parentheses indicate a positive balance in this case.

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