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7. Financing of Constructed Facilities
7.1 The Financing Problem
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. Finance is also a concern to
the other organizations involved in a project such as the general contractor and material suppliers.
Unless an owner immediately and completely covers the costs incurred by each participant, these
organizations face financing problems of their own.
At a more general level, project finance is only one aspect of the general problem of corporate finance.
If numerous projects are considered and financed together, then the net cash flow requirements
constitutes the corporate financing problem for capital investment. Whether project finance is
performed at the project or at the corporate level does not alter the basic financing problem.
In essence, the project finance problem is to obtain funds to bridge the time between making
expenditures and obtaining revenues. Based on the conceptual plan, the cost estimate and the
construction plan, the cash flow of costs and receipts for a project can be estimated. Normally, this
cash flow will involve expenditures in early periods. Covering this negative cash balance in the most
beneficial or cost effective fashion is the project finance problem. During planning and design,
expenditures of the owner are modest, whereas substantial costs are incurred during construction. Only
after the facility is complete do revenues begin. In contrast, a contractor would receive periodic
payments from the owner as construction proceeds. However, a contractor also may have a negative
cash balance due to delays in payment and retainage of profits or cost reimbursements on the part of
the owner.
Plans considered by owners for facility financing typically have both long and short term aspects. In
the long term, sources of revenue include sales, grants, and tax revenues. Borrowed funds must be
eventually paid back from these other sources. 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

companies, investment trusts, commercial banks and others. Developers who invest in real estate
properties for rental purposes have similar sources, plus quasi-governmental corporations such as
urban development authorities. Syndicators for investment such as real estate investment trusts (REITs)
as well as domestic and foreign pension funds represent relatively new entries to the financial market
for building mortgage money.
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, while special bonds would be redeemed either by special taxes or user fees
collected for the project. Grants from higher levels of government are also an important source of
funds for state, county, city or other local agencies.
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. As a result, borrowed funds that can be obtained from different sources tend to have very
similar costs, including interest charges and issuing costs.
212
As a general principle, however, the costs of funds for construction will vary inversely with the risk of
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. Loans made for projects under construction represent considerable risk
to a financial institution. If a lender acquires an unfinished facility, then it faces the difficult task of re-
assembling the project team. Moreover, a default on a facility may result if a problem occurs such as
foundation problems or anticipated unprofitability of the future facility. As a result of these
uncertainties, construction lending for unfinished facilities commands a premium interest charge of
several percent compared to mortgage lending for completed facilities.
Financing plans will typically include a reserve amount to cover unforeseen expenses, cost increases
or cash flow problems. This reserve can be represented by a special reserve or a contingency amount
in the project budget. In the simplest case, this reserve might represent a borrowing agreement with a
financial institution to establish a line of credit in case of need. For publicly traded bonds, specific

construction.
•
Construction loan and long term mortgage: In this plan, a loan is obtained from a bank or
other financial institution to finance the cost of construction. Once the building is complete, a
213
variety of institutions may be approached to supply mortgage or long term funding for the
building. This financing plan would involve both short and long term borrowing, and the two
periods might involve different lenders. The long term funding would have greater security
since the building would then be complete. As a result, more organizations might be interested
in providing funds (including pension funds) and the interest charge might be lower. Also, this
basic financing plan might be supplemented by other sources such as corporate retained
earnings or assistance from a local development agency.
•
Lease the building from a third party: In this option, the corporation would contract to lease
space in a headquarters building from a developer. This developer would be responsible for
obtaining funding and arranging construction. This plan has the advantage of minimizing the
amount of funds borrowed by the corporation. Under terms of the lease contract, the
corporation still might have considerable influence over the design of the headquarters building
even though the developer was responsible for design and construction.
•
Initiate a Joint Venture with Local Government: In many areas, local governments will
help local companies with major new ventures such as a new headquarters. This help might
include assistance in assembling property, low interest loans or proerty tax reductions. In the
extreme, local governments may force sale of land through their power of eminent domain to
assemble necessary plots.
Back to top

7.3 Evaluation of Alternative Financing Plans
Since there are numerous different sources and arrangements for obtaining the funds necessary for
facility construction, owners and other project participants require some mechanism for evaluating the

the principles for dealing with such topics enunciated in Chapter 6.
In this section, we shall concentrate on the computational techniques associated with the most
common types of financing arrangements. More detailed descriptions of various financing schemes
and the comparisons of their advantages and disadvantages will be discussed in later sections.
Typically, the interest rate for borrowing is stated in terms of annual percentage rate (A.P.R.), but the
interest is accrued according to the rate for the interest period specified in the borrowing agreement.
Let i
p
be the nominal annual percentage rate, and i be the interest rate for each of the p interest periods
per year. By definition
(7.3)

If interest is accrued semi-annually, i.e., p = 2, the interest rate per period is i
p
/2; similarly if the
interest is accrued monthly, i.e., p = 12, the interest rate per period is i
p
/12. On the other hand, the
effective annual interest rate i
e
is given by:
(7.4)

Note that the effective annual interest rate, i
e
, takes into account compounding within the year. As a
result, i
e
is greater than i
p

(7.7)

If the origination fee is expressed as k percent of the original loan, i.e., K = kQ
0
, then:
(7.8)

Since interest and sometimes parts of the principal must be repaid periodically in most financing
arrangements, an amount Q considerably larger than Q
0
is usually borrowed in the beginning to
provide adequate reserve funds to cover interest payments, construction cost increases and other
unanticipated shortfalls. The net amount received from borrowing is deposited in a separate interest
bearing account from which funds will be withdrawn periodically for necessary payments. Let the
borrowing rate per period be denoted by i and the interest for the running balance accrued to the
216
project reserve account be denoted by h. Let A
t
be the net operating cash flow for - period t (negative
for construction cost in period t) and be the net financial cash flow in period t (negative for
payment of interest or principal or a combination of both). Then, the running balance N
t
of the project
reserve account can be determined by noting that at t=0,
(7.9)

and at t = 1,2,...,n:
(7.10)

where the value of A

217
borrowed will cover the construction cost of $10.331 million and an origination fee of $169,000 for
issuing the coupon bond.
The interest payment per period is (5%) (10.5) = $0.525 million over a life time of (2) (20) = 40
interest periods. Thus, the cash flow of financing by the coupon bond consists of a $10.5 million
receipt at period 0, -$0.525 million each for periods 1 through 40, and an additional -$10.5 million for
period 40. Assuming a MARR of 5% per period, the net present value of the financial cash flow is
given by:
[FPV]
5%
) = 10.5 - (0.525)(P|U, 5%, 40) - (10.5)(P|F, 5%, 40) = 0
This result is expected since the corporation will be indifferent between borrowing and diverting
capital from other uses when the MARR is identical to the borrowing rate. Note that the effective
annual rate of the bond may be computed according to Eq.(7.4) as follows:
i
e
= (1 + 0.05)
2
- 1 = 0.1025 = 10.25%
If the interest payments were made only at the end of each year over twenty years, the annual payment
should be:
0.525(1 + 0.05) + 0.525 = 1.076
where the first term indicates the deferred payment at the mid-year which would accrue interest at 5%
until the end of the year, then:
[FPV]
10.25%
= 10.5 - (1.076)(P|U, 10.25%, 20) - (10.5)(P|F, 10.25%, 20) = 0
In other words, if the interest is paid at 10.25% annually over twenty years of the loan, the result is
equivalent to the case of semi-annual interest payments at 5% over the same lifetime.
Example 7-3: An example of leasing versus ownership analysis

twenty years to pay for the construction costs. The shortfalls for repayments on loans will
come from corporate earnings. An origination fee of 0.75% of the original loan is required to
cover engineer's reports, legal issues, etc; or
•
A twenty year coupon bond at an annual interest rate of 10.25% with interest payments
annually, repayment of the principal in year 20, and a $169,000 origination fee to pay for the
construction cost only.
The current corporate MARR is 15%, and short term cash funds can be deposited in an account having
a 10% annual interest rate.
The first step in evaluation is to calculate the required amounts and cash flows associated with these
three alternative financing plans. First, investment using retained earnings will require a commitment
of $5 million in year 1 and $7 million in year 2.
Second, borrowing from the local bank must yield sufficient funds to cover both years of construction
plus the issuing fee. With the unused fund accumulating interest at a rate of 10%, the amount of
dollars needed at the beginning of the first year for future construction cost payments is:
P
0
= ($5 million)/(1.1) + ($7 million)/(1.1)
2
= $10.331 million
Discounting at ten percent in this calculation reflects the interest earned in the intermediate periods.
With a 10% annual interest rate, the accrued interests for the first two years from the project account
of $10.331 at t=0 will be:
Year 1: I
1
= (10%)(10.331 million) = $1.033 million
Year 2: I
2
= (10%)(10.331 million + $1.033 million - $5.0 million) = 0.636 million
219

0
1
1
1
2
2
2
3-19
20

[APV]
15%

Principal
Issuing Cost
Earned Interest
Contractor Payment
Loan Repayment
Earned Interest
Contractor Payment
Loan Repayment
Loan Repayment
Loan Repayment
-
-
-
- 5.000
-
-
- 7.000

220
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. For publicly issued bonds, a trust company is usually designated to
represent the diverse bond holders in case of any problems in the repayment. The borrowed funds are
usually secured by granting the lender some rights to the facility or other assets in case of defaults on
required payments. In contrast, corporate bonds such as debentures can represent loans secured only
by the good faith and credit worthiness of the borrower.
Under the terms of many bond agreements, the borrower reserves the right to repurchase the bonds at
any time before the maturity date by repaying the principal and all interest up to the time of purchase.
The required repayment R
c
at the end of period c is the net future value of the borrowed amount Q -
less the payment made at intermediate periods compounded at the borrowing rate i to period c as
follows:
(7.11)

The required repayment R
c
at the end of the period c can also be obtained by noting the net present
value of the repayments in the remaining (n-c) periods discounted at the borrowing rate i to t = c as
follows:
(7.12)

For coupon bonds, the required repayment R
c
after the redemption of the coupon at the end of period c
is simply the original borrowed amount Q. For uniform payment bonds, the required repayment R

some measure from large increases in the market interest rate and the consequent decrease in value of
their expected repayments. Variable rate loans can have floors and ceilings on the applicable interest
rate or on rate changes in each year.
Example 7-5: Example of a corporate promissory note
A corporation wishes to consider the option of financing the headquarters building in Example 7-4 by
issuing a five year promissory note which requires an origination fee for the note is $25,000. Then a
total borrowed amount needed at the beginning of the first year to pay for the construction costs and
origination fee is 10.331 + 0.025 = $10.356 million. Interest payments are made annually at an annual
rate of 10.8% with repayment of the principal at the end of the fifth year. Thus, the annual interest
payment is (10.8%)(10.356) = $1.118 million. With the data in Example 7-4 for construction costs and
accrued interests for the first two year, the combined operating and and financial cash flows in million
dollars can be obtained:
Year 0, AA
0
= 10.356 - 0.025 = 10.331
Year 1, AA
1
= 1.033 - 5.0 - 1.118 = -5.085
Year 2, AA
2
= 0.636 - 7.0 - 1.118 = -7.482
Year 3, AA
3
= -1.118
222
Year 4, AA
4
= -1.118
Year 5, AA
5

(7.9) and (7.10), it can be found that Q = $2.5 million (K = $0.125 or 5% of Q) is necessary to insure a
nonnegative balance in the project account for the uniform payment bond, as shown in Column 6 of
Table 7-3. For the purpose of comparison, the same amount is borrowed for the coupon bond option
even though a smaller loan will be sufficient for the construction expenditures in this case.
The financial cash flow of the coupon bond can easily be derived from Q = $2.5 million and K =
$0.125 million. Using Eq. (7.5), I
p
= (5%)(2.5) = $0.125 million, and the repayment in Period 10 is Q
+ I
p
= $2.625 million as shown in Column 3 of Table 7-3. The account balance for the coupon bond in
Column 4 is obtained from Eqs. (7.9) and (7.10). On the other hand, the uniform annual payment U =
$0.324 million for the financial cash flow of the uniform payment bond (Column 5) can be obtained
from Eq. (7.6), and the bond account for this type of balance is computed by Eqs. (7.9) and (7.10).
223
Because of the optional redemption provision for both types of bonds, it is advantageous to gradually
redeem both options at the end of period 3 to avoid interest payments resulting from i = 5% and h =
4% unless the account balance beyond period 3 is needed to fund other corporate investments.
corporate earnings are available for repurchasing the bonds at end of period 3, the required repayment
for coupon bond after redeeming the last coupon at the end of period 3 is simply $2.625 million. In the
case of the uniform payment bond, the required payment after the last uniform payment at the end of
period 3 is obtained from Equation (7-13) as:
R
3
= (0.324)(P|U, 5%, 7) = (0.324)(5.7864) = $1.875 million.
TABLE 7-3 Example of Two Borrowing Cash Flows (in $ thousands)
Period
Operating Cash
Flow
Coupon Cash

- 125
- 125
- 125
- 125
- 125
- 125
- 125
- 125
- 125
- 2,625
$2,375
1,545
782
628
928
1,440
2,173
3,135
4,135
5,176
3,758
$2,375
- 324
- 324
- 324
- 324
- 324
- 324
- 324
- 324

•
A debt service reserve fund to be used for retiring outstanding debts after the completion of
construction.
224
The total sources of funds (including interest from account balances) and uses of funds are
summarized in Table 7-4
TABLE 7-4 Illustrative Sources and Uses of Funds from Revenue Bonds During Construction
Sources of Funds
Bond Proceeds
Interest Earnings on Construction Fund
Interest Earnings of Capitalized Interest Fund
Interest Earnings on Debt Service Reserve Fund
Total Sources of Funds
$7,400,000
278,400
77,600
287,640
$8,043,640
Uses of Funds
Construction Costs
Interest Payments
Debt Service Reserve Fund
Bond Discount (2.0%)
Issuance Expense
Total Uses of Funds
$5,000,000
904,100
1,891,540
148,000
100,000