EUP 222 ENGINEER

IN SOCIETY
PROJECT FINANCE
Understand the financial concepts to appraise a project
efficiently and make decisions effectively.
Dr. Sharifah Akmam Syed Zakaria, PPKA .

email: akmam@usm.my

Outline
Lecture Objective & Context

Project Financing
Owner
Project
Contractor

Financial Evaluation

Project Financing
Investment is paid back from the project profit rather than the general assets or

creditworthiness of the project owners

For larger projects due to fixed cost to establish
Small projects not much benefit
Investment in project through special purpose corporations
Often joint venture between several parties
Need capacity for independent operation
Benefits
Off balance sheet (liabilities do not belong to parent)
Limits risk
External investors: reduced agency cost (direct investment in project)
Drawback
Tensions among stakeholders

Outline
Lecture Objective & Context
Project Financing
Owner
Project
Contractor

Financial Evaluation

Contractor Financing
Owner keeps an eye out for
Front-end loaded bids (discounting)
Unbalanced bids
Contractors frequently borrow from
Banks (Need to demonstrate low risk)
Interaction with owners
Some owners may assist in funding
Help secure lower-priced loan for contractor
Sometimes assist owners in funding!
Big construction company, small municipality

PART 1 : PROJECT
FINANCING
Todays
Focus

PART 2: FINANCIAL
EVALUATION

In the context
of cleaner
production
and
sustainability

Develop or Not Develop?

Is any individual project worthwhile?

Given a list of feasible projects, which
one is the best?

How does each project rank compared

to the others on the list?

Project Evaluation Example:

Project A

Project B

Construction=3 years

Construction=6 years

Cost = RM 1M/year

Cost=RM 1M/year

Sale Value= RM 4M

Sale Value=RM 8.5M

Total Cost?

Total Cost?

Profit?

Profit?

Quantitative Method:
Profitability
Create value for
the company

Outline
Lecture Objective & Context
Project Financing

Owner
Project
Contractor
Financial Evaluation
Project Income
Inflation
Operating Costs
Time value of money
Present value
Rates
Interest
NPV
Return on Capital Employed (Accounting Rate of Return)
Payback period

Profit:

TOTAL
RM

REVENUES

5,500,000.00

COSTS

4,600,000.00

Project management

400,000.00

Engineering

800,000.00

Material & transport

2,200,000.00

Construction/commissioni
ng

1,300,000.00

Contingencies

GROSS MARGIN

200,000.00

900,000.00

Time factor?

 Profitability

Quantitative Method:

Create value for the company

Opportunity Cost
Time Value of Money
A ringgit today is worth more than a
dollar tomorrow

Investment relative to best-case

scenario
E.g. Project A - 8% profit, Project B 10% profit

Case Study: Mbox by ECOLEX

A small electronic firm, ECOLEX
intends to produce a magnetic
heating lunch box (Mbox)

A Cleaner Production (CP)

assessment at ECOLEX identified
some potentially profitable
investment projects that also has
environmental benefits.

Financial Information: A
Initial investment = RM 4 million
Selling price (current price terms)
= RM 40 per unit

Variable operating costs (current

price terms) = RM 16 per unit

Expected selling price inflation

= 6 % per year

Fixed operating costs (current price

terms) = RM340,000 per year

Expected operating cost inflation

= 8 % per year

Financial Information: B
Demand forecast for Mbox by ECOLEX marketing team:

Year

Demand (units)

120,000

140,000

240,000

90,000

No terminal value or machinery scrap value.

A nominal (money) discount rate = 10% per year

A target return on capital employed = 30% per year.

Ignore taxation.

Financial Information: C
Given discount rates :

Year
Discount at 10%
Discount at 20%

0
1.000
1.000

1
0.909
0.833

2
0.826
0.694

3
0.751
0.579

4
0.683
0.482

Project Income:
Selling price (current price terms)
= RM 40 per unit

Expected selling price inflation

= 6 % per year
1

Year

RM
Inflated selling
price
Demand
Income

(RM/unit)
(units/year)
(RM/year)

RM

3
RM

RM 40 +
.06 (40)
42.40

RM 42.40 +
.06(42.40)
44.94

120,000 X

140,000

4
RM

RM 44.94 +
.06(44.94)
47.64
X

240,000

RM 47.64 +
.06(47.64)
50.50
X

90,000

5,088,000

6,291,600

11,433,600

4,545,000

Outline
Lecture Objective & Context
Project Financing

Owner
Project
Contractor
Financial Evaluation
Project Income
Inflation
Operating Costs
Time value of money
Present value
Rates
Interest
NPV
Return on Capital Employed (Accounting Rate of Return)
Payback period

Inflation & Deflation

Inflation means that the prices of goods and services increase over time
either undetectably or in leaps and bounds.

Inflation effects need to be included in investment because cost and

benefits are measured in money and paid in current ringgit, dollars or
pounds.

An inflationary trend makes future ringgit have less purchasing power than
present ringgit.

Deflation means the opposite of inflation. Prices of goods & services

decrease as time passes.

Outline
Lecture Objective & Context
Project Financing

Owner
Project
Contractor
Financial Evaluation
Project Income
Inflation
Operating Costs
Time value of money
Present value
Rates
Interest
NPV
Return on Capital Employed (Accounting Rate of Return)
Payback period

Project Evaluation Example:

Which one is better?
Project A

Project B

Construction=3 years

Construction=6 years

Cost = RM 1M/year

Cost = RM 1M/year

Sale Value = RM 4M

Sale Value = RM 8.5M

Total Cost?

Total Cost?

Profit?

Profit?

Drawing out the examples:

Project A
RM 4M
1

RM 1M

RM 1M

RM 1M
RM 8.5M

Project B
0

Assume 10% discount rate

RM 1M RM 1M MR 1M RM1M RM 1M RM 1M

Variable Costs:

Fixed Costs:

Variable costs are corporate expenses that

Fixed costs are expenses that have to be

Variable costs are those costs that vary

Fixed costs are costs that are independent

vary in direct proportion to the quantity

of output.

depending on a company's production

volume; they rise as production increases
and fall as production decreases.

Variable costs can include direct material

costs or direct labour costs necessary to
complete a certain project.

paid by a company, independent of any

business activity.
of output. These remain constant
throughout the relevant range.

Fixed costs are not relevant to output

decisions.

Fixed costs often include rent, buildings,

machinery, etc.

Financial Information: A
Initial investment = RM 4 million
Selling price (current price terms)
= RM 40 per unit

Variable operating costs (current

price terms) = RM 16 per unit

Expected selling price inflation

= 6 % per year

Fixed operating costs (current price

terms) = RM340,000 per year

Expected operating cost inflation

= 8 % per year

Financial Information: B
Demand forecast for Mbox by ECOLEX marketing team:

Year

Demand (units)

120,000

140,000

240,000

90,000

No terminal value or machinery scrap value.

A nominal (money) discount rate = 10% per year

A target return on capital employed = 30% per year.

Ignore taxation.

Operating Costs:
Fixed operating costs
(current price terms)
= RM340,000 per year

Variable operating costs

(current price terms)
= RM 16 per unit

RM

(units/year)

Total Variable costs

(RM/year)

(+) Inflated Fixed

Costs

Total Operating costs

RM

120,000

RM

RM 16 +
.08 (16)
17.28

(RM/unit)
Inflated variable cost
Demand

Expected operating
cost inflation
= 8 % per year

RM

RM 17.28 +
.08 (17.28)
18.66
X

140,000

RM 18.66 +
.08 (18.66)
20.15
X

240,000

RM 20.15 +
.08 (20.15)
21.76
X

90,000

(RM/year)

2,073,600
RM 340,000 + .08
(340,000)
367,200

2,612,400
RM 367,200
+ .08 (367,200)
396,576

4,836,000
RM 396,576 +
.08(396,576)
428,302

1,958,400
RM 428,302 + .08
(428,302)
462,566

(RM/year)

2,440,800

3,008,976

5,264,302

2,420,966

Outline
Lecture Objective & Context
Project Financing

Owner
Project
Contractor
Financial Evaluation
Project Income
Inflation
Operating Costs
Time value of money
Present value
Rates
Interest
NPV
Return on Capital Employed (Accounting Rate of Return)
Payback period

Time Value of Money:

If we assume
That money can always be invested in the bank (or some other reliable

source) now to gain a return with interest later.

That as rational actors, we never make an investment which we know to
offer less money than we could get in the bank.

Then
Money in the present can be thought as of equal worth to a larger

amount of money in the future.

Money in the future can be thought of as having an equal worth to a lesser
present value of money.

Time Value of Money: Revisit

If we assume

That money can always be invested in the bank (or some other reliable source)

now to gain a return with interest later

That as rational actors, we never make an investment which we know to offer less
money than we could get in the bank

Then
Money in the present can be thought as of equal worth to a larger amount of
money in the future
Money in the future can be thought of as having an equal worth to a lesser
present value of money

Outline
Lecture Objective & Context
Project Financing

Owner
Project
Contractor
Financial Evaluation
Project Income
Inflation
Operating Costs
Time value of money
Present value
Rates
Interest
NPV
Return on Capital Employed (Accounting Rate of Return)
Payback period

Basic Compounding:
Suppose we invest RM x in a bank offering interest rate, i
If interest is compounded annually, asset will be worth
$x(1+i) after 1 year
$x(1+i)2 after 2 years
$x(1+i)3 after 3 years .
$x(1+i)n after n years
0
RM x

1 RM x(1+i)

2 RM x(1+i)2

n RM x(1+i)n

Present Value (Revenue)

How is it that some future revenue, r at time, t has a present value?
Answer: Given that we are sure that we will be gaining revenue, r at time t, we can
take and spend an immediate loan from the bank
We choose size of this loan l so that at time t, the total size of the loan (including accrued
interest) is r

The loan, l is the present value of r

l = PV(r)

Future to Present Revenue:

If I know this is coming
x
t

I can borrow this from the bank now

PV(x)

t
0

PV(x)

Ill pay this back to the bank later

-x

The net result is that I can convert a sure x at time t

into a (smaller) PV(x) now!
t

Present Value (Cost)

How is it that some future cost c at time t has a present value?
Answer: Given that we are sure that we will bear cost c at time t, we
immediately deposit a sum of money x into the bank yielding a known
return

We choose size of deposit x so that at time t, the total size of the

investment (including accrued interest) is c

We can then pay off c at time t by retrieving this money from the
bank

The size of the deposit (immediate cost) x is the present value of c.

Future to Present Cost

t

If I know this cost is coming

-x

I retrieve this back from the bank later

I can deposit this in the bank now

PV(x)

x
t

t
PV(x)

The net result is that I can convert a sure cost x at time t

into a (smaller) cost of PV(x) now!

Summary: Present Value

Because we can flexibly switch from one such value to another without cost,
we can view these values as equivalent

Given a reliable source offering annual return i (i.e., interest) we can shift
without additional costs between cash v at time 0 and v(1+i)t at time t

Outline
Lecture Objective & Context
Project Financing

Owner
Project
Contractor
Financial Evaluation
Project Income
Inflation
Operating Costs
Time value of money
Present value
Rates
Interest
NPV
Return on Capital Employed (Accounting Rate of Return)
Payback period

Rates
Difference between PV (v)
and FV ( =v(1+i)t ) depends
on interest, i and time, t.

Rates
Difference between PV (v) and FV ( =v(1+i)t ) depends on i and t.
Interest Rate
Contractual arrangement between a borrower and a lender

Discount Rate (real change in value to a person or group)

Worth of Money + Risk
Discount Rate > Interest Rate

Minimum Attractive Rate of Return (MARR)

Minimum discount rate accepted by the market corresponding to the risks of a
project (i.e., minimum standard of desirability)

Outline
Lecture Objective & Context
Project Financing

Owner
Project
Contractor
Financial Evaluation
Project Income
Inflation
Operating Costs
Time value of money
Present value
Rates
Interest
NPV
Return on Capital Employed (Accounting Rate of Return)
Payback period

Interest Formulas
i = Effective interest rate per interest period (discount rate or MARR)
n = Number of compounding periods

PV = Present Value
FV = Future Value

A = Annuity (i.e., a series of payments of set size) at end-of-period

Interest Formulas: Payment - Example

If you wish to have

RM100,000 at the end of five

years in an account that pays
12 percent annually, how much
would you need to deposit
now?

Interest Formulas: Payment - Example

If you wish to have RM 100,000 at the end of five
years in an account that pays 12 percent annually,
how much would you need to deposit now?
0

P=?

F=RM 100,000

(P/F, 0.12, 5) or (F/P, 0.12, 5)?

Interest Formulas: Payment - Example

If you wish to have RM 100,000 at the end of five
years in an account that pays 12 percent annually,
how much would you need to deposit now?

P = F(P/F, 0.12, 5)

P = 100,000 (P/F, 0.12, 5)

P = 100,000 0.5674 = RM 56,740