5[1]. cashflow notes

8/13/2019 5[1]. Cashflow Notes

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PROJECT CASH FLOW

Projects and contracts are commercial ventures. Both the Promoter of a project and a contractoremployed by him are investing money and taking financial risks in order to achieve some desired

benefit or return. Project and contract management is concerned with the control of both

investment and risk with the aim of achieving this return. Economic or financial evaluation ofcash flows is the primary basis for decisions relating to the choice, magnitude and pattern ofinvestment.

The use of economic evaluation is not restricted to high level management decisions such aswhether to develop an oilfield or acquire or sell an entire business activity. t the level of projector contract management there are many decisions amenable to economic analysis. E!amplesinclude"

# the effects of a design change or a change in programme

# changes in method of manufacture, operation and use of resources

# whether to purchase or hire a machine or facility.

lways remember there is an alternative way to utilise money and this is capable of beingquantified, however roughly.

1 Cash Flow

$n order to quantify both the demand for money to meet the project or contract costs and the

pattern of income it will generate it is necessary to predict the cash flow. cash flow is afinancial model of the project or contract and even in its simplest basic form will provide vitalinformation for the manager.

%e are concerned with the flow of money in and out of the account per time period. $ncome is positive and e!penditure negative" the net cash flow is therefore the difference between cash inand cash out. $n most cases we aim to produce the cumulative cash flow diagram. The model should be built#up in the following stages to aid thorough understanding of the detailsof the investment as the basic cash flow is adjusted and progressively refined. dherence to thisstructure, shown diagrammatically in &igure', will aid perception of all the implications of the

investment. $n many cases the desired decision may be made without completing all the stages.

i( )ompile the base#case cash flow simply by adding the costs and revenues to each activityon a bar#chart programme which e!tends over the entire life cycle of the project orcontract.

ii( *efine the base#case cash flow to take account of delays between incurring a commitmentand paying or receiving the money.

iii( )alculate the resulting cost and benefit together with the investment required.



iv( )onsider the implications of risk and uncertainty.

v( $f necessary, e!amine the implications of inflation.

$n particular, inflation should always be considered separately when all other aspects of the

investment are understood. dditional assumptions concerning future rates of inflation then haveto be made, which increase the uncertainty. $t is easy to be confused or misled if inflation isintroduced too early in the financial analysis.

2 Categories of Charge

There are three basic types of cost or revenue which make up the cash flow"#

a( &i!ed charges incurred at a point in time.

b( +uantity#proportional charges related to quantity of work completed, output or deliveries

of materials. -nly material costs and product revenues are strictly in this category.(

c( Time#related charges # predominantly the cost of resources. These are increasinglyimportant, particularly in resource#dominated jobs. People and resources are normallyemployed or hired by the week or month.

ny flow of money can be defined in one of these categories and the realism of the cash flow prediction will depend greatly on the correct definitions of charges. $f in doubt, ask yourself howthe bill will be paid.

3 Compilig the !ase"#ase Cash Flow

The most likely estimates of cost and revenue are added to each activity in a realistic programme.$nitially keep the programme simple by splitting the work into a small number of major activities.

et the base, or reference, date for the estimate, normally the date of the first flow of money, anddivide the contract or project life into time periods appropriate to the accuracy required.Economists may compute annual cash flows in the early stages of project evaluation but it isnormal to consider monthly cash flows when appraising or managing the project whilst it isadvisable to calculate weekly cash flows for short duration contracts.

The base cash flow is compiled using the costs and e!change rates as they were at the base date.

/istinguish between fi!ed, quantity proportional and time#related charges and when necessaryconvert all cash flows to one currency. ssume 0ero inflation.

The author recommends that the cash flow patterns are sketched on each activity in the programme, prior to computing the period cash flows and constructing the cumulative curves.These should be completed before proceeding to add the refinements introduced below. The

process is illustrated in the following e!ample, and &igures 1 and 2.

E!ample

The contract for the manufacture and installation of a machine has been defined in &igure 1 as



five activities on a bar chart, i.e. design, fabrication, installation and commissioning of themachine plus construction of the foundation. The 13 week programme is known to be tight andthe contract includes modest liquidated damages.

The costs associated with the completion of each activity are calculated and the resulting cash

flow patterns sketched onto the bar chart utilising the appropriate cost categories.

$n this e!ample"#

# it is assumed that a design team is allocated to this job for si! weeks. They generate atime#related charge of 4#5week which is shown to accumulate linearly. $f the activitytakes longer than predicted, then the cost will e!tend and subsequent activities may bedelayed(.

# fabrication of the unit incurs several different costs" a fi!ed cost for setting up the job,time#related charges for labour and the use of the facility and material charges as they are

scheduled to be delivered, all as sketched against this activity on the bar chart. Thereader will recognise that by categorising the costs the consequence of a delay or of anincrease in material costs can quickly be deduced.

# similar cost patterns are estimated for the other activities

# general costs associated with several activities have been isolated into 6indirect6 costcentres or 6hammocks6. $t is here assumed that the same crane will be retained on site forconstruction of the foundation and installation of the unit, also that overheads areincurred as a weekly charge whilst work is proceeding on site. These time#relatedhammock costs are an important mechanism in the development of this simple 6time#and#

money6 model. They should be viewed as elastic and they are, of course, sensitive tochanges in programme. The author strongly advises that all general resources should beseparated as hammocks in any model.

The total weekly costs are then accumulated to give the cumulative cost curve, as shown in&igure 2. This is the best prediction of the progressive commitment of e!penditure on thiscontract.

The pattern of income is then added to that diagram as shown by the broken line. $n this case payments are staged # on completion of design, fabrication and installation, with the largest payment at the end of the contract. This revenue curve predicts how money will be earned and

the area between the cost and revenue curves is an indication of the investment required from thecontractor.

Even in this very simple form the base cashflow model offers a useful management tool as theimplication of any change is easy to visualise. $n this e!ample, adherence to the schedule is ofgreat importance as any delay in completion will rapidly increase interest payments on thecontractor7s investment, and liquidated damages may also be incurred.

)ontract )ash &low



$t is easy to see from &igures 1 and 2 that the investment would be greatly affected by any changein the payment characteristics or any circumstances that delayed either e!penditure or receipts.The contractor7s cash flow can therefore be said to be 6sensitive6 to such changes. *ememberthat cash flow in a contract that is of relatively short duration is sensitive to"

'. The type of contract, for e!ample admeasurement or cost#reimbursable

1. The contractual payment characteristics imposed by that contract, including mobilisationfees and retentions.

2. The delay between incurring costs and paying the bills.

8. /isruption of the work plan.

9. The speed and e!tent of reimbursement of variations and claims.

$nflation is only likely to be significant if the contract duration e!ceeds '1 months and theunderlying rate of cost escalation is 9: or more.

The investment and confidence in the cash flow forecasts will also be affected by uncertaintysurrounding any aspect of the contract. full quantified risk analysis of the type applied later inthis chapter to a project cash flow of long duration will rarely be necessary for a small contract,

but risks must not be ignored. The implications of each variable should be considered andappropriate contingencies allocated in the programme and estimate.

*efining the )ontract )ash &low

The simple basic model will assist decision#making but for accounting and investment predictionsit will be necessary to adjust the base cash flow to take into account supplier credit and the lag in

payment of earned revenue. The actual cash flow will be later than shown in our basic model. $nmost cases the delay in payment of revenue e.g. in accordance with the terms of the contract6payment will be made within ! weeks of submission of the certificate6( will be greater than thelag in e!penditure as most workers e!pect to be paid weekly;

The refined cash flow predictions linked to a specified rate of interest will generate figures of theinvestment required to complete the contract. This becomes an element of the contractor7s costand must be included when determining the contract price.

$ Pro%e#t Cash Flow

There is some similarity between the contractor7s balance of account for the above contract andthat for the Promoter developing a new facility or project. $n each case, a period of investment isfollowed by a period of surplus in the account. The time scale of the project is, however, muchlonger and, consequently, this investment is unlikely to be sensitive to delays of a few weeks in

payments. The sensitive factors are here likely to be"

'. <arket forecasts of the quantity and price of the product.



1. taging the developing, i.e. the project is constructed in either one or a number ofseparate stages.

2. -perational efficiency and reliability.

8. /elay in commissioning.

9. $nflation.

$n this case adjustments to the base cash flow for the lag in payments are more likely to beintroduced in the operational phase of the project, perhaps to allow for the delay between

producing the product and selling it. Emphasis must here be given to the analysis of risk.

& Profita'ilit( )*i#ators

lthough it is sometimes possible to compare different investments by reference to their cashflow diagrams, it is advisable to employ and tabulate several of the various profitability indicatorsthat quantify the investment when choosing between alternatives. These include"

Profit # the arithmetical difference between total payments and total receipts # is an obvious case.<a!imum profit could be the criterion selected for the choice of one of several alternative plans,all of which satisfy the time and resource requirements. The profit figure does not, however, giveany measure of the investment required or of the effect of time on the flow of money whichconstitutes that investment.

imilarly, ma!imum capital lock#up and payback period which quantify, respectively, the

ma!imum demand for capital and the time taken from the start of the contract or project for theinvestor7s account to move into credit, could be used. By reference to &igure 9, we see that jointly these three figures define the key ordinates on the cumulative net cash#flow curve= noneof them, however, takes into account the time value of money. By this we mean that it is betterto receive one pound today rather than in twelve months7 time, for we will have had the use of themoney in the intervening period.

The process we use to introduce a measure of the time value of money into our calculations iscalled discounting which is briefly described in the nne! to this paper. The individual periodcash flows incurred over the duration of the contract or project are converted to their equivalentvalues at a single point in time # normally the start of the investment.

The +et Preset ,al-e .p/0 tells you by how much a potential investment will increase thevalue of the business in today>s terms money value(. $t takes account of the total money the project will earn and of the time factor when you get the money. $t is, however, at the mercy ofthe reliability of the forecast of cash inflow on which the calculations are based.

The )teral rate of Ret-r .)RR0 gives a percentage rate measurment of return. The $** isthe discount rate at which the npv becomes 0ero, in other words, it is the rate of discount thatmakes the npv of all the cash inflows e!actly equal to the amount of money being invested. $t isdetermined by trial and error. $t is the highest borrowing rate for a given investment that willallow the recovery of the investment plus interest on borrowings.



$t is probable that either net present value or internal rate of return would be used in conjunctionwith several of the other criteria for the selection of a project or to identify a preferred contractcash flow. &or e!ample, a positive net present value or some specified minimum value of internalrate of return may be required in addition to a minimum level of profit. short payback period isalso desirable and is given prominence in the selection of many commercial projects. The use and

tabulation of several profitability indicators is strongly advised whenever comparing investments.

The author has also found the total investment, the area below the hori0ontal base line e!pressedin 4#years, to be useful during project appraisal. The total investment in new industrial plant isthe area of the triangle ? appro!imately [email protected] million 4 # years. The same criteria are also aconvenient way of evaluating change in either contract or project. $n both cases, the investor isgreatly concerned with the effect of change on his investment.

)flatio

$nflation is the decrease in the purchasing power of money arising from escalation of costs and

prices. The effect is compound, cumulative and is consequently e!tremely time sensitive. %hen base case cash flows are escalated to predict 6money of the day figures6 the increases can appeardramatic" they can also be misleading;

&igure 3 illustrates this effect when the base#case costs and prices for new industrial plant are allincreased at an inflation rate of 'A: p.a. $n 6money of the day6 terms both the demand forcapital and the predicted profit increase significantly, the former from 4'2.9m to 4'3.1m and the

profit from 4m to 418Am. The apparent improvement in benefit is, however, a myth as the purchasing power of money will decrease over the life of the project.

The difficulty of predicting future rates of inflation is obvious when one considers the technical,

political and economic changes of the last decade # all of which affect commodity values,e!change rates and market confidence. /ifferent elements of cost will also escalate at differentrates, for e!ample changes in the cost of labour or fuel may not be reflected in the cost ofimported materials or construction plant. Published national 6rates of inflation6 are normallylinked to a collection of domestic prices to indicate movement in 6the cost of living6 and may bevery different from the costs of raw materials used by your project.

The author concluded that"

# for projects of more than 'A years overall duration and particularly where the cash flowanalysis is performed primarily for ranking purposes, escalated forecasts should be given

relatively little weight and the decision based on the non#escalated figures.

# in all cases the ma!imum escalated demand for capital should be determined.

&ortunately for the project manager he or she is unlikely to be required to generate 6money of theday6 figures when estimating project costs and benefits. This is more often the responsibility ofeconomists or accountants who may simulate the implications of a range of inflation rates. Ta!and5or royalty payments levied on the profits generated by your project will, of course, becalculated at 6money of the day6 values.

$n engineering contracts the risk arising from variations in e!change rates should be clearly



allocated to one of the parties. &or contracts e!ceeding twelve months in duration it is normal tocompensate the )ontractor by the application of a )ontract Price djustment formula linked to

published national indices. The CD 6Ba!ter6 formula incorporates twelve cost categoriescommon to civil engineering works and is a good e!ample of an equitable and simple method ofcompensation.

Ris 4aagemet

The simple time and money models described and developed in this chapter are valuable whendefining and evaluating the uncertainties associated with the estimates and predictions for any

project or contract. ll engineering projects and most contracts are subject to uncertainties whichmust be investigated if realistic estimates and responses to risk are to be generated. Thee!amples given in this chapter have illustrated that uncertainties such as resource output can give

benefit as well as loss and that many risks in the implementation phase result in delay. $t shouldalso be noted that the earlier in the project or contract life that action is taken to reduce risk # themore effective it is likely to be.

$t is relevant to emphasise the following selected conclusions drawn from recent research.

. ll too often risk is either ignored or dealt with in an arbitrary way" simply adding a 'A:7contingency7 onto the estimated cost of a project is typical. This is virtually certain to beinadequate.

. The greatest uncertainty is in the earliest stages of a project, which is also when decisionsof greatest impact are made. *isk must be assessed and allowed for at this stage.

. *isks change during most projects. *isk management should therefore be a continuing

activity throughout the life of a project.

. <uch can be learned about the implications and management of project risk withoute!tensive numerical analysis. *isk analysis is essentially a brain#storming process ofcompiling realistic forecasts and answers to 6what happens if6 questions.

. The quantitative assessment of risk requires analysis of the likely e!tent and interaction ofvariable factors. The analysis should be carried out by those trained to do so jointly with

project planners and cost estimators. The need for judgement should not be used as ane!cuse for failing to give adequate consideration to project or contract risk.

. /elay in completion can be the greatest cause of e!tra cost and of loss of financial returnand other benefits from a project. The first estimate of cost and benefits should be basedon a realistic programme for a project. -n this basis the potential effects of delays can be

predicted realistically.

. The overriding conclusion drawn from the research is that all parties involved inconstruction projects and contracts would benefit greatly from reduction in uncertainty

prior to financial commitment. <oney spent early buys more than money spent late.%illingness to invest in anticipating risk is a test of a client7s wish for a successful project.



F5RTHER REA6)+7

Perry F G and Thompson P , 'H@@, Construction finance and cost escalation, Proc. $nstn. )iv.Engrs., 31, 312#318, Iovember

%earne J ed(, 'HH, Control of Engineering Projects, Thomas Telford, Kondon, )hapter 9(

Gaisford *, 'H3, Project Management in the North Sea, $nternational Fournal of Project<anagement, Lol 8, Io ', &ebruary

<errett F and ykes , 'H@2, The Finance and Analysis of Capital Projects, Kongman

Thompson P and Iorris ), 'HH2, The Perception, Analysis and Management of Financial Riss in Engineering Projects, Proc. $nst. )iv. Eng. Lol H@, &ebruary

Thompson P and %illmer G, 'H9, CASPAR ! a program for Engineering Project Appraisal

and Management, Proc. 1nd $nternational )onference on )ivil M tructural Engineering)omputing, Kondon, L.', pp @9#', $nstn. )iv. Engrs.

Perry F G, Thompson P et al, 'HH1, Engineering Construction Riss ! A "uide to Project Ris Analysis and Ris Management , Thomas Telford

Iorris ), Perry F G and imon P, 'HH1, Project Ris Analysis and Management , ssociation ofProject <anagers Bulletin, <arch

E/) for )ivil Engineering, Price Adjustment Formulae for Ci#il Engineering $ors, J<-,Kondon

A++E8

$f a stream of future payments representing an investment is discounted to the presenttime, the present value of the investment is calculated. %hen both payments and receipts arediscounted, the net present value is given.

The present value p of a cash flow )n in period n is given by"

p ? )n ! NNNNNNN'NNNNNNN

l O r(n

where r is the discount rate per time period e!pressed as a decimal(.

)are must be taken to ensure that all the alternatives to be compared are evaluated on thesame basis, i.e. that the discount rate, the same base date, and the same time period or interval isused. $n a non#inflationary situation, the discount rate is normally selected to represent the costof capital t the investor" the time period may be years or months for a project and months orweeks for a contract.

$t is rarely necessary to calculate the discount factor '5' O r(n as this is tabulated and is



readily available in many te!tbooks. )alculation of the net present value is then simply a matterof multiplying the net cash flow in the first time period by the relevant factor to give thediscounted cash flow and then repeating this process for each successive time period. *eceiptsare designated as positive and payments as negative cash flows. The net present value is thearithmetical sum of the individual discounted values.

)alculations of present value assume a discount rate and it is sometimes convenient toutilise the internal rate of return # which is defined as the discount rate that will produce 0ero net

present value, i.e. net present value is a measure of the gain from a project or contract, whereasinternal rate of return measures gain relative to outlay.

The author emphasises that discounting is an e!pedient technique used only to aidcomparison of investments. This technique for taking into account the 6time#value6 of moneyshould not be confused with provision for cost escalation which should be considered separately.

T"variouscashflow



&igure '



&igure 1

&igure 2



&igure 8



&igure 9



&igure 3

5[1]. cashflow notes

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