HARD BID BY NET PRESENT VALUE

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1 HARD BID BY NET PRESENT VALUE Djalil H. Abadi P.E. Djalil Abadi is a registered professional engineer in the State of California and Colorado. After receiving his engineering degree in structural engineering he continued his MBA studies at the University of Northern Colorado in the field of financial and construction management. Mr. Abadi has over 25 years experience in construction industry and is currently the manager of project controls at Lenax Construction Services Inc. in Los Angeles, California. He specializes in construction management, value engineering, constructability reviews, scheduling, and cost estimating. He also provides services in, budgeting, financial management and analysis, forecasting, and claim analysis and settlements. Abstract: The majority of the public Infrastructure projects traditionally will go through various stage of value engineering in order to reduce the cost of the project s construction elements; however, no known structured method of value engineering has been adopted for reducing the project s financing cost. This paper will review the financing cost of major public projects and will explorer methods that can be adopted to reduce the financing cost and ultimately the total project cost. The current bid evaluation methodology is based on the total cash value of the project and ignores the time-value of money. For long-term infrastructure projects over three years and more than $300 million in value, we recommend awarding the project based on the Net Present Value (NPV) of project cash flow instead of total cash value. The methodology for including the timevalue of money in the bid evaluation process is the vehicle for measuring a project s financing cost and implementing methods for reducing this cost.

2 Page 2 of 5 The majority of public Infrastructure projects are constructed by private contractors. The financing of these projects requires significant amount of working capital and a strong financial background. Only a handful of contractors possess the required resources to submit a bid-for-construction on these projects which limits the competition. The project s construction cost is based on the estimated cost of all the work items plus the financing cost of the project construction that can add up to millions of dollars. The financing cost of the construction will be distributed to all of the bid items and the owner will ultimately pay for it. Owners traditionally implement various stage of value engineering to reduce the cost of the various construction elements of the project; however, no known standardized method of value engineering has been adopted for reducing the project s financing cost. This paper will review the financing cost of major public projects and will explorer methods that can be adopted to reduce the financing cost and ultimately the total cost of the project. The construction of major public Infrastructure projects requires an investment of large amounts of working capital within an extended period of time. The financing cost of this capital investment will add up to the total project cost and the owner will pay for it. Some contributing factors to the financing cost are: Structure of the bid schedule Method of advance payment for costly initial setup expenses Time required for processing and approval of the payment application The rate of retentions Contractor credit rating and its rate of borrowings Contractor s distribution of cost to the pay items (Degree of frontloading) None of above factors can be measured or show the transparent amount in the bid if we ignore the time-value of the money. Therefore, the first step in reducing the financing cost is to implement methods that measure the financing cost in the bid and evaluating it. Measuring the time-value of money should be incorporated in the structure of the bid schedule so that the bid evaluation and contract award go to the bidder with the actual lowest present value.

3 Page 3 of 5 The current bid evaluation methodology is based on the project s total cash value and ignores the time-value of money. This simple evaluation methodology is effective and practical for short-term contracts with minimal financing cost. However, for the longterm public Infrastructure projects (in the range of $100 million with substantial financing cost), ignoring the time-value of money simply disregards any opportunities for reducing the financing cost. Additionally, ignoring the time-value of money promotes front-loading practices by contractors, can result in unfair competition, and may prevent the awarding of the contracts to the actual lowest bidder. As a result, the owner will end up contributing to the contractor s partial financing cost without receiving any benefit. For long-term infrastructure projects (over three years and above $300 million in value), we recommend awarding the project based on the Net Present Value (NPV) of project cash flow instead of total cash value. For measuring a project s financing cost and implementing methods to reduce this cost, factoring the time-value of money in the bid evaluation is a place to start. In order to include the time-value of money in the bid, assign a Net Present Value (NPV) factor to each item in the bid schedule. These NPV factors will be calculated based on the project construction schedule (or project cash flow) and the average interest rate that the contractors are paying banks for financing the project. The dollar value of each bid item is calculated by each contractor and is multiplied by the Net Present Value of the item as defined by the owner. These dollar values will be used by the contractors to generate an NPV for their total bid amount. The bid s NPV will represent the bid amount to determine the actual lowest bidder. The bid s total cash value equals the sum of all items in the bid schedule. The total cash value will not be changed and will function as the base amount in awarding the contract. Using these methods (calculating the NPV and the total cash value) will be clearly stated in the Request for Bid Proposal and communicated to all potential bidders. We have provided a sample project detailing this methodology in Appendix A. Using the above method to evaluate the contractors bid proposals allows us to measure and quantify the effects of project cash flow on the project s financing cost and to explore opportunities for reducing these costs.

4 Page 4 of 5 Shifting the partial burden of financing a project from the contractors to the owners in a transparent way can significantly reduce those costs. Frontloading is a practice that savvy contractors have been taking advantage of in order to reduce their financing costs. This practice is not legitimate since the owners do not receive any consideration for shifting of the financing costs. Shifting the partial burden to the owner will result in cost saving on the project. Since the owner s cost of money (financing) is significantly lower than the contractors. The public owners generally allocate the project s construction budget in advance by fiscal year and deposit funds in short-term bank accounts for monthly payments. The deposited project funds earn minimum amounts of interest in the banks. On the other hand, contractors finance project construction by borrowing money from the banks. The contractors depend on their credit rating to pay higher amounts of interest on the amount they borrow. The different between the rate that the banks pays for the short-term deposit versus the rate that they charge the contractor for borrowing is directly proportional to the cost saving of the project. If we approach the project s financing from a global prospective (considering the owner, the contractor and the project as one whole entity) it become obvious that controlled accelerated payment to the contractor will result in significant cost saving to the project. In frontloading practices, the contractor benefits solely at the expense of the owner. However awarding the project based on the Net Present Value (NPV) the cost saving becomes transparent to all bidders. Therefore, since using this method of calculation will reveal cost saving, adopting this approach as a standard in value engineering, the cost saving will reduce the overall project cost and will benefit the owner and the public at large. One can argue that the contract risk associated with default by the contractor and possible bankruptcy will be increased by adoption of accelerated method of payments. The author does not agree with this conclusion since we are dealing with high profile contractors and advance payment will not be a factor for default or bankruptcy. But there is possible increases to the project s bonding cost that will be insignificant to overall cost savings.

5 Page 5 of 5 The long-term benefit that can result from adopting the method of he awarding the project based on the Net Present Value (NPV) and shifting of the partial burden of financing from the contractor to the owners is increased competition. The increased competition will be achieved by reduction of the working capital necessary for successfully completing each project. Therefore the contractor with the existing level of working capital can compete and undertake more projects.