Development Finance - Falkirk Housing Project - Case Study Example

The Management of ABC Developers A. Consultant ABC’s Housing Project in Falkirk Report 0 Introduction The main objective of undertaking or investing in projects is to create value (Emery et al 2007). Housing projects are just one of the many projects that are undertaken for that reason and while there are many tools available to appraise an investment in order to determine its profitability and also its value creation potential, their suitability is dependent on the type of project. ABC Developers Falkirk Housing Project is of the speculative type and so some of the commonly used appraisal methods may not be applicable. Three of the most commonly used methods of project appraisal are the internal rate of return (IRR); net present value (NPV) approach; and payback period (Titman 2011). The housing market has benefited from booms; however, there are also instances of bust where the demand is little or non-existent as seen in the housing crisis which started in 2007and led to financial crisis and turmoil in Europe and North America (Taylor 2008). There were unrealistic expectations which helped to fuel the boom (Case and Shiller 2003). This shows how fickle the housing market is and indicates the level of risk that may exist in investing in housing projects. In fact, real estate projects can be affected by a wide range of events and this is no different for ABC Development’s small housing project in Falkirk. These events normally result in delays in project completion and have negative implications for cost. This means that what was anticipated to be a profitable project may turn out to be a loss making event. In order to safeguard against too many revisions to budgets, preparers need to take a more conservative approach. In fact, budgets that address different scenarios like – most pessimistic outcome; most favourable outcome, and most likely outcome should be prepared in order to determine whether the risk is worth taking. 2.0 Revision of Project Costs The feasibility study for the Falkirk Housing Project provided an estimated of the cost of land and construction at £1,100,000. This figure includes the cost of the land - £320,000; construction costs - £580,000; road and infrastructure construction - £120,000; and development expenditure of £80,000. Some of these costs have been impacted negatively by the delay in the granting of planning permission. Table 1 in the Appendix 1 provides a comparison of the planned land and construction cost and the related revised costs resulting from a delay of two weeks in planning and five weeks in construction. Table 1 show that the cost of land and construction will increase by £52,000 as a result of increases in development expenditure and specifically advertising costs - £3,000; road and infrastructure - £8,400; and construction cost - £40,600. In order to make revisions to project plan and the resulting changes in the cost of the project a revised summary schedule of the project programme is required. This revised summary is shown in Table 2 in Appendix 1. The information in Table 2 indicates that in addition to the two week delay in obtaining planning permission, a five week delay in construction is expected. This is expected to impact the completion of the project as other aspects of the project will be delayed. These delays are translated into a five week delay in the sale of the units as well as in the completion of sale. 3.0 Comparison of Feasibility Study and Project Out-Turn A comparison of various components of the feasibility study with the project out-turn – namely the schedule of cash flows and the developers budget has shed some light on the funding requirements of the project. It has also provided information on how delays can be costly. This is how important the time value of money concept is as this case shows how inflation and risk has a great impact on project costs. The revised cash flow schedule and the updated Developer’s budget are discussed under their appropriate headings. 3.1 Revised Cash Flow Schedule A cash flow schedule/projection which is synonymous with a cash budget shows cash expected to come in and cash expected to go out of the business. It is a method of managing cash resources in order to facilitate the smooth running of the business. In fact, Navon (1996) points to the importance of adequate cash flow management to convince financiers to lend money for construction projects. Cash Flow projections are normally prepared for a project in order to determine the timing of receipts and payments. This helps the developer to determine the need for additional working capital; the availability of funds to undertake further projects; and facilitates pro-activity in making the necessary arrangements to maintain liquidity in the business. The revised cash flow projection is shown in Table 3 in Appendix 2. The information suggests that with a delay in planning permission of two weeks; a delay in construction of five weeks; an increase in advertising from £10,000 to £13,000; construction price increase of £49,000; and an interest rate increase of 0.3% per month on bank loans and 0.5% per month on bank overdraft were responsible for the changes. These increases have led to a less favourable position than previously anticipated for ABC Developments. Although the loan provider has no intention of increasing the amount of funds allocated to the project, the interest rate and therefore the interest expenses will also increase because of inflation and the increased level of risk involved. The contractor will not only have to pay more interest on the land and construction loan but also the overdraft facility. In fact, the loan provider has reduced the percentage of the loan for construction from 75% to 70% (Lowe n.d.)). This is an indication of the higher risk it anticipates on the project. In comparison with other industries the construction industry in the UK has always experienced a high level of insolvencies (Edum-Fotwe et al 1995). Chen et al (2010) attributes this to the improper use of cash resources. ABC Developers will have to finance a greater portion of the costs than previously anticipated through an overdraft facility. This implies even more interest expenses and therefore greater financial risk. Financial risk is the risk associated with debt financing (Holton 2004; Horcher 2005). It increases the financier’s exposure and leads to uncertainty. This exposure and uncertainty stems from the possibility that the management of ABC Developers may not be able to satisfy the firm’s debt obligations as they fall due. Gabriel and Baker (1980) indicate that the ability of a business to fulfil its obligations is dependent on the level of fixed obligations and the liquid resources it has at its disposal. The feasibility study indicates that the finance costs incurred on the loan for the land initially would be £12,000. However, the revised cash flow schedule in Table 3 in Appendix 2 provides an estimated sum of £23,328. This is almost twice as much as previously anticipated. In fact, it represents a 94.4% increase in interest expense specifically related to the purchase of the land. This is a significant increase and it shows how much delays in projects can lead to increases in project expenses and possibly losses. Construction finance also increased from £9,799 (as shown in the feasibility study) to £15,731 (as shown in the revised cash flow schedule in Table 3 of Appendix 2) – an increase of 60.5%. Not to be ignored is the Developer’s finance cost which relates to interest on the bank overdraft. This has increased from £14.092 to £20,522 – an increase of 45.6%. The difference in the percentage increases in the land loan and the construction loan finance costs can be attributed to the timing of the purchase of the land and the construction start date. Although the interest rate changes were the same – the date of the transaction in the case of the land purchase did not change while the construction start date was delayed by five (5) weeks. The rate on the bank overdraft facility was different – moving from 1% to 1.5% per month compared to an increase from 0.5% to 0.8% on the land and construction loans – a 50% increase versus a 60% increase, respectively. 3.2 Revised Developers Budget and the factors influencing change The revised developer’s budget is similar to an income statement. It takes the total income on the project and deducts from that the several classes of expenditures to arrive at the gross margin. The developers finance cost is then deducted to arrive at the net profit margin. The delays have led to a 6.1% increase in costs (before accounting for development finance) from £1,131,799 to £1,201,059. The estimates provided in the feasibility study indicate a net profit margin of 24% and a margin on developer’s outlay of 136%. However, the revised budget shows a profit margin of 19% and a margin on developer’s outlay of 125%. These changes can be attributed to the several delays in the project (delay in the grant of planning permission and delay in the start of construction); increases in the rate of interest on both bank loans and overdraft facility; and the need for increased financing which was provided through the overdraft facility. One writer indicates that a net profit of between 20% and 25% is reasonable. The revised net profit margin of 19% falls outside of this range. 3.3 Factors responsible for change in cash flow and budget The factors responsible for the change in the cash flow schedule and the developer’s budget were similar. However, while the cash flow projection was affected by timing, this was not so obvious for the developer’s budget, except for the fact that the timing of cash inflows and outflows both affects the requirement for working capital. The delay in construction and therefore the sale of the units were impacted by an increase in inflation which led to increases in interest rates and the need for the developer to source additional funds. The difference in construction costs as a result of inflation contributed significantly to the increase in total costs when compared to finance cost £52,000 versus £23,690. Potential Changes to Feasibility Studies and the Developers Budget In order to avoid giving a misleading view the management of ABC developers need to consider the following points: 1) Conservative estimates - The need to prepare more conservative estimates of income and expenditure. It was mentioned in the case that the price of units may have to be reduced. This means that the market is not as buoyant and it was previously and so the prices need to reflect this. They need to be related to the demand conditions that exist when they are being built. Things may change for better or worst and so there is no need to built houses if the demand does not exist. This is like tying up well need funds. 2) Assessing the demand for houses – An assessment needs to be done to determine whether there is a healthy demand for houses in the area where the construction is taking place. This assessment will be based on the economic conditions that exist before and during the construction and a research for the housing needs in that community. 3) Delay – Delays are very important aspects of any project whether in construction or otherwise. These need to be factored in so that the determination can be made of the profitability of the project. If a project is not profitable, it does not make any economic sense to undertake such a venture since there is an opportunity cost involved in choosing whether or not to invest in a project versus finding a more profitable alternative. 4) Determining profitability – There needs to be a set of guidelines to determine the profitability of projects. There needs to be some decision criteria that determine whether a project is accepted. Some of these include: return on capital employed (ROCE); net profit margin; interest cover; 5) Determine the level of risk involved – As mentioned before projects involve risks. It is therefore important that the level of gearing is considered. Loan providers are very cautious and so they lend to the extent that there a safe margin for error in case the project is not completed or sales are slow. Conclusion This case study provides information on the pitfalls that affect a number of construction projects. It is extremely important that standards are laid done to assess profitability. There is an opportunity cost involved as there are other investment options available. They may not be in the same area – the construction industry but they provide an opportunity to create value. There has to be some way of determining this and this is where investment appraisal comes to the fore front. These methods should be utilised where possible. References Case, K.E. and Shiller, R.J. (2003). Is There a Bubble in the Housing Market? Brookings Papers on Economic Activity, 2, p.299-342 Chen, C., Wang, M.H, Liu, K.F and Chen, T. (2010). Application of project cash management and control for infrastructure. Journal of Marine Science and Technology, 18(5), p. 644-651 Edum-Fotwe, F., Price, A and Thorpe, A. (1995). A review of financial ratio tools for predicting contractor insolvency. Construction Management and Economics: 1996 (14), p. 189 - 198 Emery, D.R., Finnerty, J.D. and Stowe, J.D. (2007). Corporate Financial Management. 3rd ed. USA: Prentice Hall Holton, G.A. (2004). Perspectives: Defining Risk. Financial Analyst Journal: 60(6), p. 19 - 25 Horcher, K.A. (2005). Essentials of Financial Risk Management. New Jersey: John Wiley & Sons Lowe, J. (n.d.). ABC Developers: a development finance exercise. Internal Paper Series, Teaching Paper Number 2, p. 1 -10 School of Engineering and the Built Environment, Glasgow Caledonian University, . Navon, R. (1996). Company-Level Cash-Flow Management. Journal of Construction Engineering and Management, 122(1), p. 22-29 Taylor, J. B. (2008). The Financial Crisis and the Policy Responses: An Empirical Analysis of What Went Wrong. [Online] Retrieved from http://www.nviegi.net/teaching/taylor1.pdf [Accessed 30 October 2012] Titman, S., Martin, J.D and Keown, A.J. (2011). Financial Management: Principles and Applications. Prentice Hall Appendix 1 ABC Developments - Falkirk Housing Project Construction Cost of Land and Construction - Comparison of Revised and Planned Costs   Revised Planned Difference   £ £     Cost of Land   320,000 320,000             Construction costs:         Substructure 9,630       Shell and roof 24,610       Internal fittings and fixtures 19,260       External fittings and fixtures 8,560         62,060 10 units 620,600 580,000 40,600 Road and infrastructure construction:         Road and pavement 80,250   75,000   Drainage 32,100   30,000   Landscaping 16,050   15,000       128,400 120,000 8,400 Development expenditure:         Architects fees 20,000   20,000   Advertising 13,000   10,000 3,000 Agents fees @ /£1,750 per unit 17,500   17,500   Legal fees 25,000   25,000   Local authority fees 7,500   7,500       83,000 80,000       1,152,000 1,100,000 52,000 Table 1 ABC Developments - Falkirk Housing Project Summary of Project Programme (Revised) Details 2013 2014 Jan Feb Mar Apr May Jun Jul Aug Sept Oct Nov Dec Jan Feb Land purchase 1-Jan                           Outline planning 1-Jan                           Detailed planning     15-Mar                       Construction starts       1-Apr 6-May                   Completions commence             1-Jul 5-Aug             Completions end                     1-Nov 5-Dec     Sales commence               1-Aug 5-Sep           Sales complete                       31-Dec   4-Feb Land loan facility starts                             Land loan repaid                       31-Dec   4-Feb Construction loan starts       1-Apr 6-May                   Construction loan repaid                       31-Dec   4-Feb NB: Revisions are shown in blue and the plan affected in red Table 2 Appendix 2 ABC Developments - Falkirk Housing Project Cash Flow Schedule (Revised)     January February March April May June July August September October November December January February   Cash flow   2013 2013 2013 2013 2013 2013 2013 2013 2013 2013 2013 2013 2014 2014 Total                   Land facility                 Land purchase b/f 240,000 240,000 240,000 240,000 240,000 240,000 240,000 240,000 240,000 240,000 192,000 144,000 96,000 48,000 240,000                   Interest 75%   3,600   3,600   3,600     2,880 1,440 15,120                   Repayments         0 0 48,000 48,000 48,000 48,000 48,000 240,000                   Total land c/f 240,000 240,000 240,000 240,000 240,000 240,000 240,000 240,000 240,000 192,000 144,000 96,000 48,000 0 0                   Construction facility                 Plot 1     10,000 18,000 18,000 16,060     62,060 Plot 2     10,000 18,000 18,000 16,060     62,060 Plot 3       16,000 20,000 13,000 13,060   62,060 Plot 4       16,000 20,000 13,000 13,060   62,060 Plot 5       16,000 18,000 16,000 12,060   62,060 Plot 6       16,000 18,000 16,000 12,060   62,060 Plot 7         15,000 18,000 15,000 14,060 62,060 Plot 8         15,000 18,000 15,000 14,060 62,060 Plot 9         19,000 22,000 21,060 62,060 Plot 10         19,000 22,000 21,060 62,060 Roads etc           80,250       48,150 128,400 Total construction             100,250 68,000 108,000 124,120 132,120 98,120 70,240 48,150   749,000                     Total advance 70%       70,175 47,600 75,600 86,884 92,484 68,684 49,168 33,705   524,300                       Revolving advances b/f         70,175 117,775 193,375 280,259 267,883 231,707 176,015 104,860                         Cumulative advance         70,175 117,775 193,375 280,259 372,743 336,567 280,875 209,720 104,860                         Interest payment           1,907   4,948   2,977 9,832                       Repayments             104,860 104,860 104,860 104,860 104,860 524,300                           Revolving advances c/f           70,175 117,775 193,375 280,259 267,883 231,707 176,015 104,860 0   Table No 1: Schedule of payments and repayments on loan facilities Developers cash flow                                   b/f 137,500 139,975 146,095 148,724 151,401 194,708 223,613 72,398 123,985 23,213 -137,574 223,613                   Land                 Balance 25% 80,000             80,000                   Construction                 Balance 30%   30,075 20,400 32,400 37,236 39,636 29,436 21,072 14,445   224,700                   Finance                 Commitment fee   5,000             5,000 Disposal fee         1,000 1,000 1,000 1,000 1,000 5,000 Land finance     3,600   3,600   3,600   2,880 1,440 15,120 Construction finance       1,907   4,948   2,977 9,832                   Contractors own finance   2,475 2,520 2,630 2,677 2,725 3,505 4,025 1,303 2,232 418       24,509                   Development expenditure                 Architects fees   20,000             20,000 Agents fees         3,500 3,500 3,500 3,500 3,500 17,500 Advertising       5,000 5,000 3,000     13,000 Legal fees   25,000             25,000 Local authority fees   7,500             7,500                   Income         195,140 195,140 147,140 147,140 195,140 879,700                       Cumulative deficit/earnings c/f 137,500 139,975 146,095 148,724 151,401 194,708 223,613 72,398 123,985 23,213 -137,574 -253,284 -132,695 -193,700 432,539 Finance institutions cash flow                                               Net cash flow -235,000 0 3,600 0 -47,600 -64,668 -47,600 30,260 27,524 61,376 85,176 110,549 23,155 157,277 -76,383                 Cumulative cash flow -235,000 -235,000 -231,400 -231,400 -279,000 -343,668 -391,268 -361,008 -333,485 -272,109 -186,933 -76,383 -53,228 104,049 104,049                                   Table No 2: Cash flow schedule for developer and financier Table 3 ABC Developments - Falkirk Housing Project Developer’s Budget (Revised) Income               Detached Villas 10 units @ £150,000 £1,500,000     Land purchase   Purchase price £320,000 £320,000       Construction costs   Villas 10 units @ £62,060 £620,600   Roads and infrastructure £128,400 £749,000       Development expenditure   Architects fees £20,000   Agents fees 10 units @ £1,750 £17,500   Advertizing £13,000   Legal fees 10 units @ £2,500 £25,000   Local Authority fees £7,500 £83,000       Finance costs   Commitment fee £5,000   Redemption fee 10 units @ £500 £5,000   Land finance From cash flow £23,328   Construction finance From cash flow £15,731 £49,059 £1,201,059       Gross margin £298,941     Developers finance From cash flow £20,522 £20,522   Net margin £278,419     Margin on turnover 19%       Margin on developers outlay 125%   Table 4 – Developers Budget Read More