FINANCIAL ASPECTS OF PROJECT ENGINEERING AND

CONTRACTING
PROJECT APPRAISAL FOR BIOPROCESS

REVISION

Richard Hill

Whitewater Limited
Consulting Engineers & Scientists
 2008 Question 1
 Q.1 On 1st February 2006 a contractor receives a
contract with a value of £48m which was priced with a
contribution of 30%. The estimated completion time is 24
months.
 Terms of payment are:
 10% with order
 20% on completion of drawings
 50% in monthly payments against certified work completed on site
 10% on take-over of the works by Client
 10% retention for twelve months after completion of construction
 Payment is due 30 days from the date of invoice.

Whitewater Limited
Consulting Engineers & Scientists
 2008 Question 1
 During the financial year (January to December) the Contractor:
 completed all the drawings by April 31st 2006 and invoiced the Client
 started work on site on April 1st 2006 and completed 75% of the site work
 received invoices for materials to the value of £12m for which payment is
due on 31 January
 hired a tower crane, site cabins and JCB for the contract at an average of
£15,000 per month starting at 1st April
 submitted a claim on 31st December to the Client for extras valued at
£500,000
 What are the values of the above items and of the remaining contract
value and how will they appear in
 The Balance Sheet [10 marks]
 the Profit & Loss Account [10 marks]

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 2008 Question 1
VALUE P&L BS
1st stage payment received 10% £4.8m Turnover Does not appear
2nd stage payment received 20% £9.6m Turnover Does not appear

Payment against work completed is total 50%, that is £24m

Work completed is 75% of this £24m = 18m (37.5%) This is in 9 months (April – Dec) so £2m per
month.
8 months’ work (£16m) will be invoiced and paid but the December invoice (£2m) will not yet have
been paid hence:
3rd stage payment received 33% £16.0m Turnover Does not appear

3rd stage payment invoice 4.2% £2.0m Turnover Current Assets (Debtors)
Materials invoice £12m Cost of Sales Current liabilities (Creditors)
Site equipment 8 months at £120k Cost of Sales Does not appear
£15,000
Site equipment 1 month (Dec) £15k Cost of Sales Current liabilities (Creditors)

Claim Does not appear Does not appear

Balance of contract value 33% £15.6m Does not appear Current Assets (WIP)

Whitewater Limited
Consulting Engineers & Scientists
 2008 Question 5
 Very briefly define
 Turnover
 Contribution
 Overheads
 Profit [4 marks]
 These four items make up the outline of a year’s business plan.
 Assuming that all sales yield the same percentage contribution, draw
a graph showing the relationship of the last three of these items
against turnover. On it, show a year’s planned work and profit, and
the “breakeven” point, with some typical numbers [6 marks]
 With reference to the graph, very briefly describe Over-trading and
its consequences [6 marks]
 Briefly describe Marginal Selling, its uses and limitations [4 marks]

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Consulting Engineers & Scientists
 2008 Question 5 a
 Turnover is the total sales for the year (total invoiced)
 Contribution of a contract is the contract price minus the direct costs
 Overheads are costs which cannot be attributed to individual contracts
 Profit is Turnover - (Direct Costs + Overheads), or Contribution –
Overheads

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Consulting Engineers & Scientists
 2008 Question 5b
3.5

3 PLANNED C
PROFIT
Contribution £m

OVERHEADS B
2.5

2 A

1.5

0.5

0
0 2 4 6 8 10 12
Turnover £m

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Consulting Engineers & Scientists
 2008 Question 5c
 Overtrading is the result of committing the company to producing more than it is
capable of performing, and in particular more than the company’s working
capital can support. (Show on graph)
 The temptation to overtrade lies in the fact that the graph seems to show that
exceeding the planned turnover results in sharply increased profitability. In fact
it will probably not do so. The graph is based on the assumption that the
overheads are fixed (I.e. independent of the turnover) This is only true for small
changes in turnover. Exceeding the planned turnover will result in increased
overheads which will eat up some or all of the increased profit which the graph
appears to promise.
 Since the company’s plan should have committed the company to produce as
much as its limitations allow, overtrading means overstepping one or more of
these limitations. The problems which arise depend on which of the company‘s
limitations is being exceeded:
 *Exceeding the company’s capacity for work, or its technical capability, will lead
to delay and expensive mistakes.
 * If the company’s working capital cannot sustain the increased demand, the
company may become insolvent. This can happen even while the company is
apparently trading profitably.
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 2008 Question 5d
 Marginal Selling is useful only when a company has unused capability.
When that is the case, the company can lower its contribution below the
planned level, in the hope that the reduced selling price will bring in extra
work to take up the slack. Any sales made in this way will not bring in the
planned contribution, but they will bring in some, which is better than none.
 Marginal selling can apply to the whole company if it does not achieve its
planned output, or to parts of the company which happen to be under-
employed.

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Consulting Engineers & Scientists
 2009 Question 1
 Define and briefly explain the following:
 a) Profit Margin [1 mark]
 b) Return on Shareholders’ Capital [1 mark]
 c) Current ratio [1 mark]
 d) Liquid ratio [1 mark]
 The 2008 published Profit and Loss Account and Balance
Sheet for Wessex Water plc, whose principal business is
drinking water supply, are set out below. For each year
calculate the values for each of the above parameters and
comment on how and why they differ from typical values for the
contracting industry. [16 marks]
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 2009 Question 1
PROFIT AND LOSS ACCOUNT 31 MARCH 2008

2008 2007
£m £m

Turnover 394.4 366.8

Operating costs (200.5) (199.7)
Operating profit 193 .9 167. 1
Interest (payable) (88.9) (72.0)
Interest receivable 18.4 7.4
Other finance income / (costs) 1.1 (0.4)
Profit on ordinary activities before taxation 124.5 102.1
Taxation on profit on ordinary activities (29.0) (12.2)
Profit attributable to shareholders 95.5 89.9

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 2009 Question 1
BALANCE SHEET 31 MARCH 2008

2008 2007
£m £m
Fixed assets
Tangible assets 1,891.2 1,750.5
Investments - -
1,891.2 1,750.5
Current assets
Stock and work in progress 4.3 4.3
Debtors 116.9 104.5
Cash at bank and in hand 290.0 255.0
411 .2 363.8

Creditors – amounts falling due within one year (468.4) (127.0)

Net current (liabilities) / assets (57.2) 236.8

Total assets less current liabilities 1,834.0 1,987.3

Creditors – amounts falling due after more than one (1,380.7) (1,548.2)
year
Provisions for liabilities and charges (86.4) (88.1)
Net assets 366.9 351.0

Capital and reserves

Called up equity share capital 81.3 81.3
Profit and loss account 285.6 269.7 Whitewater Limited
Equity shareholders’ funds 366.9 351.0 Consulting Engineers & Scientists
 2009 Question 1a

a) Profit Margin (Operating Profit + Interest Receivable)/(Turnover) [1 mark]

2008 2007
Operating profit from P&L a 193.9 167.1
Net Interest received from P&L b -70.5 -64.6
Turnover from P&L c 394.4 366.8
Profit margin = 100 x (a + b)/c 31.3% 27.9%

These profit margins are typical for a capital-intensive business like water supply and are very high by
comparison with the contracting industry. [4 marks]

b) Return on Shareholders’ funds (Operating Profit + Interest Receivable)/(Capital & Reserves)

[1 mark]

Capital and Reserves from Balance Sheet d 366.9 351.0

Return = 100 x (a + b)/d 33.6% 29.2%

Shareholders’ Capital is the capital and reserves (the shareholders’ assets). This is higher than
Whitewater Limited would
normally be found in a capital intensive business and similar to what would beEngineers
Consulting expected in the
& Scientists

contracting industry where (a) the fixed assets are lower and (b) the risk is much higher. [4 marks]
Operating profit from P&L a 193.9 167.1
Net Interest received from P&L b -70.5 -64.6
Turnover from P&L c 394.4 366.8
Profit margin = 100 x (a + b)/c 2009 Question 1b 31.3% 27.9%

These profit margins are typical for a capital-intensive business like water supply and are very high by
comparison with the contracting industry. [4 marks]

b) Return on Shareholders’ funds (Operating Profit + Interest Receivable)/(Capital & Reserves)

[1 mark]

Capital and Reserves from Balance Sheet d 366.9 351.0

Return = 100 x (a + b)/d 33.6% 29.2%

Shareholders’ Capital is the capital and reserves (the shareholders’ assets). This is higher than would
normally be found in a capital intensive business and similar to what would be expected in the
contracting industry where (a) the fixed assets are lower and (b) the risk is much higher. [4 marks]

c) Current Ratio (Current Assets)/(Current Liabilities) [1 mark]

Current assets from Balance Sheet e 411.2 363.8

Current liabilities from Balance Sheet f 468.4 127.0
Current ratio = e/f 0.88 2.86

The Current Ratio is an indicator of the company’s financial health since a Current Ratio greater
Whitewater than 1
Limited
means the company is solvent and a Current Ratio of around 1.5 indicates sufficient working
Consulting capital.
Engineers & ScientistsIf

the Current Ratio exceeds about 2 it is indicative that there is too much working capital and that loans
 [1 mark]

Capital and Reserves from Balance Sheet d 366.9 351.0

Return = 100 x (a + b)/d 2009 Question 1c 33.6% 29.2%

Shareholders’ Capital is the capital and reserves (the shareholders’ assets). This is higher than would
normally be found in a capital intensive business and similar to what would be expected in the
contracting industry where (a) the fixed assets are lower and (b) the risk is much higher. [4 marks]

c) Current Ratio (Current Assets)/(Current Liabilities) [1 mark]

Current assets from Balance Sheet e 411.2 363.8

Current liabilities from Balance Sheet f 468.4 127.0
Current ratio = e/f 0.88 2.86

The Current Ratio is an indicator of the company’s financial health since a Current Ratio greater than 1
means the company is solvent and a Current Ratio of around 1.5 indicates sufficient working capital. If
the Current Ratio exceeds about 2 it is indicative that there is too much working capital and that loans
should be reduced. The Wessex Current Ratios indicate a company with low liquidity (although its high
fixed assets means that it is far from insolvent). [4 marks]

d) Liquid Ratio (Current Assets – Stocks)/(Current Liabilities) [1 mark]

Stocks from Balance Sheet g 4.3 4.3

Liquid ratio = (e-g)/f 0.87 2.8 Limited
Whitewater
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The Liquid Ratio – also called the acid test – is the ratio of the liquid assets to current liabilities. The
The Current Ratio is an indicator of the company’s financial health since a Current Ratio greater than 1
means the company is solvent and a Current Ratio of around 1.5 indicates sufficient working capital. If
the Current Ratio exceeds about 2 it is indicative that there is too much working capital and that loans
2009 Question 1d
should be reduced. The Wessex Current Ratios indicate a company with low liquidity (although its high
fixed assets means that it is far from insolvent). [4 marks]

d) Liquid Ratio (Current Assets – Stocks)/(Current Liabilities) [1 mark]

Stocks from Balance Sheet g 4.3 4.3

Liquid ratio = (e-g)/f 0.87 2.8

The Liquid Ratio – also called the acid test – is the ratio of the liquid assets to current liabilities. The
liquid assets are those which can be drawn upon immediately without the need to sell stock – or, in the
case of a contractor, to complete current contracts. If the Liquid Ratio is less than 1, as is the case with
the Wessex 2008 accounts, the liquid assets are insufficient to meet current liabilities so the company
would be unable to meet its debts without realising some of its fixed assets. The change in liquidity
from 2007 to 2008 is the result of a large increase in creditors in 2008 probably due to capital
investment for which the contractor has not yet been paid. Typically a Liquid Ratio of around 0.75 is
regarded as adequate but utility companies, because of their unique position, can afford to have low
liquidity. [4 marks]

Whitewater Limited
Consulting Engineers & Scientists
 2009 Question 3
 In month 1 of the present financial year a
contractor was awarded a contract to design,
supply, deliver, install and commission a
pharmaceutical manufacturing facility valued at
£300m.
 Terms of payment are
 10% with order
 20% on approval of drawings
 50% on completion of installation
 10% on commissioning and
 10% retention for 12 months.

Whitewater Limited
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 2009 Question 3
 During the present financial year:
 (a) The contractor’s drawings were approved in Month 4.
 (b) The contractor completed installation and invoiced in
Month 11 with payment due 3 months later.
 (c) Commissioning is scheduled to be completed and
invoiced 3 months after completion of installation.
 (d) The contractor has received invoices from all the
materials suppliers and subcontractors totalling £225m for
which settlement is due in 30 days after the end of the
current financial year.
 (e) The contractor has submitted a claim to the Client for
extras valued at £15m.
 How will these items appear in:
 (i) The Balance Sheet [10 marks]
 (ii) The Profit & Loss Account [10 marks]
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 2009 Question 3

Item Value Balance Sheet Profit & Loss

10% with order £30m N/A Turnover 3 marks
20% on approval of drawings £60m N/A Turnover 3 marks
50% on installation £150m Current Assets – Turnover 3 marks
Trade debtors
10% on commissioning £30m Current Assets – N/A 3 marks
Work in progress
10% retention £30m Current Assets – N/A 3 marks
Work in progress
Invoice from suppliers £225m Current liabilities – Cost of sales 3 marks
Trade creditors
Claim weighted N/A N/A 2 marks

Whitewater Limited
Consulting Engineers & Scientists
 2009 Question 4
 Briefly define:
 (a) Turnover [1 mark]
 (b) Direct costs [1 mark]
 (c) Contribution [1 mark]
 (d) Profit [1 mark]
 (e) Breakeven [1 mark]

Whitewater Limited
Consulting Engineers & Scientists
 2009 Question 4
 You are the Chief Executive Officer of a contracting company in the chemical
process plant sector. In 2008 your turnover was £150m and the Profit and
Loss account showed:
£'000
Turnover 150,000
Cost of sales 105,000
Gross profit 45,000
Net operating costs 36,000
Operating profit 9,000
Retained profit brought forward 21,300
Retained profit carried forward 30,300

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 2009 Question 4
 As a result of the global economic situation, you
anticipate a downturn in the market for 2009 by
as much as 40%.
 (f) At the 2008 level of contribution and overhead
costs, what turnover would you need to achieve
breakeven in 2009? [4 marks]
 (g) If your turnover were to drop by 40% how would
this affect your projected profit for 2009 assuming
contribution and overheads remain at the 2008 values?
[4 marks]
 (h) What steps might you consider taking in order to
reduce the impact of the reduced turnover? [7 marks]
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 2009 Question 4
 (a) Turnover is the company’s output in the year,
measured by the total invoiced. [1 mark]
 (b) Direct Costs are costs directly attributable to identified
contracts. [1 mark]
 (c) Contribution is the value of a contract minus its direct
costs; it is the sum of money that a contract contributes to
the company’s overheads and profit or "Gross Profit".
[1 mark]
 (d) Profit is the sum left after all company’s costs in the
year have been deducted from all the earnings. [1 mark]
 (e) Breakeven is the turnover that just covers the
company’s direct costs and overheads leaving no net
profit. [1 mark]

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Consulting Engineers & Scientists
 2009 Question 4
2008 2009 2009 2009
actual Scenario 1 Scenario 2 Scenario 3
£'000 £'000 £'000 £'000
breakeven 40% downturn Reduced overheads

Turnover 150,000 120,000 90,000 90,000

Cost of sales 105,000 84,000 63,000 63,000
Cost of sales 70.0% 70.0% 70.0% 70.0%
Gross profit 45,000 36,000 27,000 27,000
Contribution 30.0% 30.0% 30.0% 30.0%
Net operating costs 36,000 36,000 36,000 27,000
Operating profit 9,000 0 -9,000 0
Operating profit 6.0% 0.0% -10.0% 0.0%
Retained profit brought forward 21,300 21,300 21,300 21,300
Retained profit carried forward 30,300 21,300 12,300 21,300

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 2009 Question 4
 (f) Breakeven turnover at 2008 contribution and
overheads £120m [4 marks]
 (g) A 40% reduction in turnover gives a 10% loss. [4
marks]
 (h) Reduce overheads to £27m to give breakeven – other
options such as marginal selling (but this may not be
possible if market is depressed), sell engineering services
(design only for future investment) or commissioning
services [7 marks]

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 2009 Question 6
 (a) What factors contribute to what might be considered
to be a reasonable level of interest on a bank loan? [5
marks]
 (b) The Bank of England holds regular meeting to set the
Base Rate. What circumstances might make the Bank of
England want to raise or lower it? [4 marks]
 (c) What is LIBOR, how is it set and how does it affect
interest rates on loans to companies? [5 marks]
 (d) How do banks actually set the interest rates which
they charge on loans to companies? [2 marks]
 (e) Why does a change in the Base Rate have an
immediate impact on some of those who have bank
loans? [4 marks].

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 2009 Question 6
 (a) The factors are:
 Base Rate [1 mark]
 Security/Risk [1 mark]
 Admin Costs [1 mark]
 Profit [1 mark]
 NOT inflation rate - that is included in the Base Rate [1 mark]
 (b) The Base Rate indirectly controls the amount of
money coming into the economy. High rates discourage
borrowing, and vice versa. If the economy is depressed
and needs boosting, the bank can do that by lowering the
base rate, and vice versa. If inflation is seen to be rising to
an undesirable level, the base rate will be raised in the
hope of slowing down or reversing the rise. [4 marks]
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 2009 Question 6
 (c) London Interbank Offered Rate [1 mark] which is the
rate for unsecured loans between banks [1 mark].
 It is set weekly by committee of British Bankers' Association
(BBA) [1 mark].
 It is now a better measure of the rate at which banks can
borrow money than the base rate so has a greater influence
on interest rates charged by banks [2 marks].
 (d) In practice banks charge as high a rate as they can,
limited mostly by competition from other banks and
lenders [2 marks]
 (e) Rates of interest on many loans are set at “Base
Rate+ x%”, and the interest payments on such loans
varies automatically with the Base Rate [4 marks]
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 2009 Question 8
 (a) The Present Value of a future sum of £S per
annum is given by:

 (1  (1  i)T 
P  S 
 i 
 Explain what the different terms in the formula
mean. [4 marks]

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 2009 Question 8
 (b) You have to install a pumping station to deliver 1200m3/h of
water for 70% of the year and 800m3/h for 30% of the year. You have
the options of installing three 600m3/h pumps each 25kW or four
400m3/h pumps each 15kW.
 In the first option, two pumps will run continuously and the flow will be
throttled to meet the 800m3/h duty with no reduction in power
consumption. In the second option three pumps will run to meet the
1200m3/h duty and two will run to meet the 800m3/h duty.
 The 25kW pumps cost £20,000 each and the 15kW pumps £18,000
each.
 Electricity costs 10p/kWh. Use an interest rate of 5%pa to calculate
the NPV of each option so as to identify the lowest cost over the
fifteen year life of the pumping station. [16 marks]

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 2009 Question 8
 (a) In the formula:
 PV = present value
 S = future value (value of the income or cost per
annum)
 i = the interest rate over each time interval used
to calculate the NPV.
 T = the number of years over which the sum
£Spa is paid

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 2009 Question 8
OPTION 1 OPTION 2 Marks
3
Pump delivery flow m /h 600 400
Head m 10 10
Power kW 25 15
Number installed 3 4
Capex per pump £ 20000 18000
Total capex £ 60000 72000 2
Power cost p/kWh 10 10
Flow m3/h 1200 1200
Pumps in service No 2 3
Power kW 50 45
Utilisation at this flow 70% 70%
Operation h/year 6132 6132
kWh/year 306600 275940
Opex £/year 30660 27594
3
Flow m /h 800 800
Pumps in service No 2 2
Power kW 50 30
Utilisation at this flow 30% 30%
Operation h/year 2628 2628
kWh/year 131400 78840
Opex £/year 13140 7884
Total opex £/year 43800 35478 6
Life years 15 15
Interest rate 5% 5%
PV of income (= -opex) £ -454629 -368250 6
NPV = Total Capex - PV income 514629 440250 2
Hence Option 2 is the lower cost over 15 years and is preferred.
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 2009 Question 8
 (b) NPV = PV of Future income – Investment
 NPV = PV of operating cost – capital cost
 NPV Option 1 = -£454629 – £90,000 = -£-544629
 NPV Option 2 = -£368250 – £144,000 = -£512250
 Hence Option 2 is preferred

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 2008 Question 2
 The UK Base rate is the interest rate which the
Bank of England charges on loans to other banks.
1. What percentage is the UK Base Rate today? [2 Marks]
2. How and why is it changed from time to time? [5 Marks]
3. Companies usually depend in part on bank loans. What
are the benefits and disadvantages of this? [6 Marks]
4. What is the connection between the Base Rate and the
interest charged by banks on loans to companies?
[3 Marks]
5. Why would a bank be likely to give a larger loan to a
manufacturing company than to a contracting company
with a similar turnover? [4 marks]

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 2008 Question 2
1. The current base rate is ….%. (2)
2. Its level is reviewed and possibly changed monthly (1) by a
committee (1) of the Bank of England (1). If the economy
needs stimulating, (1) the committee may decide to reduce
the bank rate. This makes it less expensive to borrow money
and so encourages spending and investment. Raising the
bank rate has the opposite effect (1).
3. A company borrows money in order to increase the capital
available to support its business. (1) If the additional
contribution which this brings in is greater than the interest
payable on the loan, the company’s profit and the return on
shareholders’ capital will increase, (2). Interest on a loan
must be paid whether the company is doing well with it or
not(1). Taking out too large a loan means the interest
payment can ruin a company. (2).

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 2008 Question 2
1. Interest on new loans is normally some percentage
points higher than the Base Rate (1) and some loans
pay interest at some fixed percentage above Base
Rate, so the it changes automatically whenever the
Base Rate changes (2)
2. The typical contractor has few or no fixed capital
assets.(2) If the company fails, therefore, there is
nothing left with which the bank can at least recover
some of its loan. (2) By contrast, typical manufacturers
have premises, machinery, work in progress and stock.

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