Capitalized Interest for Water Plant

[jartgo]

OK, so this really isn't specific to water plants, but I didn't know where else to put it. Been doing this calculation and now second guessing the correct way.

When you're building a water plant, let's say it takes 3 years to build it, so you want to borrow enough to cover the total project costs, and three years of capitalized interest. I think my mind is playing tricks on me, as I can't get my head around how that should be figured, and I've been doing it with a spreadsheet for a few years.

My current thought is that I should just figure the project amount, incurring interest for three years, and making no payments during that three years which would be:

I = (P(1+i)^N)-P

Where i is the interest rate, N is three (representing three years), P is the project cost, and I is capitalized interest.

You would then add this capitalized interest to the construction cost, then the loan would actually be amortized over 37 years (after construction is completed).

You've essentially borrowed the construction costs and three years of interest from the lender, then paid it back in 37 years, I think this is correct...any takers?

 

[semo]

With your calculation, you are compounding the interest and would end up with extra money. No big deal. Better safe than sorry.

Because you pay the interest each year (why you capitalize it), you won't compound the interest like your calculation does.

You only need to borrow an extra:

I = N * P * i

At the end of each of the first 3 years you will pay the interest and end up with the same principal you started with at the beginning of year 1.

 

[jartgo]

good point. thanks!

 

[bimr]

0 = PV + (1+ip) pmt [1-(1 + i)^-N)/i] + FV (1+i)^-N

The construction time for a water treatment plant is more likely 12-14 months.

It is reasonable to figure the payments to the Contractor would start in the 4th month of construction. The disbursements to the Contractor would then cover 90% of the toal project cost for the next 6 months or about 15% per month. The final month (12th month would be the balance (about 10%)

The cost of engineering would be paid in advance, so that cost (say 10%) would be financed for maybe 1-2 years.

The first loan repayment occurs at the end of the first year that you borrowed the money.

 

[jartgo]

Thanks bimr, my original interest wasn't this in depth (I was actually trying to explain it to someone else in general terms for their project and got tripped up and started to question myself). But just for curiosity's sake, if you were borrowing the entire amount for the example you gave, would you take the entire loan at the start of the project or do people commonly take it as a "line of credit" so that they aren't paying interest on money they aren't yet spending?

 

[bimr]

If you borrow money from the State, it is basically a line of credit. If you change the scope of the project, you do not have to disburse the entire amount, only what you use.

 

[jartgo]

So, when you're doing an initial project budget (again using your example) do you break out the timelines for drawing down the money, so that the interest cost isn't unnecessarily inflated in the budget?

 

[cvg]

Funds are taken from the loan through a process referred to as a "draw". A draw is the method by which funds are taken from the construction budget to pay material suppliers and contractors. Each lender has different requirements for processing a draw. For example, some allow the borrower to request draws online, while others require paperwork and periodic inspections. This process helps ensure that the loan proceeds are actually used for the construction and that the construction process is moving smoothly. The borrower is only charged interest on the amount borrowed at any one point.

Instead of paying each month during construction, almost all construction loans in the United States have extra funds borrowed right away and stored in a locked account known as an "interest reserve". Each month the monthly payments are taken from the account so that the borrower does not have to start paying out of pocket until the project is completed.

http://en.wikipedia.org/wiki/Construction_loan

 

[bimr]

It depends on where you get the loan.

If you are getting money from the State revolving loan program:

The loan is given out basically as a line of credit.

If you have a construction loan as CVG is referring to:

It is basically a line of credit as well, except you only pay the interest (not the capital) during the construction phase until the project is finished. At the project completion, you roll the construction loan over into a new loan.

If you get a loan from the state revolving loan program, then your interest costs are covered because you raise the user rates before the project begins.

To answer your question about the budget, it will depend on how sophisticated your client is and what the interest rate you have, and also the value of the project.

Right now, the stimulus program is giving out 0% loans. Last year, the State revolving loan program was giving out 4% loans. So that loan rate will not be much of a factor in the budget.

On the other hand, I read recently that Harley Davidson borrowed $300 M from Warren Buffet at 15%. That is a big hit to the budget.

I recall a real estate professor stating that the interest costs during construction will eventually kill the mega skyscraper projects. You would have to start moving clients into the building on the first floor before the top of the building is completed.

 

[semo]

As Bimr mentioned, it all depends on where you borrow the money.

I don't know if this project is private or municipal. If private, you typically pay as you borrow.

If municipal and bonds are sold, many times the bonds are sold up front so you start your payments for the full amount right off the bat. Some institutions have interim financing however, that lets you pay as you borrow and then after the project is complete, the bonds are sold.

Best solution is to check with your lender.

 

[jartgo]

great discussion, thanks again.