Lending to builders (16 marks)

The Bank of Australia (BA hereafter) construction division specializes in lending to construction companies. You are working for BA as a responsible lending officer. One of your clients, King of Builders Ltd (KB hereafter), has been banking with BA for over ten years. KB has been recently awarded a contract to build an office building for MM University. Construction of this type of property has been KBs primary business since it was founded over 30 years ago.

KB has ten months to complete the building. The total contract price is $150 million. It is estimated that KB will make a profit of 20% of the contract value. Labour costs and material costs are expected to be 60% and 40% of the construction costs, respectively. As this is a relatively straightforward project for KB, it is safe to assume that construction progress will be spread evenly over the life of the project.

Assume that monthly progress certificates will be issued at the end of the month and the corresponding payments received from MM University will occur a month after the issue of the progress certificate.

At the beginning of the project, the retention fund of KB should have 5% of the total contract value. Additionally, KB has to set up a retention fund which will require retentions at the rate of 10% of the monthly payments. As a well-established construction company, KB expects no difficulties in obtaining two-month credit terms from the suppliers of the necessary construction materials.

(a) Calculate the minimum overdraft level that will be needed to fund this project. (12 marks)

Answer:

(b) Now BA requires that you, as a lending officer, have to add a safety factor of 20% to this minimum level of overdraft (computed in part (a)). This is because some long-range weather forecasters are expecting increased rain over the upcoming year, which will delay construction and thus payments. Do not add the additional 20% funds requirement to the retention fund. BAs policy requires that KB should provide at least 40% of the total cash requirements (as its own equity) for projects like this. Whats the maximum loan amount that you will grant to KB, allowing this safety factor? (4 marks)

Answer: