Risk Assessment in Fixed Guideway Transit System Construction, Jan 1994

Click HERE for graphic.

Risk Assessment in Fixed

Guideway Transit System

Construction

Final Report

January 1994

Prepared by

Ali Touran, Paul J. Bolster,

and Scott W. Thayer

Northeastern University

Boston, MA 02115

Prepared for

University Research and Training Program

Federal Transit Administration

U.S. Department of Transportation

Washington, D.C. 20590

Distributed in Cooperation with

Technology Sharing Program

U.S. Department of Transportation

Washington, D.C. 20590

DOT-T-95-01

 TABLE OF CONTENTS
 Page

Chapter 1 - Overview 1

Chapter 2 - Risk identification 7

Chapter 3 - Understanding financial risk from the owner's

 perspective 15

Chapter 4 - Surety's risk assessment 37

Chapter 5 - Risk modeling and assessment 53

Chapter 6 - Risk allocation and mitigation 87

Appendix A - List of References A1

Appendix B - Supplementary comments on the risk checklist B1

Appendix C - List of contributing individuals C1

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 CHAPTER 1 - OVERVIEW

OBJECTIVE

 The importance and urgency of risk analysis in today's complex

projects, in face of financial constraints, has spurred several

research efforts in this area. Cost overruns are commonplace in

the design and construction of complex capital projects such as

fixed guideway transit systems. One major reason for cost overruns

is the uncertainty inherent in various aspects of the work. This

uncertainty can result in a wide range of outcomes that in turn may

impact project cost and schedule in unfavorable ways. Risk

assessment is difficult in large capital transit projects. Yet, it

is imperative that the owners or sponsors engage in a rigorous,

systematic analysis of major sources of risk.

 The objective of this report is to help the owner or sponsor

in developing a framework for managing risk in the design and

construction of fixed guideway transit projects. Risk, as used in

the context of this report, is defined primarily as the potential

for monetary loss resulting from uncertainty about the project. In

order to develop the risk management framework, first the sources

of risk must be identified and categorized. Then a measurement

system should be used to quantify the risk. Finally, each risk
item should be allocated between the parties involved in an

equitable manner. If the project risks can be identified in a

timely manner, quantified in a logical way, and allocated properly

between the project participants (sponsor, owner, contractor, and

engineer), then the likelihood of significant cost and schedule

overruns will be reduced considerably.

INTRODUCTION

 Large construction projects are generally prone to budget and

schedule overruns. This may stem from the fact that construction

projects are unlike the products of most manufacturing and

industrial projects. Peculiarities of construction such as the

uniqueness of every project, exposure to external elements,

characteristics of the workforce and the industry have been

documented in various sources (Gilly, et al, 1987). According to

Thompson and Perry (1992), 63% out of 1,778 projects financed by

the World Bank in the period 1974-1988 experienced cost overruns. 

In the United States, cost overruns in large complex projects such

as powerplants have been common. Cost estimates for the Boston's

Central Artery/Third Harbor Tunnel Project, currently the largest

public works project in the United States, have been continuously

adjusted upwards in the past six years. Major capital transit

projects are not an exception in this regard. Pickrel (1990)

studied

 1

10 large U.S. transit projects and found out that nine out of ten

of these projects suffered from budget overruns. The amount of

overruns ranged from 13% to 106%.

 Many parameters may be responsible for budget overruns in

transit projects. Scope changes or optimistic scenarios yielding

low estimates of costs and high estimates of benefits, incomplete

information about the project objectives and features, estimation

error, and delay in construction start date are some of the more

important parameters contributing to the budget overruns. Some of

these factors are of a technical nature and depend on the project

complexity, location and size; others are financial issues and are

affected by the state of economy, affordability, cost of funds, and

the owner's creditworthiness. Still, other factors depend on the

political atmosphere surrounding the decision-makers and the

general public. Although these social and political factors are of

utmost importance, they are not the primary subject of this report. 

We shall rather focus on design, construction and financial risks

affecting the project budget and schedule.

 Based on our research and discussions with FTA experts, we

have divided project uncertainties into two main categories:

design/construction risks and financial risks. Design/construction
risks pertain to the process of construction and technical factors

that affect the construction cost and schedule. Examples include

unusual inclement weather, unfavorable underground conditions

especially in projects where tunneling comprises a major portion of

the work, and possibility of contractor's inability to meet project

deadlines and/or quality standards. Financial risks relate to all

aspects of project financing and budgeting and may include

unfavorable changes in interest rate, shortfall in the estimated

revenues, and uncertainty in construction budget cash flows.

 In addition to evaluating these risks, one has to consider the

interaction between financial and construction risks. For example,

a shortfall in revenues dedicated to the project may delay

construction. Conversely, a delay because of construction

difficulties may increase financial burden on project sponsors.

STEPS IN PROJECT RISK MANAGEMENT1

 The risk management program has three phases as depicted in

Figure 1. 1. The first step in a risk management program is to

identify risk prone areas in a project. After the risk

identification process, a methodology for measuring design,

construction and financial risks should be devised. The

methodology, though based on sound theoretical principles, must be

practicable and convenient to apply to real life problems. After

risks are appropriately identified and measured, they should be

allocated to various parties involved in the project in a fair and

equitable way. This should be done in a way that ensures the

prudent expenditure of public funds

-------------------------

 1Traditionally, the term "Risk Management" is used in

conjunction with an insurance program. Here, "Risk Management"

consists of dealing with all types of construction and financial

risks.

 2

and at the same time provides reasonable compensation to the

providers of construction and financial services.

 The importance and urgency of risk analysis in today's complex

projects, in face of financial constraints, have spurred several

research efforts in this area resulting in many publications. In

preparing this report, we have reviewed, discussed, and elaborated

on many of these
Click HERE for graphic.

publications. Depending on who is doing the risk analysis, the

process may vary. The contractor's interest and emphasis will be

somewhat different from the owner's. In this report, most of the

discussion proceeds under the assumption that the end user of the

report will be either the sponsor of a transit capital project

(such as FTA) or the local owner (transit agency). Furthermore,

most of the examples and cases cited are relevant to transit

projects or those with components similar to major transit

projects. We believe that the document in its present form

contains a wealth of information about the state-of-the-art in the

practice of risk analysis and mitigation.

ORGANIZATION OF REPORT

 We address each of the steps of risk management mentioned

earlier, in an independent chapter. Chapter 2 covers risk

identification. Chapter 3 discusses different types of financial

risks affecting the project. Although elements of financial risk

are identified in Chapter 2, we include this chapter to further

highlight and elaborate on various aspects of financial risks. 

This chapter could be very useful to construction experts. While

these experts are proficient in technical aspects of the project,

they may lack the detailed knowledge about financial issues.

 Chapter 4 describes the process of risk assessment by the

surety industry. The surety, in effect, indemnifies the owner in

case of contractor default. Because of the nature of its

responsibility, surety has to perform a thorough risk evaluation

before bonding a contractor. We included this chapter because we

feel that it is useful to consider the surety's unique perspective

on risk Clearly, virtually all risk analysis carried out by the

surety is relevant to this research. Furthermore, FTA experts felt

that the agency would benefit from a better understanding of the

surety's function and procedures.

 3

 Chapter 5 addresses risk modeling and measurement and Chapter

6 covers risk allocation and mitigation. An extensive reference

list is included as Appendix A. This will help the reader to locate

sources of information in related areas. Appendix B contains a

detailed set of comments about the risk checklist presented in

Chapter 2. Appendix C provides a list of names of the individuals

who contributed to this research. The following is a brief summary

of each chapter's contents.
Chapter 2 - Risk Identification

 This chapter describes various types of risk (especially the

ones related to construction and design) that may impact a capital

transit project. Several methods of risk classification are

described and a suitable classification method is recommended. A

detailed risk checklist is developed. This list breaks down

construction and financial risks into fifteen broad categories. 

Each category is subdivided into important risk items. Important

items in the risk checklist are described and highlighted in the

commentary section provided in Appendix B. Development of the risk

checklist helps the project owner to focus on risk elements and

develop an appreciation for what may go wrong during the course of

project implementation.

Chapter 3 - Understanding Financial Risk from Owner's Perspective

 Broad sources of financial risk such as the cost of capital

and inflation are described and then financial risks that directly

affect the owner (or sponsor) of transit projects are analyzed. 

Issues such as sources of revenue, bonds, bond rating, exchange

rate risk, and project-specific parameters are discussed. 

Operating risk factors are covered also because they may impact the

project feasibility at the conceptual level. In addition, the

contractor's exposure to financial risk is discussed.

Chapter 4 - Surety's Risk Assessment

 This chapter provides an overview of the surety industry and

the procedures used by the surety for evaluating contractor's risk. 

The surety is exposed to huge losses in case of contractor's

failure. Because of this, the surety has to perform a careful

analysis before deciding to bond a contractor for a particular

project. Therefore, studying the surety's methods of risk

evaluation can be useful to the owner in contractor

prequalification and also result in a better understanding of the

parameters contributing to a project's risks.

Chapter 5 - Risk Modeling and Assessment

 This chapter builds upon the material covered thus far and

explains owner's and contractor's risks and levels of contingency. 

Deterministic and probabilistic approaches in estimating the

 4
potential for cost and schedule overruns are covered, with more

emphasis placed on probabilistic approaches. Both analytical

methods and simulation approaches are introduced and explained. 

Several elaborate examples and case studies are used to illustrate

the process of quantifying the level of uncertainty in budget and

schedule and to calculate contingency. Furthermore, conceptual and

computer software tools available for risk measurement are

described and their strengths and weaknesses elaborated. Areas of

research and development in this field are identified. A realistic

risk picture for a transit project is only possible by evaluating

the impact of financial and construction risks and considering the

interaction between these risks.

Chapter 6 - Risk Allocation and Mitigation

 This chapter reviews various methods proposed for risk

allocation and mitigation. Based on the work done by others and

research conducted by the authors, a method for classifying risk

mitigation measures is proposed. A well thought out and fair

contract is an excellent vehicle for allocating risk to various

parties. Ideally, there should be a set of circumstances where the

owner and the contractor assume their fair share of responsibility

and the owner does not have to pay for some contingency that will

never be utilized. To foster this process, a set of guidelines

should be prepared to help the owner in developing an effective

contract. A detailed table is developed that incorporates the

experiences gained in the past two decades in risk allocation in

construction contracts. This Table is based on the risk items in

the Risk Checklist presented in Chapter 2. The material in the

Table is cross-referenced to various publications and augmented by

explanatory remarks and comments. We believe that this Table is a

convenient tool for checking the contract's effectiveness. 

Further, it brings together various aspects of this project by

providing recommended solutions to most of the risk items

identified in Chapter 2 and measured in Chapter 5.

ACKNOWLEDGMENT

 Several people from engineering firms, construction companies,

insurance companies, Federal and State agencies have contributed to

this effort by providing information and reviewing earlier drafts

of portions of this report. We have included a list of the names

of these individuals in Appendix C. The authors would like to

express their appreciation to those who helped, and apologize to

anyone inadvertently not included in the list.

 The authors accept full responsibility for any errors and

would appreciate it if readers comment on those.
 Ali Touran, Department of Civil Engineering

 Paul J. Bolster, College of Business Administration

 Scott W. Thayer, Department of Civil Engineering

 Northeastern University, January, 1994.

 5

 CHAPTER 2 - RISK IDENTIFICATION

 Every technique for risk analysis must begin with the

development of a method for the identification and classification

of individual risks inherent in a particular projecT. While every

construction project has its own unique set of risks, there are

many risks that are common to all projects. Examples include

unknown underground conditions, severe weather possibilities,

contractor reliability, and the risk of maintaining adequate

funding. One of the most adaptable methods for risk identification

and classification is the development of a risk checklist. This

technique allows the user to list common project risks, and then to

append the list with those risks peculiar to the project at hand. 

Virtually every method studied in this research included the use of

a risk checklist

 The current planning process employed by the Federal Transit

Administration (FTA) for Environmental Impact Statements (EIS)

contains many of the risks common to all transit projects. The

significant risks delineated by EIS process include capital cost,

land use and economic development, air quality, noise and

vibration, ecosystems, water resources, energy, utilities,

historical/archaeological, safety and security. These items and

others were used to develop a risk checklist for this report (Table

2.1).

 Risk identification is heavily dependent upon the experience

and perceptivity of project management. In order for a checklist

to be effective, there must be a concentrated effort during the

development stage to identify all relevant risks by all members of

the management team. This process can be particularly arduous

because humans are not predisposed to identify more risks and

thereby creating more things to worry about. By identifying risks

and developing appropriate courses of action should such events

occur, management will trandescend the "putting out fires" mode. 

That is, management will become proactive instead of reactive.

BACKGROUND
 Ostensibly there are several different approaches to organize

a risk checklist into a logical, understandable, and useable

format. One approach (Diekmann, 1988; C.I.I. Pub. 6-8 1989;

Curran, 1989) proposes that risks should be organized in terms of

the nature of the risk itself. Specifically, risks can be

classified as either knowns, known-unknowns, or unknown-unknowns. 

A known risk is an item or condition that is understood, but cannot

be measured with complete accuracy. Generally, such risks occur at

a relatively high rate and contain a range of possible outcomes. 

Labor productivity is a good example of a known risk. Knownunknowns conditions or events that are foreseeable, but not

normally expected. Normally, such events have

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a relatively low frequency and result in severe consequences. 

Earthquakes, hurricanes, strikes and unusual difficulty with a

contractor are examples of this type of risk. Unknown-unknowns are

conditions or events that cannot be predicted. These items are

generally catastrophic in nature and have a low probability of

occurring. Examples of unknown-unknown include asbestos related

hazards or AIDS before the were recognized. Once an unknownunknown is identified, it becomes a known-unknown.

 A second method for organizing a risk checklist is to classify

the risks according to their nature and their primary sources

(Wideman, 1992). Under this scenario, risks are placed into one of

the following categories: external-unpredictable, externalpredictable, internal non-technical, technical, and legal. 

Examples of external-unpredictable risks include natural hazards or

regulatory changes. External-predictable risks involve inflation,

currency changes, environmental impacts, and social impacts. 

Internal, non-technical risks are embodied by items such as

schedule, cost, cash flow, and management. Technical risks evolve

from changes in technology, from sheer size or complexity of the

project, and from design or performance standards. Finally, legal

risks arise from patent rights, force majeure, licensing,

contractual problems, and insider and outsider lawsuits. This

classification system provides the benefit of arranging the groups

according to their relative controllability. For instance, natural

hazards are considered external-unpredictable and have a low degree

of controllability while contractual risks are ranked as legal

risks with the highest controllability.

 Yet another approach to classifying risks is based upon their

effect on the project. Under this method, risks would be

considered as either cost risks, schedule risks, or quality risks. 

Unfortunately, many risks fall into more than one category, and
accordingly, create the potential for double counting when

mitigation procedures are being considered (Wideman, 1992).

CONSTRUCTION AND FINANCIAL RISKS

 In order to facilitate the next phase of the risk management

process, i.e., risk measurement, the authors have divided risks

into two broad categories: design and construction risks and

financial risks. This is somewhat analogous to classifying risks

broadly according to their source and is proper because the

objective of this research is to analyze risks from the owner or

the sponsor's point of view. So while major risk items deserve

scrutiny, we are not interested in details that a contractor would

want to be concerned with.

 While financial risks appear to affect the project at the

earlier stages (such as planning and feasibility phases when

alternative methods of financing are evaluated), construction risks

tend to accompany the project throughout its lifecycle and

especially during the construction period. Also, financial risks

tend to affect the project in a broad sense while construction and

design risks are sometimes peculiar to a limited part of the

project. For example, uncertainty in the tax revenue dedicated to

the project can impact the whole project and even postpone it. But

an unexpected condition at the site of a tunnel may impact the

tunnel advance rate and impact those project components that are

directly tied to the tunneling operation.

 8

 The effect of financial and construction risks are usually

estimated independently using methods and models developed in two

separate fields of engineering and finance. Despite this

traditional approach, design, construction, and financial risks are

complementary. For example, if a major impediment to the

completion of a project surfaces during the construction phase, the

contractor or owner may be forced to raise additional funds at a

time when interest rates are unfavorably high. Alternately, it is

possible that contingency financing is difficult or impossible to

obtain in the short term, creating delays and engendering an

increase in construction costs. An extensive example of the effect

of the financial and the construction risks on project cost is

developed in Chapter 5.

 Subsequent to the establishment of the two major risk

categories, a further breakdown is appropriate. This breakdown has

been developed by considering various types of risks that can

potentially affect the project chronologically from the feasibility

study phase until completion of the construction. Subcategories
can be project size, contract clauses, factors such as geography

and local economic conditions, site factors such as topography,

site accessibility, etc. Perseverance will result in a checklist

that will reflect all areas of risk for a particular project. 

Furthermore, it will provide a systematic and objective approach to

the risk identification process of future projects, ensure that no

major risk item is overlooked, and provide the basis for analyzing

groups of projects as a portfolio.

THE RISK CHECKLIST

 The risk checklist presented in this report has been organized

with the objective of developing an easy to understand and

repeatable set of guidelines for fixed guideway transit systems

from the owner's perspective. We have concluded that a checklist

based upon the source of risk best achieves this goal because it is

easy to understand and use. The following checklist (Table 2.1) is

organized with a chronological format. That is, an item which

would occur first in the normal lifecycle of a construction project

is listed first in the checklist. Based upon the feedback that we

have received from the industry, this is a very useful format. To

elaborate somewhat, the checklist contains fifteen major risk

categories, each of which is then divided into several subcategories. Also note that the checklist developed can be used at

various phases of the project lifecycle. For example, it can be

used in the conceptual planning phase to establish broad risk

factors affecting the project. Evaluation and re-evaluation of

risk checklist can then be conducted at various stages of project

lifecycle. It should be noted however, that the later one attempts

to evaluate risks, the less flexible would be solutions to any

potential problems.

 Every item in the risk checklist can be earmarked as high,

moderate, or low risk. For example, if an individual project

involves major underground construction, then risks associated with

some of the subcategories of "Site" will become very important and

will deserve extra attention. The checklist can be examined for

every project and filled in so as to reflect specific project

characteristics. It provides a systematic and objective approach

to risk identification process, ensures that no major risk item is

overlooked, and provides a basis for risk measurement and

mitigation. This checklist has been thoroughly reviewed by various

experts from the government and industry. Most of their viewpoints

have been incorporated into the checklist

 9

 TABLE 2.1 - An Outline for
 THE RISK CHECKLIST

 from the Owner's Point of View

This risk checklist is developed from the owner's point of view. 

Therefore it is possible that some important parameters that

contribute to the project uncertainty, but were not owner's

responsibility, have been left out. Also, not all the elements

reported in this checklist have similar impact on the project cost

and schedule. In fact, some items such as environmental

regulations have a profound impact on the project cost, schedule,

and construction while others may have only a marginal effect on

cost and schedule. The checklist may be used as a reminder for the

planners and all the items may not relate to a specific project.

I. Project Feasibility

 A. Technical feasibility

 B. Long-term viability

 C. Political circumstances

II. Funding

 A. Sources of funding

 B. Inflation and growth rates

 C. Accuracy of cost and contingency analysis

 D. Cash flow

 E. Exchange rates

 F. Appropriation

III. Planning

 A. Scope

 B. Complexity of the project

 C. Technical constraints

 D. Sole source material or service providers

 E. Constuctability

 F. Milestones (schedule)

 G. Tune to complete (schedule)

 H. Synchronization of work and payment schedules

IV. Engineering

 A. Design and performance standards

 B. Unreliable data

 C. Complexity

 D. Completeness of design

 E. Accountability for design

 F. System integration

 10

Table 2.1 continued...
V. Type of Contract

 A. Lumpsum

 B. Unit price

 C. Cost plus

VI. Contracting Arrangement

 A. Turnkey

 B. Joint venture

 C. Single prime contractor

 D. Several prime contractors

 E. Innovative procurement methods

VII. Regional and Local Business Conditions

 A. Number of bidders

 B. Unemployment rate in construction trades

 C. Workload of regional contractors

VIII. Contractor Reliability

 A. Capability

 B. Capacity

 C. Credit worthiness

 D. Personnel experience

IX. Owner Involvement

 A. Management of project

 B. Supplying of material

 C. Testing and inspection

 D. Safety programs

 E. Communications and problem solving

 F. Partnering

 G. Start-up operations

X. Regulatory Conditions

 A. Licenses, permits, approvals

 B. Environmental regulations and requirements

 C. Patent infringement

 D. Taxes and duties

 E. DBE (Disadvantaged Business Enterprise) involvement

XI. Acts of God

 A. Storm

 B. Earthquake

 C. Flood

 D. Fire

 E. Impact of site location on any of the above

 11
Table 2.1 Continued...

XII. Site

 A. Access

 B. Congestion

 C. Underground conditions

 * Soil conditions (rock vs soil, etc.)

 * Water

 * Utilities (existing and new)

 * Archeological finds

 * Hazardous wastes

 D. Noise, fume, dust

 E. Abutting structures

 F. Security

 G. Disruption to public

XIII. Labor

 A. Productivity

 B. Strikes

 C. Minority representation

 D. Sabotage

 E. Availability

 F. Work ethics

 G. Wage scales

 H. Substance abuse

 I. Local rules

 J. Unions

 K. Material wastes

 L. Workman's compensation

XIV. Loss or Damages

 A. Owner's responsibility

 B. Contractor's responsibility

 C. Engineer's responsibility

 D. Vandalism, sabotages

 E. Accidents

 F. Third Party Claims

XV. Guarantees

 A. Schedule

 B. Performance

 C. Consequential losses

 D. Liquidated damages

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 Appendix B contains a commentary designed to clarify and

highlight risk items enumerated in the checklist. As mentioned

previously, dividing risk items according to financial, design, and

construction risks, contributes to a better understanding of how
these uncertainties function and affect the project. It also

distinguishes between the types of skills required to study and

handle these risk items. It is only natural that many items in

various categories of the checklist may relate to a combination of

design, construction, and financial issues as these issues interact

strongly. Table 2.2 divides the fifteen categories of the risk

checklist into design, construction, and financial risks. For

example, the site is considered a construction risk. This is due

to the fact that difficulties originating at the site (i.e.

excessive ground water, differing soil conditions, difficult

access) predominantly affect construction.

Click HERE for graphic.

 13

The degree to which each of the four principal parties (sponsor,

owner, engineer, contractor) involved in a rail transit project is

exposed to each type of risk is presented in Table 2.3. The main

purpose in including this table was to emphasize the categories

that are of higher importance to the sponsor and the owner.

Click HERE for graphic.

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 CHAPTER 3 -- UNDERSTANDING FINANCIAL RISK FROM THE OWNER'S

 PERSPECTIVE

 Financial risk is directly tied to the owner's (i.e., the

Transportation Authority's) ability to design and execute an

adequate financial plan. As project managers lose control over

this process due to insufficient planning, unforeseen construction

problems, or abrupt changes in financial markets, both the amount

and cost of project financing are affected. This means that it is

essential to examine financial risk from the owner's perspective.

 It is important to remember that the owner's risk in a project

is constantly reassessed by the various sponsors who have provided

financing. This group includes not only the FTA and other public

agencies, but private investors as well. Therefore, it is

important that we also consider how these parties assess the risk

of their investment in individual projects. Note that the owner

must monitor and accept the risk associated with this particular
project while the outside sponsors (investors) may be more

concerned with the risk that this project contributes to their

total portfolio of investments. This "portfolio" perspective

maintained by those who provide financing for a variety of projects

means that their risk exposure from a single project is moderated

(or in some cases, amplified) by the risks associated with other

projects.

 The owner's objective in the management of financial risk is

to secure adequate financing at a reasonable cost. In this

section, we begin with a discussion of the broadest sources of

financial risk maintaining the perspective of the owner. These are

sources of risk that all owners must bear and that they have little

control over. Next, we review more specific sources of risk that

will differ for different owners or for individual projects. 

Third, we consider operating risk factors. These factors are

highly specific to an individual project. Finally, we return to a

broader perspective to consider the project's financial risk in a

portfolio context. The portfolio perspective is essential for

parties at all levels of a large, scale construction project,

owners, contractors, and investors.

 While there are a number of critical decisions the owner will

be involved in that will affect the financial risk of a particular

project, it is the outside investor who must finance the lion's

share of construction costs. The relevance of project risk to

outside investors can not be overemphasized. It is their

assessment of risk that will ultimately determine the cost of

financing the project and it is this cost that the owner is

obligated to pay.

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I. BROAD SOURCES OF FINANCIAL RISK FROM THE OWNER'S PERSPECTIVE

 From the owner's perspective, risks associated with the

construction of any large scale project can be assessed by

considering the uncertainty in cash flows into and out of the

project. Capital costs associated with fixed guideway transit

system construction are sizable and they depend on a number of

factors. Ultimately, these factors are evaluated by independent

agencies (public and private) who will provide financing, for the

project.

 If a sufficient level of financing can be identified and

secured prior to the construction phase, then financial risk is

largely under control of the owner. This scenario assumes that the

project proceeds through construction phases with no material

surprises. However, it is the nature of such projects to produce

surprises and in a minority of cases the owner has to obtain

supplementary financing to cover these unexpected problems as they
arise. In addition, financing costs are uncertain. Even if

outside parties have committed to provide initial or supplementary

financing, the cost of those funds remains uncertain.

 It is difficult to separate financial risk from construction

risk since both are ways of describing variations in cash flows

associated with the project. To describe financial risks, let's

begin with the assumption that the owner, through careful

assessment of the project, has determined the level of financing

needed including, a reasonable amount for contingencies that may

arise. Once this amount is determined, the owner is faced with the

problem of obtaining the needed funds. The cost of obtaining this

capital (i.e., the price of money) will be a function of several

factors. These factors include expectations of inflation, real

rates of return, and ultimately, the perceived creditworthiness of

the owner who must repay the funds in the future.

The Cost of Capital

 The cost of capital is the interest rate the owner must

promise to investors in order to raise enough funds to finance the

project. For large scale construction projects, financial risk is

uncertainty with respect to (1) the dollar amount of financial

resources that the project is expected to consume and (2) the

interest rate that the owner must pay to obtain those funds. The

first element overlaps significantly with construction risk. The

owner budgets a specific amount that includes an appropriate

contingency sum. As the project progresses, the actual costs may

be higher than expectations due to higher than expected

contingencies. This will require the owner to locate supplemental

financing for the overage. On the other hand, if contingencies are

lower than expected, the owner has obtained financing. that is not

needed. Interest expenses will be incurred on this surplus and the

owner must seek short-term investments to produce income to offset

this expense.

 The second element of financial risk, deviation from the

expected cost of capital, will vary over time as inflationary

expectations, risk-free rates of interest, and the additional risk

premium demanded by investors fluctuate. This cost of capital,

denoted as i, can be modeled as follows:

 16

 i =R+ IE+ RP

 where R is the risk-free rate of interest,

 IE represents inflationary expectations,
 RP represents the risk premium assigned to this 

 particular project.

 It is this third component that is of most interest to

individual owners or transit agencies financing individual projects

since this is what differentiates them from one another in the

competition for investment funds. Each of these components will

now be examined in detail.

The Risk-Free Rate

 The risk-free rate of interest refers to the component of the

owner's cost of capital that represents the investor's desired

growth in purchasing power. In other words, it is the interest

rate that the investor needs in absence of inflation or risk of any

kind. It is the minimum level of compensation any investor would

need to make some riskless investment. One commonly cited proxy

for this rate is the interest rate on Treasury Bills. Treasury

Bills are short-term securities issued by the U.S. Treasury. They

mature in one year or less with 90 days being the most common life

span. Investors will also add a premium for inflationary

expectations to the riskfree rate they are willing to accept. 

Therefore, these securities provide a widely used proxy for this

component of the cost of capital. Consider the illustration on the

next page (Figure 3.1) showing the yield on Treasury Bills and the

inflation rate for the period from 1950 to 1993. As the following

graph illustrates, investors have demanded a risk-free rate of

return that exceeds the inflation rate by approximately 1.5% to 3%

during this period.

Inflationary Expectations

 The rate of inflation is factored into all interest

calculations since both borrowers and lenders know that the

purchasing power of a dollar will change over time. There is some

uncertainty associated with this inflation premium over time since

the inflation rate changes. Examine Figure 3.2. The rate of

inflation is measured by monitoring the change in price levels for

inputs used by the construction industry. Note that the level has

fluctuated significantly. Inflation was moderate throughout the

50s and through most of the 60s. However, it was extremely high in

the early 70s and again in the early 80S. Thus far, the 90s have

been characterized by very low inflation rates.

 17

Click HERE for graphic.
Click HERE for graphic.

 18

 Clearly, investors are willing to provide capital for a

project only if they believe that they will receive an adequate

return. Therefore, the owner must include compensation for the

expected level of inflation during the investment period. Since

the level of inflation that will actually materialize during the

project's construction and subsequent operation can not be known

with certainty, the owner must also consider the risk of Unexpected

inflation. As an example, suppose the owner must offer a 5%

premium to meet investors' inflationary expectations (IE) and to

secure financing over a ten year period. If actual inflation

averages 3% during this period, then the owner has overcompensated

investors. If actual inflation averages 7%, then the owner has

obtained funds at a bargain rate.

 While this source of financial risk may seem inevitable since

all owners must provide compensation for it at the prevailing

level, there are ways of sharing the risk with the investor.

For example, consider the adjustable rate mortgage. In this

arrangement, the home buyer (owner) is seeking funds but is willing

to alter the interest payments to the bank (investor) to compensate

for changes in inflation. Contrast this with a fixed rate

mortgage. Now, if inflation is significantly higher than expected,

the home buyer's fixed payments are worth less and the bank loses. 

However, if inflation is lower than expected, the home buyer's

payments are worth more in real terms.

 An example of the outcomes of alternative financing costs to

the owner is provided in Table 3. 1. This illustrates the tradeoff

between fixed and variable interest rate contracts under several

inflation scenarios.

 This means that the owner has a choice when financing: either

negotiate fixed rate financing and place the risk of unexpected

changes in the inflation rate with the investor, or negotiate a

variable interest rate plan where the uncertainty of inflation rate

changes is retained by the owner.

 An example of a variable rate issue is the $90 million of

bonds sold by the Massachusetts Bay Transportation Authority in

1984. These bonds carried an initial interest rate of 6.25%. After

each 6 month period, the interest rate is readjusted to reflect

rates on securities with similar maturity and risk. According, to

the contract, the interest rate is capped at 12%.

 The choice between fixed rate and variable rate financing is
not trivial. Investors will expect compensation for bearing

inflation risk and therefore, the prevailing rate for fixed rate

financing will typically be above that prevailing for variable rate

financing. Variable rate bonds are most popular during periods of

high expected inflation.

The Risk Premium

It is worth restating the simple equation that began this section

with a minor modification:

 19

 i = (R + IE) + RP

This suggests that two of the three components of the cost of

capital are largely determined by broad economic forces. While the

owner must be aware of these forces and their influence on

financing costs and risk, the owner has no material control over

these factors. It is this third factor, the risk premium, that is

somewhat under the control of the owner.

Click HERE for graphic.

 The owner's cost of capital is largely a function of the

investor's expectation of being compensated as promised. For a

large transit project this will be a function of a variety of

factors. One group of factors is related to the project's

operating risk, or the variability of revenues and expenses during

and beyond the construction phase. Other factors are more specific

to the contract between the owner and those providing the

financing.

 20

II. SOURCES OF FINANCIAL RISK THAT ARE SPECIFIC TO THE OWNER AND

THE PROJECT

 To obtain financing, the owner must be able to prove to public

funding, agencies and private investors that there is significant

expectation of future cash inflows from the project. There are

four primary sources of revenue that the owner can use to meet

interest and principal obligations. These are new tax revenues

(sales or use taxes, or other special assessments), direct Federal

grants from the FTA, guarantees of subsidies from the municipality,

state, or a third party, and user fees (or farebox revenues) that

begin to flow once the project is operational. We will discuss the

first three of these sources and leave user fees for the subsequent
section regarding operating risk factors.

The Breadth of the Revenue Stream

 A primary determinant of the cost of financing, a large scale

transit project is the sources of future cash flows that can be

used to repay the financial obligation. Revenue bonds are sold to

investors with the stipulation that repayment will be made from

cash inflows generated directly from the project. There are a

variety of examples of the types of projects financed with revenue

bonds including turnpike construction (repaid with tolls),

university facilities (repaid with tuition revenues), power plant

construction (repaid by consumers of electricity), and public

transit facilities (repaid with special taxes or fares).

 Consider the inherent risk associated with such financing if

the revenue stream does not materialize or is significantly below

original expectations. A famous example of such a failure is

illustrated by the default status of bonds issued in the 1970s by

Washington Public Power Service. These bonds were sold to finance

the construction of new, nuclear powered Generators needed to meet

projected demand for electricity in the state of Washington in the

coming, years. After these revenue bonds were sold, the project

began to experience significant cost overruns. Moreover, the tide

of public opinion began to move against the construction of nuclear

power facilities. The combination of cost overruns and delays

created by public opposition eventually caused the project to be

abandoned. A similar fate awaited holders of Public Service of New

Hampshire bonds issued at about the same time.

 General Obligation bonds represent an alternative method of

specifying the future cash flows that will be used to service

project debt. Here, the municipality, state, or political region

with the authority to levy taxes, agrees to accept the obligation

to repay the debt. This means that if expected revenues do not

materialize, the state (or other political entity) will make

payments out of general tax revenues. From the investor's

perspective, this is a more secure investment since repayment does

not ultimately depend on project specific future cash flows. 

Hence, this explicit guarantee provided by the state will lower the

risk premium associated with the bonds and result in a lower cost

of capital. The vast majority of bonds associated with large scale

transit projects fall into the General Obligation category.

 21

Specific Sources of Revenue Associated with Financing

Broad Based Taxes: A number of transit projects in recent years
have used a new sales or excise tax as a primary source of funds

for construction and operation. For example, in 1992, the Orange

County Local Transportation Authority raised $525 million for a

variety of projects by initiating a 1/2% sales tax for a twenty

year period. In a healthy economy, this represents a significant

contribution to revenues. Yet, the expected revenue may not

materialize if the level of economic activity falls below the

original forecast. This means that the financial success of the

project is closely tied to the vitality of the local economy. 

While the transit project may provide a stimulus for economic

growth, the overall growth or contraction of the economy will

depend on more fundamental economic factors such as the level of

new investment and the unemployment rate. Macroeconomic factors

such as these can not be managed by the owner and thus, they

represent a source of risk that the owner and those who provide

financing for the project must bear.

 Even in a robust economy, these revenue sources may still be

at risk. What the government grants in tax revenues, it can also

take away. Consider the 1% sales tax recently approved to finance

transit projects in metropolitan Houston. The transit authority

can collect and employ these funds, but they have no authority to

issue bonds for longer term project financing. This means that

they may be obliged to "save up" tax revenues until they accumulate

a sufficient amount to begin a capital project. However, there may

be competition for these accumulated funds from other groups who

see these funds as a source of financing, for alternative transit

projects.

 A second method of raising funds for construction and

operation requires a special assessment of the municipalities

served by the new project. These arrangements can be negotiated

prior to the initiation of the project, minimizing the risk

associated with these revenues. However, it is possible that

problems will develop in the future if these districts do not see

the expected benefits materializing. Local governments may attempt

to withhold payment of this assessment in later years. Such issues

of equity may also arise if the ability to pay the assessment

differs significantly across communities receiving equal benefits

from the project. Poorer communities may attempt to shift part of

their assessment onto their wealthier neighbors. Again, many of

these issues can be addressed in advance of the projects startup,

but such problems may develop at some future point. The owner may

find itself scrambling to find alternative sources of financing

while the ultimate balance of assessments among communities served

is determined through a lengthy legal or political process.

 One additional method of financing, transit projects is

through establishment of partnerships with private developers. 

Union Station in Washington, D.C. is an excellent example of such

an arrangement. Not only is the station a high volume, multi-modal
transportation facility, it also houses a variety of shops and

restaurants and is a legitimate tourist attraction. Private

developers agreed to assist in the upgrade of the facility and to

share operating costs with the public transit

 22

authority partners. As in the initial discussion off sales tax

financing, this arrangement will work well only if the shops and

restaurants are successful. Otherwise, they will not generate

revenues sufficient to cover their share of the station's operating

costs. If the private partners default on the agreement to pay

part of the operating costs, the transit owner will be obligated to

cover them.

Federal Appropriations: The Federal government provides both

Capital Expansion Funds and Operating Assistance Funds as outright

grants through the FTA. Once a project has been approved for

funding, it will receive these sources of financing. However, a

different type of risk must be considered here. Much of the FTA's

grant money is derived from the federal tax on gasoline. Their

share of these revenues is not specified until late September or

early October of each year. In practice, this means that the

transit agency can expect to receive all funding allocated to the

project, but is unlikely to receive funding exactly when it is

needed. This leaves the transit agency with a financing gap that

must be filled using alternative temporary sources of funds. There

are several sources of such funding, one of which is the sale of

Tax or Grant Anticipatory Notes. These are short term IOUs issued

by the owner that are collateralized by the past approval of

federal funding. This provides the owner with the needed financing

to manage the project properly. However, it also saddles the owner

with an additional interest expense since the investors who

purchase these securities expect some compensation for their loan

of financial resources.

Municipal, State, and Third Party Guarantees: Recall the

distinction between Revenue bonds and General Obligation bonds

discussed previously. Most large transit authority financing,

involves a guarantor. The Guarantor may be the government

sponsoring the transit authority or it may be a private insurer. 

General Obligation issues carry an explicit guarantee that the

state will provide funds to meet the project's financial

obligations in full if necessary. However, since transit

authorities are public agencies, even revenue bond agreements may

infer a guarantee that the sponsoring government will make up any

revenue shortfalls associated with the transit project during

construction or once under operation. This inference of a more

general obligation, or "implicit guarantee," has been upheld in

very few cases.
 Even when the sponsoring government has explicitly guaranteed

to subsidize the project, there is still uncertainty regarding the

timing and extent of the government's supplemental payments. While

most investors would expect the government to make good on such

promised payments, some governments are perceived as more

creditworthy than others. So, investors require some compensation

for this uncertainty. This is the role of the private insurer. An

owner can secure the explicit guarantee of payment in full to

bondholders from a private agency. If this is done, there is less

inference of coverage. However, the extent of the coverage will be

a function of its cost. The owner must assess the tradeoff between

the cost of coverage and the interest cost reduction that the

coverage will produce.

 23

An aggregate measure of financial risk: Bond Ratings

 All of the factors previously discussed require careful

scrutiny and synthesis to quantify financial risk. Nearly every

substantial sale of long term securities requires the owner to

engage the services of a rating agency to certify the level of

financial risk. Few large investors will consider providing funds

for a project that has not been rated by a bond rating agency. 

Moody's and Standard and Poor's are the two largest bond rating

agencies in the U.S. A rating agency will issue a rating to a bond

issue after carefully considering the details of the project and

the financial history of the owner. A high rating denotes a high

level of creditworthiness and means that investors will require a

lower risk premium from the owner. An owner with a low rating is

obliged to provide higher risk compensation to investors. One

alternative is to find a larger investor who is willing to finance

the entire project without obtaining a rating. However, such

financing sources may be difficult to locate and will require some

assessment of creditworthiness anyway.

 The owner has significant incentive to manage the financial

risk of the project as it will influence the bond rating, hence the

cost of capital. The difference in interest expense between two

adjacent bond ratings can easily be 0.5%. While this may not appear

to be large, for a $100 million bond issue, it represents a

recurring, annual difference of $500,000 for the life of the bonds

issued. The owner also has the option of insuring the issue. This

assures the bondholders of payment and provides the bond issuing

agency with a lower interest expense since the bonds will carry the

higher rating of the insurance company. As an example, Los Angeles

County Transportation Commission issued two series of bonds in

1991. One series carried the bond rating of Los Angeles county,
"A". The other bonds were insured by AMBAC Indemnity Corporation

and were given the superior rating of "Aaa". This translated into

an approximately 0.3% interest rate differential between the issues

that raised a combined total of $281.5 million.

 Table 3.2 - A Sample of Recent Interest Rates for Municipal Bonds

 with Different Ratings: August to October 1993

 Twenty-Year Bonds August September October 12 mo. High

 Aaa 5.37% 5.25% 5.14% 6.10%

 Aa 5.50 5.39 5.25 6.23

 A 5.62 5.52 5.41 6.37

 Baa 5.84 5.76 5.63 6.51

 Ten-Year Bonds

 Aaa 4.73 4.62 4.49 5.24

 Aa 4.80 4.72 4.60 5.36

 Source: Moody's Bond Record, October 1993.

 24

 In addition to factors that are specific to the project or the

issuer, the size of the risk premium investors demand fluctuates

with general economic conditions. During periods of growth, the

differences between risk premia for projects (or owners) with

differing levels of risk, grow smaller. Overall concern with

partial, or complete default is minimal during such periods.

Therefore, financing of risky projects is relatively cheap.

However, during recessionary periods, the opposite is true. 

Investors are more wary of high risk projects and will finance them

only at significantly higher rates compared to other projects. 

While the owner may have a sense of urgency to initiate and

complete a risky project during an economic downturn, financing

will be more costly. This source of financial risk can be managed

with patience.

Other Sources of Project Specific Financial Risk

1. Size of contract: Generally, financing, of smaller amounts

(under $50 million) is more costly due to the fixed costs of

finding buyers for what may be seen as a specialized issue. Also,

as the aggregate value of total issue becomes smaller, so does the

number of potential traders in the secondary market. In other

words, as investors desire to resell the bonds they purchased in

the original financing, they will find fewer buyers unless they are

willing to sell at a heavily discounted price. The investor who

purchases securities from a small issue must bear liquidity risk

and will expect a higher interest rate as compensation.
2. Need for Working Capital: Since a large project requires

significant funds for day-to-day operations, the cost of these

funds also represents a source of financial risk. Short-term

interest rates are more volatile than longer term rates. Yet, on

average, they are lower. This produces a risk management decision

for the owner. Do you finance most, or all of your working capital

using short term sources? If so, then you expect to have a lower

cost of capital, but there is also the risk that this cost will

fluctuate adversely. Or do you finance most, or all of your

working, capital with long term sources? Here, your cost of capital

is certain, but will probably be higher than prevailing rates for

short term sources.

3. Bankruptcy of Contractor: In all ma or construction projects,

the contractor is required to secure a performance bond from a

surety company. This reduces the loss associated with nonperformance by the contractor. However, if the contractor is

unable to complete the project because of an inability to contain

costs on this project (or possibly on some other projects), the

owner will experience a fluctuation in the cash flows dedicated to

the project. These sources of financial risk may include changing

the payment pattern to maintain solvency of the contractor, delays

in obtaining payment from the surety, the amount of rework needed,

or the cost of abandoning the project.

 Although, the surety industry serves this purpose well, the

financial health of the contractor is clearly an issue for the

project owner. While much of this concern is addressed in the

 25

prequalification process, it is worthwhile to briefly consider the

primary determinants of the financial condition of the contractor. 

These can be assessed through thorough scrutiny of 0

financial statements and also by developing a variety of test

statistics based on these figures. One well-known statistic, the

Z-score, will be reviewed.

 The central financial question the owner wants to answer with

respect to the contractor is: Does the contractor have the

financial capacity to complete the project in a timely manner and

within other contractual standards? One common method of assessing

the likelihood of contractor's financial viability is through

financial statement analysis. This analysis examines the

contractor's current and past financial statements to detect trends

in various strengths and weaknesses. These trends may also be

considered in conjunction with the trends exhibited by industry

peers.
 Financial ratios are the most common method of analyzing

financial statements. These ratios show the relationship between

various items in financial statements and are attempts to measure

some dimension of financial strength, e.g., liquidity. They are

simple mathematical calculations and have little meaning by

themselves. Only by comparing ratios and determining the

underlying causes of differences among them does ratio analysis

become meaningful.

 Ratios can be grouped into several categories including

Liquidity, Profitability, Operating Efficiency, and Leverage. For

example, the current ratio is a common measure of liquidity or the

ability of a firm to meet its short term obligations. It is a

simple ratio of current assets to current liabilities. A low or

declining current ratio may be indicative of a firm with especially

effective cash management or one that is having, increasing

difficulty paying its bills. Profitability measures are the

proverbial "bottom line". These measures examine profits

(operating profits, after-tax profits, etc.) as a percentage of

sales or assets. A number of financial ratios are used to measure

the operating efficiency of a firm relative to some standard. 

These ratios provide a rough indication of the degree of idle

investments in various assets and liabilities. They also measure

the firm's effectiveness at generating revenues from various

classes of assets.

 The last group of ratios, Leverage ratios, examine the debt

position of the firm. In addition to the need to generate

sufficient financing to cover fixed operating costs, debt carries a

fixed financial obligation. Therefore, high debt usage also

indicates a high level of interest expense that remains high

regardless of any increase or decrease in revenues generated. This

means that firms with high levels of debt are riskier than similar

firms with more moderate levels of debt. The effects of debt

financing are often described in terms of creating financial

leverage. This means that use of debt magnifies the gains or

losses that the firm will experience.

 Financial statement analysis, including ratio analysis, is

further discussed in Chapter 4. For a more detailed examination of

financial statement analysis, see Keown, et. al (1993).

 There have been a variety of attempts to forecast financial

failure, or bankruptcy, of firms by using financial ratios. One of

the most widely cited is model developed by Altman (1968,

 26

1983). This model generates an index, or Z-score, which has been

shown to be a reasonable indicator of the likelihood of bankruptcy
of an individual firm during the upcoming 12 months. A current

version of the Z-score model uses the following 7 ratios:

 - Retained Earnings/Total Assets (measures profitability)

 - Standard Deviation of Operating Income/Total Assets

 (stability of earnings)

 - Earnings before Interest and Taxes/Total Assets (measures

 profitability)

 - Earnings before Interest and Taxes/Interest Expense

 (measures leverage)

 - Current Assets/Current Liabilities (measures liquidity)

 - Market Value of Common Stock/Book Value of Equity

 (measures leverage)

 - Total Assets

 The Z-score model was developed by examining financial

statements of a sample of firms one year prior to bankruptcy and

financial statements for a sample of firms that survived. The

statistical technique used here is called discriminant analysis. 

It is a form of regression analysis that distinguishes the best

statistical relationship between the variables listed above and the

Z-score. The weaker a finn's collective measures of financial

health, the lower the resulting Z-score. Once this model was

estimated using samples of bankrupt and surviving firms, its

validity was verified using new samples of observations. The model

has been shown to be 95% accurate at forecasting bankruptcy one

year in advance and 72% accurate two years in advance.

 Two problems with the general model outlined above are (i) the

lack of stability in ratios for individual firms over time and (ii)

the variation in ratios that results from different industry norms. 

These problems can be addressed if the ratios are expressed in

"industry relative" form. This means that the ratios described

above are restated, dividing each firm-specific ratio value by the

average for its industry. This technique allows the owner to

assess the financial health of an individual contractor relative to

other contractors instead of a broader sample of firms from many

different industries. Platt and Platt (1990) show that this

refinement provides superior prediction of bankruptcy.

 In summary, the owner has a significant interest in developing

an independent evaluation of major contractors for a project. 

While this financial analysis is undertaken by the surety firm, the

owner still bears some risk in the event of contractor default. 

The level of risk can be assessed through several modes of

financial statement analysis and should be performed by the owner

during the process of evaluating contractor bids.

4. Role of International Financing: Large scale capital projects

require large scale financing. When arranging financing, the key
issue for the owner or sponsor of a transit project is the cost of

this financing that is represented by the interest rate that

investors require. Why limit this search for financing to domestic

sources when there is a significant possibility that foreign

investors would accept the same level of project risk in return for

a lower rate of interest?

 Capital markets are truly global. The investment banking

industry has evolved to assist in

 27

the financing of large projects. Investment bankers are adept at

identifying potential sources of funds throughout the world. 

Foreign investors may be willing to finance a public transit

project in the United States to diversify their holding and reduce

their portfolio's overall risk. They may also want to buy bonds

that make interest payments in dollars and use these funds to meet

a dollar denominated liability. This reduces the need to make

costly currency exchanges and also reduces the investor's exposure

to risk from fluctuation in exchange rate.

 Today, it is not uncommon for a large portion of capital

needed for a major construction project to come from foreign

investors. If financing is obtained through the sale of bonds or

notes to foreign investors and these investors are expecting

repayment in their home currencies, then the owner has an

additional potential for cash flow swings: exchange rate

fluctuations. For example, if Japanese investors purchase

securities that are denominated in yen, then the owner must make

interest and principal payments in yen according to a fixed

schedule. As the dollar grows stronger against the yen, the owner

can purchase the needed yen with fewer dollars and reduce financing

costs. However, if the dollar weakens against the yen, the same

amount of yen will cost more in dollar terms and financing, costs

will increase. In fact, the dollar has weakened against the Yen

and against other important currencies, such as the Deutchmark, in

recent years as Figure 3.3 illustrates.

Click HERE for graphic.

 Two other elements are important to keep in mind. First, the

owner will not borrow funds abroad unless they are expected to be

less costly than those that could be borrowed in the U.S. Second,

there are well established methods involving forward and future

contracts for foreign currencies that can be used to hedge this

exchange rate risk, but these techniques are costly.
 A simple example can illustrate exchange rate risk and

hedging. Suppose a transit agency raises short-term funds by

selling notes worth 110 million Yen. These notes mature in 6

months and carry a 3% interest rate. If the current exchange rate

is 110 Yen per $ 1, then the sale will

 28

raise $1 million. Now consider the three scenarios illustrated in

Table 3.3.

Table 3.3 - Illustration of the Effects of Exchange Rate Risk on

Borrowing Costs

 Strong Dollar Stable Dollar Weak Dollar

Amount borrowed $1 million $1 million $1 million

New exchange rate 120 Yen/$1 110 Yen/$1 100 Yen/$1

Yen to repay 113.3 million 113.3 million 113.3 million

Dollar cost $0.94 million $1.03 million $1.13 million

Interest expense -6.0% 3.0% 13.0%

 Clearly, the fluctuation in exchange rates causes the interest

expense to vary considerably. One simple method for stabilizing,

or hedging, this risk is to enter into a forward contract by

agreeing to take delivery of 113.3 million Yen in six months. This

allows the transit agency to lock in an exchange rate for the

future transaction. If the forward rate is 109.5 Yen per $1, then

regardless of fluctuation in the exchange rate, the agency can

purchase the 113.3 million Yen needed to satisfy the loan for

$1.035 million. This effectively locks in an interest expense of

3.5% for the funds. While there are fees associated with these

hedging transactions, there is also a reduction in exchange rate

risk.

III. OPERATING RISK FACTORS

 Very few transit projects actually generate operating revenues

in excess of operating costs. Therefore, operating cash flows are

at best, a secondary consideration in determining the financial

risk of a project. However, since the need for operating subsidies

varies from year to year and since operating and financing costs

are covered from a set of overlapping sources of funds, it is

worthwhile to consider sources of operating risk. In this section,

we first discuss the primary sources of operating revenue and then

examine the impact of different types of operating costs on
operating risk.

 Since the project that the owner is constructing is expected

to have a long life, the revenue stream that the project will

produce after it begins operation is a secondary source of funds

for repayment. There are two primary sources of operating revenue

that the owner can use to meet operating expenses and possibly

contribute to interest and principal obligations. These are user

fees (or farebox revenues) and operating subsidies (from the FTA,

municipality, or state). In addition, the examples of broad based

taxes described above may be designed to contribute to operating

expenses after the original construction costs of the project have

been repaid.

 29

Sources of Operating Revenues

Farebox revenues: Any public transportation project must provide

some forecast of ridership and farebox revenues in order to

determine its feasibility. Such forecasts are essential to

determine the likely levels of such revenues and the variability of

these cash flows under various conditions. Forecasts of ridership

and revenues will also depend upon fare structures that subsidize

certain groups (e.g., senior citizens, students, non-peak time

riders). This will make the task of forecasting farebox revenues

more difficult. Refer to Pickrell (1990) for a more detailed

discussion of the determinants of ridership and forecasting errors. 

But a more relevant source of operating risk related to the

subsidization of riders is the political dimension. Governments

within the region served by the project may force the owner to

alter the subsidy mix at some future point. This means that the

owner's ability to control this source of operating risk is

imperfect at best.

 It is also essential to put farebox revenues in perspective. 

They provide less than half of the revenues needed to cover

operating expenses. For example, Table 3.4 provides the farebox

revenues as a proportion of operating expenditures for a sample of

transit systems that have recently issued new bonds:

 Farebox

 Revenues as a

 OWNER % of

 Operating

 Expenditures

 Metro. Atlanta Rapid Transit System 37.2%

 L.A. County Transportation Comm. 39.0%
 Regional Transportation Dist.(Denver 15.0%

 Greater Cleveland Reg. Transit Auth. 24.1%

 Orange County Local Trans. Authority 26.9%

 Source: Moody's Municipal Credit Report, 1992

Furthermore, farebox revenues are initiated only after construction

is completed. This means that other sources of revenue must be

secured to meet financial obligations to investors.

 30

Federal, State, and Municipal Subsidies:

 A final source of operating revenues for the owner is direct

operating subsidies from the FTA or the state, county, or

municipality where it operates. For example, the Commonwealth of

Massachusetts provided 62.2% of the total expenses incurred by the

MBTA during 1991. Virtually all of this subsidy was used to cover

operating expenses. The MBTA also received Operating Assistance

Funds from the FTA during this time. The revenue stream from a

specific source (farebox or sales tax revenues) may fluctuate in

the future, but the government can levy taxes to assure continued

operation of the transit system. It is important to emphasize the

role that the governmment's willingness to subsidize operations

plays in the determination of current and future costs of financing

construction. If the subsidy is seen to be certain, investors will

also see a high likelihood of repayment of capital costs and will

accept a lower risk premium. This results in more moderate capital

costs for the owner.

The Nature of Operating Risk: Operating Leverage

 Operating, expenses can be categorized as variable or fixed. 

For example, some expenses, such as fuel, vary directly with the

level of operations. As activity rises or falls, fuel costs do the

same. Contrast this relationship with the expenses generated by

the establishment of a new structure to house the administrative

activities needed by the project. The maintenance and operation of

this facility will not rise and fall with ridership. Once

established, such a facility represents a fixed operating cost to

the project. The level and proportion of fixed and variable

expenses have an important relationship to operating risk. This

relationship is referred to as operating leverage and will be

discussed in the subsequent section.

 The previous section detailed a variety of financing

alternatives and the sources of risk associated with each. The
owner's risk exposure is also a function of the cost structure

associated with the project. If we again consider the operating

expenses of the project during construction and operation as fixed

or variable, we can illustrate the influence of different levels of

fixed cost. Variable cost items typically include such items as

wages of non-administrative labor, supplies, and utility expenses. 

Variable cost items vary directly with the output of the project

which may be measured in passenger miles. Fixed cost items are

those expenses that are incurred in their entirety regardless of

the planned or actual level of output. These would include

salaries of administrators, office space, and construction costs.

 The numerical example in Table 3.5 further illustrates the

influence of cost structure on operating cash flows and risk. 

Consider two transit agencies, A and B. A generates revenues of

$0.40 per passenger mile and incurs variable costs of $0.15 per

passenger mile. A also has fixed operating costs of $6,000,000 per

year. B also generates revenues of $0.40 per passenger mile. But

B has variable operating costs of $0.30 per passenger mile and

fixed operating, costs of $3,000,000 per year. Both A and B

forecast ridership for the upcoming year at 20,000,000 passenger

miles.

 31

 Table 3.5 - Illustration of the Effects of Operating, Leverage

 Transit System A Transit System B

 Revenue per PM: $0.40 $0.40

 Var. Cost per PM: 0.15 0.30

Contribution to Fixed

 Costs per PM: $0.25 $0.10

Forecast of PM for year: 20,000,000 20,000,000

Operating funds to apply

 to Fixed Costs: $5,000,000 $2,000,000

Fixed Operating, Costs: $6,000,000 $3,000,000

Forecast of Surplus or

 Subsidy needed ($1,000,000) ($1,000,000)

 In this example, both transit systems will require an

additional $1,000,000 subsidy if the forecast of ridership is

accurate. However, if actual ridership is 10% below the forecast,

the situation will differ. Following the approach used in the

above example, A will now need a subsidy of $1,500,000 and B will
need a subsidy of $1,200,000.

 Why is the subsidy needed now greater for A? It is the

relative prominence of fixed operating costs. This is the effect

of operating leverage. When actual demand is below expected

demand, the need for operating subsidies expands (or the operating

surplus contracts) more rapidly for the organization with greater

fixed operating costs. Conversely, the operating surplus expands

(or the operating deficit is reduced) more quickly if actual demand

is above expected demand.

 This difference in cost structures can be illustrated across a

broader range of ridership in the graph shown in Figure 3.4.

 The graph illustrates the higher operating risk associated

with B's operating cost structure. There is one additional method

of measuring and interpreting this source of risk. It is called

the Degree of Operating leverage, or DOL. DOL must be calculated

with reference to some specific level of demand (or ridership). It

is common to use to the estimate of expected demand to derive the

measure. The simple formula for DOL is:

 (Total Revenues - Total Variable Costs)

DOL = ------------------------------------------------------------

 (Total Revenues - Total Variable Costs - Fixed Operating Costs)

 32

Click HERE for graphic.

 So, in this example, total revenues result from an expected

ridership of 20,000,000 passenger miles times $0.40 per mile. This

results in revenues of $8,000,000 for both A and B. The

calculations are as follows:

 [$8,000,000 - ($0.15)(20,000,000)]

DOL for A = -----------------------------------------------

 [$8,000,000 - ($0.15)(20,000,000) - $6,000,000]

 = 5.0

 [$8,000,000 - ($0.30)(20,000,000)]

DOL for B = -----------------------------------------------

 [$8,000,000 - ($0.30)(20,000,000) - $3,000,000]

 = 2.0

 These statistics can be interpreted as follows. Every 1%
decrease in ridership on system A will reduce the surplus or, in

this case, increase the need for subsidization by 5%. However,

system B's finances will be less severely affected by deviations

from the expected level of ridership. It will experience a 2%

increase in the need, for subsidization for every 1% reduction in

passenger miles. In this example, both A and B are similarly

affected by changes in demand,

 33

but A has the greater risk of large operating losses due to

unfavorable chances in ridership.

 In summary, the more prominent the role played by fixed

operating costs, the greater the degree of operating leverage, or

operating risk. This is relevant to the planning process in the

construction of large scale transit projects for two reasons. 

First, all large scale projects pass a significant fixed cost

component on to the subsequent operation of the new or expanded

system. Unless the new operating revenues can cover new, variable

operating expenses and also make a significant contribution to

covering new fixed costs, operating leverage and project risk will

increase. Second, project managers may have several alternative

construction and operating designs with different levels of fixed

operating costs. The ability to select designs that result in

lower fixed operating costs will reduce the leverage and risk

associated with the project.

IV. FINANCIAL RISK FROM THE PERSPECTIVE OF THE CONTRACTOR: THE

PORTFOLIO PERSPECTIVE

 Obviously, the owner and funding agencies will not grant funds

to projects it does not expect to be completed. Yet, with every

project there is some probability that events, unforeseen at the

time of the award, will force both the local transit authority and

other funding agencies to reevaluate the project's viability. This

reassessment may lead to the need for a significant increase in the

agency or owner's financial commitment, a scaling back of the

project's scope, a postponement of the construction schedule, or

outright abandonment of the project.

 Again, in its assessment process, the owner considers the

viability of projects prior to issuing grants to assist with

construction. This assessment should entail significant

examination of financial and construction risks and should account

for many of the financial risk elements discussed in the previous

section.

 Yet, the contractor has one significant risk management tool

that is not typically available to local transit authorities:
Diversification. This term refers to the contractor's ability to

make investments in a variety of projects each of which generates a

cash flow that is in some way different from cash flows generated

by other active projects.

 Consider the following simple example. Suppose Contractor X

has been approved to participate in two projects, A and B. Further,

suppose A and B represent two ma or rail projects in New England. 

Since both projects are in the same region, involve similar raw

materials and production technologies, profitability of both

projects will react similarly to changes in the cost of a key input

or new local legislation. From a financial perspective, both

projects will be helped or hurt by a change in a common factor.

 Now suppose that A is a rail project in New England project

and B is a rail project in the Southwestern U.S. While there are

still many common factors regarding, inputs and technologies, there 

are also likely to be distinctions between wage rates, costs of

other basic

 34

inputs, and other aspects of the projects. It is these differences

that provide Contractor X with the opportunity to diversify risk. 

It is possible that an interruption in the delivery of steel may

slow progress on the project in Boston while the Santa Fe project

continues unimpeded. The reverse situation could be true as well. 

In other words, by diversifying funds across regions of the U.S., a

problem that is concentrated in any one region will have less of an

impact on Contractor X's portfolio of projects.

 Diversification can be achieved using other scales as well as

location. For example, certain categories of projects may have

similar construction inputs. The contractor could modify its

exposure to this source of risk by developing a portfolio of

projects with dissimilar construction inputs or technologies. This

may mean that the contractor will bid for a project which appears

very risky when compared to other alternatives because the costs

associated with the risky project are not highly correlated with

other ongoing projects. This means that it is not the "raw" risk

of a project that matters to the contractor. It is the risk that

the new project brings to the existing portfolio of projects.

 It is apparent that large construction firms have greater

opportunity to exploit diversification benefits than smaller firms. 

Smaller firms may be forced to specialize in a particular niche

until they accumulate the flexibility to manage several large

projects in different geographic regions or using different

construction technologies or inputs. For example, Perini is a very
large firm that builds embassies for the U.S. government in foreign

countries. But this firm also encases in the construction of

tunnels and highways in the U.S. and elsewhere. This provides

Perini with significant advantages that would be difficult to

exploit for a smaller construction firm. The smaller firm must

balance the risks associated with inexperience in a new line of

construction with the potential benefits of diversification.

 The concept of diversification is simple and powerful. By

investing in projects that are viable when considered in isolation

but also bearing distinct features not found in other projects, the

contractor can reduce its exposure to financial risk and

simultaneously improve its performance as measured by the budgetary

success of projects funded.

V. SUMMARY

 Financial risk results from uncertainty regarding capital

costs. This uncertainty results from changes in the rate of

inflation and the risk-free rate of return. In addition, and

unique to the project, a risk premium must be added to these other

costs to compensate the investor for the possibility of default or

delay in receiving interest and principal payments. Ibis premium

is largely determined by risk associated with specific sources of

revenues to be used to repay the funds borrowed. Investors will

also require a higher risk premium during recessionary periods and

a lower one during periods of growth since the economy wide rate of

default changes during such periods.

 35

 Beyond the broad economic factors that influence capital

costs, there are a variety of financial risk factors that are

specific to,the owner and the project. One such factor is the

breadth of potential sources of cash flow that can be applied to

servicing the debt. General Obligation bonds provide an explicit

promise by the state or municipality to use general tax revenues to

cover interest and principal expenses if revenues generated from

sources specific to the project are insufficient. Revenue bonds do

not carry such an explicit promise and rely solely on project

specific revenues for repayment. They are therefore more risky

from the investor's perspective and more expensive from the owner's

perspective. Further analysis of project specific revenues and

other guarantees are needed to assess the level of financial risk.

 Bond ratings represent a useful proxy for financial risk

factors. These ratings reflect the creditworthiness of an owner as

assessed by an independent rating agency. Since most of the bonds

sold to finance large scale transit projects are sold to large
institutional investors, obtaining a bond rating is a necessity. 

Furthermore, the rating itself will have a significant influence on

capital costs.

 Other project specific sources of financial risk include the

fluctuating need for working capital and the potential for delays

due to a number of construction risk factors (i.e., chanced

conditions, work stoppages, political concerns, and possibly the

bankruptcy of the contractor). If the owner has financed using

funds from a foreign country and is required to repay these funds

with foreign currency, then there is also exposure to exchange rate

risk. While there are several methods the owner can employ to

minimize this exposure, each carries a cost.

 Finally, from the perspective of the contractor, there may be

significant opportunities to diversify risk associated with any

individual project by investing in a varied portfolio of projects. 

If the sources of financial (and construction) risk vary by project

type, geographic region, or some other distinguishing attribute,

then there is opportunity for the contractor to reduce its overall

exposure to risk. The ability to exploit these sources of risk

reduction are largely a matter of size and experience of the

contractor. Effective risk management by the contractor is

relevant to the owner because diversified risk does not require

compensation. Therefore, the well diversified contractor can

afford to submit a lower bid for a project than a contractor who

has not diversified effectively even if both perceive the project's

"own" risk to be the same.

 36

 CHAPTER 4 - SURETY'S RISK ASSESSMENT

 One of the most important questions that an owner will

ask.during the contractor selection process is: "Does this

construction company have the financial strength, managerial

talent, and technical expertise to complete the project

successfully?" Essentially, this question focuses on die risk

exposure to the owner in the event of default of the contractor. 

Since many of the projects financed by government agencies entail

large sums of money and long durations, a contractor failure would

inevitably result in schedule delays and cost overruns. 

Accordingly, an in-depth evaluation of the selected contractor is a

necessary step in risk assessment. Surety, the provider of payment

and performance bonds to the contractor has to answer the same

question before bonding a contractor. So studying the methods that

surety industry use in evaluating a contractor's riskiness can

provide insight into project's risk assessment.
BACKGROUND

 Beginning with the passage of the Miller Act in 1935, the

surety industry became a distinct, yet integral part of the

construction business. The Miller Act requires that every

contractor bidding on work for the Federal Government in excess of

$25,000 be able to provide a bid bond, a payment bond, and a

performance bond (Halpin and Woodhead, 1980). In the past few

years there have been several suggestions that the $25,000 minimum

should be increased to a higher level The Office of Federal

Procurement Policy is studying the possibility of increasing the

threshold for surety bonds and permitting the use of Letters of

Credit in place of bonds (Hancher, et al (1991). These bonds are

obtained from the contractor's Surety Agent. It is the function of

the surety industry to first analyze each contractor applying for

bonding and then to issue the appropriate bonds if it determines

that the risk of failure on the part of the contractor is minimal. 

In essence, the surety prequalifies the contractor for each

particular project. Accordingly, an owner should view the surety

industry as a risk evaluation and transfer mechanism.

 Suretyship is defined as the obligation to pay the debt of, or

answer for, the default of another. It is therefore, a tripartite

relationship. The surety contract binds the surety to guarantee

the obligee (project owner) that the obligor (contractor) will

complete the work as agreed in the construction contract. In the

event of default, the owner has the right to request that the

surety complete the work, or have it completed by another party. 

The surety is liable up to the face value of the performance bond

(Halpin and Woodhead, 1980).

 37

Surety vs Insurance

 Surety professionals are emphatic about the fact that their

industry should not be confused with the insurance industry. There

are many differences between the two groups. For example, the

insurance industry is based upon the assumption that losses will

occur. The probability of events such as hurricanes, fires,

accidents, etc. are determined by actuaries from large populations. 

Premiums are based upon the likelihood of the disaster and their

magnitude, and benefits are paid when a loss is sustained by the

insured. On the other hand, the surety industry carries the

assumption of no losses. According to surety professionals

interviewed for this research, the premium that is charged is

simply perceived as a fee for the extension of credit and for the

prequalification services performed. Suretyship is a lossavoidance mechanism designed to prequalify firms based on their

credit strength. It should be noted that construction company
principals retain the economic risk of contract default by signing

an indemnity agreement, which, in essence, holds the surety

harmless for losses incurred (Bickelhaupt, 1983). Accordingly,

construction bonds are risk-transfer mechanisms that shift the

potential for loss from the owner to the surety. In the event of

an actual loss, the surety can and will try to get its losses from

defaulted contractors. This is perhaps the most profound

difference between insurance and surety as far as the contractor is

concerned.

Regulations

 All surety companies desiring to provide bonding to federally

funded construction projects must attain certificates of authority

from the Department of the Treasury. On July I of every year, the

Department publishes a listing of acceptable sureties in the

Federal Register, Circular No. 570 (1992). This pamphlet lists the

names, addresses, underwriting limitation per bond and locations

(States) in which each surety is licensed. As of July 1, 1992, 279

sureties were approved by the Department of the Treasury. Although

limitations have been established on a per bond basis, the

Department of the Treasury does not set limits on the total face

value (penal sum) that a surety may have outstanding. The bonding

ceilings set forth are not legal maximums, but rather boundaries

below which a surety need not acquire external protection for

itself. That is, ff a surety desires to provide a bond in excess

of its underwriting limitation, it must protect the amount above

the demarcation line with either reinsurance, coinsurance, or other

methods of risk sharing in compliance with Treasury Circular 297

(1978). The Treasury considers these amounts to be an excess risk

(Circ. 570, 1992). According to the responses obtained from our

interviews, surety companies rarely reach their bonding limitation. 

This is due to the fact that being in the risk analysis business,

they recognize that it is preferable to coinsure rather than put

all of their eggs in one basket. On large-scale construction

projects, there is typically more than one bonding company. In

such instances the sureties will form an underwriting group, known

in the trade as cosurety situation. The assemblage will have a

lead surety and prorate the liability in accordance with each

company's participation in the project. The mechanism for risk

sharing between bonding companies is through a written agreement

called a Side Agreement (Bickelhaupt, 1983). Thus, the sureties

spread the risk over large populations and remain within their own

self

 38

imposed bonding limits. These firms generally have internal
bonding ceilings below those published in the Federal Register1.

 An alternative to coinsurance is reinsurance. Reinsurance

occurs when the risk (penal sum) is greater than the level that the

surety may legally assume on one project, or is larger than it is

willing to accept. Essentially, the company will "write the bond

and reinsure the excess liability with other surety companies"

(Bickelhaupt, 1983). As of July 1, 1992 there were eight companies

listed by the Department of the Treasury as holding certificates of

authority as acceptable reinsuring companies for Federal

construction projects. Most of these firms are U.S. branches of

foreign insurance companies. These eight firms are only authorized

for reinsuring, whereas, the 279 other sureties are authorized for

both bonding and reinsuring.

 Seeing that the surety company is essentially extending

unsecured credit to the contractor, it will perform a very careful

analysis prior to making its decision to bond, or not to bond. It

has been found that this yes/no decision is primarily based upon

the credit worthiness and general character of the applicant. 

Inherent risks of the construction project itself are not

fundamental factors in the surety's decision-making process. This

bonding endorsement may be taken on its own merit, or may be used

as a supplement to the owners own contractor qualification

procedures.

SURETY'S PERFORMANCE

 During the mid to late 1980's, the surety industry as a whole,

suffered significant losses from bonding operations (Table 4.1).

Relative to the premiums collected, the combined loss and expense

ratio in 1987 for bonding companies was 127%. In fact, losses have

been so overwhelming that sureties had to hire claims handling

consultants just to keep up with the demand Hancher, et al, 1991). 

Inasmuch as a prime tenet of this business is an assumption of no

losses, it would seem obvious that the assessment techniques

employed are not foolproof. While there may be many reasons why

these net operating losses occurred, it seems plausible that

macroeconomic factors such as the general downturn in the economy,

the new tax laws of 1986, general industrial deregulation during

1980-1987, and the severe budget deficit were the primary factors.

 In addition to macroeconomic and tax factors, the industry

suffered losses in the 80's because there was an emphasis on "cash

flow" underwriting. During this period, sureties were selling as

many bonds as possible with the expectation that the income derived

from investing the premiums at high rates of return would more than

offset underwriting losses. To achieve this goal, the contractor

prequalification guidelines were softened somewhat. As a

consequence, more marginal construction companies acquired bonding,

defaulted, and the bonding companies were
-------------------------

 1Interview with D. McCarter, ITT Hartford, November, 1992.

 39

called upon to meet their obligations. The "cash flow" theory did

not work and therefore, the reimplementation of sound underwriting

ideology has led to better profitability (Russell, 1992).

 TABLE 4.1 - Surety Failure Data (Hinze, 1992)

 Year No. Contractors Failed Liability, $millions

 1945 92 3.6

 1950 912 25.6

 1960 2,600 201

 1968 2,200 323

 1987 6,735 2,387

 During the latter part of the 1980's, the United States

witnessed the disruption of the Savings and Loan Industry, a longterm recession, and an overall weakening of the insurance industry. 

Accordingly, owners would be wise to evaluate the surety company

providing bonding to every project. This may be accomplished by

inspecting "Best Insurance Report, Property-Casualty." Virtually,

all bonding companies are evaluated and rated annually by A.M. Best

Company. This organization publishes a corporate profile and

financial data for each surety company. The surety is analyzed

qualitatively and quantitatively, and then assigned a rating from

A++ (superior) to F (in liquidation). Moreover, it has a Watch

List for those firms which have suffered a decline in their

profitability and/or liquidity parameters since year-end, but not

to the extent that an actual reduction in rating is warranted

(Best, 1992).

 It may be interesting to note that the process of bonding the

contractor as prevalent in the United States is not common in most

other areas of the world. In Europe and many Asian countries, the

owner (in many cases the government) requires a letter of credit

(for example for 10% of the project bid) from the contractor.

THE BONDING PROCESS

 In this section, the surety's methods for bonding decision are

elaborated. Risk items in a construction project can be divided

into two broad categories: contractor related and project related. 
Based on our research, we have found that sureties basically

evaluate contractors. Projectrelated risks are then evaluated with

much less detail. If they feel the contractor is competent, most

of the time they will provide bonds assuming that the contractor

has considered projectrelated and technical risks. In almost all

cases, the surety only considers project characteristics cursorily. 

In other words, they are bonding the contractor and not the

project. Although there is some justification in this approach, one

can expect that in many occasions, the contractor defaults

 40

because of difficulties experienced on the project due to the

nature of the project and the contract It would be interesting to

investigate the reasons for the increasing levels of surety failure

data (Table 4. 1) and to see what portion of these failures are

attributable to project difficulties. We have conducted a survey

to inquire about the surety's current approach. Based on the

responses received, one can say that the surety industry is looking

more closely at the project characteristics and the contract

specifications. The potential losses arising from hazardous

wastes, differing site conditions, stringent liquidated damages

clauses are all cause for concern for the surety. It is

interesting to note that the sureties generally do not employ

technical staff in the field of engineering. Time may come that

they may utilize engineers or at least part-time consultants for

evaluation of complex projects more regularly.

 In a recent NCHRP study (Hancher, et al, 1991) key factors

considered by the surety when evaluating contractors were compiled

by conducting an extensive survey. Although most of these factors

were of a financial nature (such as contractor's working capital,

net worth, and profit history) a major concern was hazardous

wastes. This is clearly a project-specific issue and analyzing

cases of this nature require that the surety utilize knowledgeable

technical personnel. It is common for the surety to hire a

technical consultant to perform pre-default and post-default

investigation of the contractor (Schwartzkopf, et al, 1990). It

may be reasonable to use engineering expertise to evaluate the

technical difficulties of the project in more depth when deciding

to bond a contractor.

Contractor Related Risks

 In order for a contractor to be approved for bonding, a surety

will evaluate what is known as the three C's: Character, Capacity,

and Capital. Character relates to the assessment of a contractor's

track record, including its reputation. Capacity answers the

question of how much work can a company produce, given its current
resources. Capital is an analysis of a contractor's financial

condition. Each of these categories will now be examined in

greater detail.

Character: Character can be described as the corporate personality. 

Specifically, the surety will look at such items as whether the

contractor has ever been involved in fraudulent activities, been

engaged in price fixing with other bidders, been debarred from

bidding on any government contracts, declared bankruptcy, is prone

to excessive litigation, has not lived up to quality or schedule

agreements, or has ever failed to finish a project. The surety

will investigate the contractor's integrity by asking for

references from suppliers, subcontractors, clients, and

professional contacts. It will inquire about the contractor's

ability to live up to its word, how it conducts normal business

activities, and whether it performs administrative duties in a

timely manner.

 During the past decade sureties have been carefully

scrutinizing the amount of work that is classified as underbilled. 

It was determined that large unrecognized losses were being placed

into the wrong account and thereby avoiding the scrutiny of the

surety examiner. Sureties currently

 41

perform even closer inspection of corporate accounting practices. 

In fact, they will go so far as to evaluate the qualifications of

the C.P.A. preparing the contractor's' financial statement

(Russell, 1992). Other issues that the surety is likely to be

interested in are potential and pending law suits and any tax liens

on the contractor's property[goto pg. 42].

 Bonding companies are also interested in the ability of a

contractor to remain in business in the event of the death or

disability of a principal during the projected duration of the

project. In addition, if a construction company suffers from the

loss of a key individual, the surety will want assurances that the

business will have a stable (or at least well planned) transition. 

The surety will review the company's organizational chart to

determine whether the individual who is next-in-line is capable of

fulfilling the leadership position.

Capacity: Capacity is related to the amount and nature of

resources needed to efficiently complete current work in progress

plus work starting in the near future. Resources include company

management, project management, labor, material, equipment, and
financial reserves. With respect to company management, a surety

will first analyze how well previous projects have been

administered. Specifically, they will evaluate the experience and

education of the personnel involved with estimating, their track

record with this company, the spreads on project bids, who

determines the amount of profit to be added to project costs, and

what controls are in place for the estimating system. The surety

will consider contractor's job-cost monitoring system, as well as

the ability to process paperwork such as change orders and pay

requisitions (Russell, 1992).

 Corporate practice on the dealings with subcontractors is an

important concern of sureties. This concern is focused on the

amount of work that the contractor "subs-out," whether these

subcontractors are required to be bonded, and how well the

subcontractor is monitored and controlled. Sureties that are to

bond the general or prime contractor perceive far less exposure to

themselves when the subcontractors are bonded. For example, if the

total project cost is $100 million, and the prime contractor will

perform $20 million worth of work, and bonded subcontractors will

execute the remaining $80 million, then the bonding company for the

prime contractor will only be exposed to $20 million in damages. 

Accordingly, it will be more likely to approve the bonding request

than if no subcontractors were bonded. It should be noted that in

the above example, the prime surety will still issue a bond for

$100 million and charge the appropriate premium to its client.

Since sureties are legally permitted to bond both the prime and

subcontractors for a particular project, the potential exposure to

the surety will vary with each individual situation. When a surety

decides to bond both the prime and a subcontractor, the process is

known as double-dipping3.

----------------------------

 2Interview with Joseph Philips, Safeco, December, 1992.

 3Interview with D. Hixon, Reliance Insurance Co., Nov., 1992.

 42

 An aspect of corporate management that demonstrates the

ability to identify and correct weaknesses, and to improve

strengths, is business planning. A surety will determine whether a

contractor has attempted to improve current shortcomings, whether

he has assessed the market and his competitors for future

opportunities, and if he has generated pro forma financial

statements. Moreover, the bonding agent will study the planning

that has been put into future operations. What type, amount, and

risk factors are involved with the companies' desired work? Does

the company have plans to open regional offices in new locations?
To what extent has the connector established or increased bank

lines of credit to achieve these goals (Russell, 1992).

 One of the major techniques for measuring the ability of

financial managers is to study cash flows. With a depressed

economy, sureties are taking a closer look at the aging of accounts

receivable. If a high percentage of accounts are in the over 90

day or over 120 day category, then the probability for bad accounts

will be greater. Furthermore, the bonding agent will review

whether the contractor has the ability to regulate his overhead

expenses in conjunction with the vacillations in the economy4.

 In a broad sense, the managerial capacity of a construction

company is determined by its track record over the last three to

five years. Normal items to evaluate are the number of completed

jobs, the project locations, the project types, duration of each

undertaking, contract amount (both bid and final), and gross profit

(both bid and final). With the data for company and project

management in hand, the surety is able to identify the

corporation's managerial capacity. This information is then

combined with work in progress to determine whether additional jobs

can be managed properly.

 Labor resources are carefully analyzed because of the labor

intensive nature of the business. An investigation into the

availability and character (union vs open shop) of workers is

critical. If the project is to transpire in a unionized area, then

the aggregate of laborers being employed at other projects will

impact the availability of workers for the proposed undertaking. 

It is recommended that the current union contract be reviewed for

items which may adversely effect future endeavors.

 As a matter of standard procedure, sureties will study the

type, quantity, and availability of construction equipment in the

contractors possession. The agent will inquire about maintenance

schedules and repair facilities. In addition, the method for

determining depreciation and equipment rates will be requested. 

Finally, the bonding company will want to learn of any proposed

equipment purchases or leases so as to determine the impact on the

bottom line.

 Sureties are interested in what materials will be used on a

particular project to the extent of the potential impact on

profitability. This concern is bilateral. First, any materials

which are on the critical path and subject to potential delays in

delivery may subject the contractor to

-------------------------

 4Interview with D. Hixon, Reliance Insurance Co., Nov., 1992.
 43

liquidated damages. Second, any material prices linked to some

index (such as asphalt being tied to crude oil) will create an

extra risk in terms of cost instability (Russell, 1992).

Capital: Capital, the third C, entails a thorough analysis of the

contractors financial condition. In order to perform a proper

evaluation, the surety will generally request three years of

financial statements. This information is studied for the quality

of the data contained and then is analyzed for a comparison to

industry standards. Of the four gills of certified public

accountant's opinions that could be attached to the statement, a

surety will prefer to see an unqualified opinion. An unqualified

opinion will declare that the auditor's examination as well as the

statements themselves, were properly prepared and presented. With

reference to the accuracy of the data itself, the bonding company

is most comfortable with an audited statement An audited statement

is generated when the contractor's C.P.A. applies extensive

procedures to verify that the underlying data is in fact correct,

and that it has been presented in accordance with generally

accepted accounting principles. Sureties prefer income to be

recognized by a technique known as the percentage of completion

method. This procedure requires the contractor's CPA. to make an

estimate of what percent complete each project is on a certain

date. This percentage is then multiplied by the anticipated total

project estimate to calculate the value of completed jobs. Thus,

income is recognized as work progresses. The advantage of this

tactic is that it provides the best correlation between income to

expense (Russell, 1992).

 Finally, sureties will make an evaluation of the accounting

firm that prepared the financial statements for the contractor. If

the organization is perceived by its peers as being highly

professional and objective, then the surety will take the

statements at face value. However, ff the accounting company has

some flaws in its reputation, then the bonding analyst will inspect

the report with a bit of concern5. Subsequent to the financial

statements being evaluated for quality, the surety will proceed to

perform a financial analysis on the data itself. A summary of

ratios typically employed by bonding companies is presented below.

Financial Ratio Analysis: One of the most common techniques

employed by the surety industry to identify sources of potential

risk is the analysis of the contractor's finances. The primary

objective of this analysis is to identify irregularities in a

financial statement that need further study to fully understand a

company's current and future standing. Important insights into a
firm's performance can be secured using financial ratios. Analysts

typically evaluate a firm's ratios by two methods: first, they will

compare a specific company's standing to industry norms, and

second, they perform a trend analysis.

 Financial rating agencies such as Robert Morris Associates and

Dun and Bradstreet annually publish information regarding the range

of various ratios for different industries. The financial rating

community has segmented all businesses into hundreds of specific

industry groups. For

-------------------------

 5Interview with D. Hixon, Reliance Insurance Co., November, 

 1992.

 44

purposes of this report, we have chosen Group No. 1622 of the

S.I.C.(Securities Industry Classification) groups tided "Bridge,

Tunnel, and Elevated Highway Contractors." Table 4.2 contains

median and average values of different financial ratios discussed

in this research. A surety underwriter may compare ratios

generated for a contractor to the norms reported for this group in

order to determine the contractor's relative position. If several

ratios for the contractor fall below his peer group, then the

underwriter will perceive high risk and possibly deny bonding.

 Trend analysis is another method for evaluating the

contractor. The underwriter will evaluate the trend of a firm's

ratios for the past few years relative to the industry. If the

contractor's trend is upward (or at least better than the industry

trend), then an indication of sound management is evident. 

Accordingly, it may be a less risky situation for the surety.

 For purposes of ratio analysis, a surety may look at four

groups of financial ratios, namely, Liquidity Ratios, Operations

Ratios, Leverage Ratios, and Profitability Ratios. These ratios

are briefly discussed below.

Liquidity Ratios: The goal of liquidity is for an organization to

have sufficient funds on hand to meet short-term (within one year)

obligations when they become due and to have sufficient cash for

emergencies. The most common ratios used for evaluating liquidity

are the Current Ratio and the Quick Ratio. The Current Ratio is

determined by dividing current assets by current liabilities. 

Current assets are defined as cash, short-term investments, notes

receivable, accounts receivable, merchandise inventories, and

prepaid expenses. Current liabilities are all liabilities that are
due within one year.

 Current Assets

CURRENT RATIO = ------------------------------

 Current Liabilities

 The Current Ratio is commonly used as an indicator of a firm's

liquidity and ability to settle short-term debts. A careful

analysis must be made as to the quality and constituents of each

contractor's current assets and current liabilities. Oftentimes a

surety will ignore the total current asset category given in a

financial statement, and create its own new current asset total

after a thorough examination of the underlying data (Needles,

1989). The higher the ratio, the more assurance exists that the

retirement of current liabilities can be made (Duns, 1991). A

Current Ratio of 1.5 or greater is considered favorable in the

construction industry (Clough, 1986).

 One of the shortcomings of the Current Ratio is that it does

not consider the composition of current assets. Since these items

may be received or converted into cash within one year, some cannot

be readily used to pay bills. For example, a dollar in cash is

much more liquid than a dollar of inventory. Therefore, the Quick

Ratio adjusts for this fault by measuring short-term liquidity. 

The Quick (or Acid Test) Ratio is cash plus marketable securities

plus cash equivalents, all divided by current liabilities.

 45

Click HERE for graphic.

 46

 Cash + Cash Equivalents + Marketable Securities

QUICK RATIO = ---------------------------------------------------

 Current Liabilities

 A Quick Ratio of less than 1.0 indicates that current

liabilities may be becoming dependent upon inventory or other

current assets for payment While a relatively high Quick Ratio is a

sip of security for creditors, if excessive, it will signal a low

return on current assets.

Operations Ratio: Operating abilities are evaluated by the ratios

of Receivable Turnover, Average Days Sales Uncollected, Equity

Turnover, and Working Capital Turnover. Receivable Turnover
measures the relative weight of a firm's Accounts Receivable and

the contractors ability to collect credit sales in an efficient

manner. It is a reflection of the companies credit and collection

policies. It is indicative of how many times, on average, the

Receivables were converted into cash during the year. This ratio

is calculated by dividing net credit sales by average accounts

receivable. An average of two consecutive periods will provide a

better picture of Accounts Receivable than only one period. This

will help to smooth out the variations that tend to occur within

the year.

 Net Credit Sales

RECEIVABLE TURNOVER = -------------------------------------

 Average Accounts Receivable

 A more understandable way of looking at this data is to

calculate Average Day's Sales Uncollected. This ratio expresses

the waiting period, in days, before an average payment is received. 

It is computed by dividing the number of days in a year by the

Receivables Turnover.

 365

AVERAGE DAY'S SALES UNCOLLECTED =------------------------------

 Receivables Turnover

 In construction, this period is usually the amount of time

between the date the contractor bills the owner and the date that

he receives payment.

 Sureties measure how hard a firm's invested capital is working

by calculating the Equity Turnover. This ratio is determined by

dividing net sales by tangible net worth.

 Net Sales

EQUITY TURNOVER = --------------------------

 Tangible Net Worth

 Working Capital Turnover is a measure of the degree of safety

for current creditors. It is a gauge of the firms proficiency in

financing current operations. Specifically, it reflects how

efficiently working capital is used. This ratio is calculated as

follows:

 47

 Net Sales

WORKING CAPITAL TURNOVER = --------------------------------------

 Current Assets - Current Liabilities

Creditors compare this ratio with that of industry averages and
company historical data. An unusually low ratio may be indicative

of poor use of working capital, while a high ratio will signal

overtrading. This ratio must be viewed in conjunction with other

ratios (Current Ratio, for example). Sluggish sales and an

extremely thin Working Capital position will still provide a high

Working Capital Turnover Ratio.

Leverage Ratios: Leverage ratios gauge the amount of debt pressure

and the susceptibility of the company to downturns in the economy. 

Of highest importance is the Debt to Equity Ratio. This measures

the proportion between capital lent by creditors and capital

invested by owners. It is indicative of the degree of safety

provided to the creditors by the owners. A company with a low

ratio will have a far better chance for long-term survival than a

company with a high ratio. The calculation is as follows:

 Total Liabilities

DEBT TO EQUITY RATIO = --------------------------

 Net Worth

A firm with a high Debt to Equity ratio is said to be highly

leveraged and will generally find it difficult or costly to borrow

additional funds. Values ranging from 1.0 to 2.0 are generally

deemed acceptable to creditors (Clough, 1986).

 To measure the proportion of the capital invested by the

owners that has been reinvested in fixed assets(land, buildings,

equipment), the ratio of Fixed Assets to Tangible Net Worth is

computed. Essentially, this ratio expresses the degree of safety

to creditors in the event of bankruptcy. A low ratio is preferred

by creditors. The computation is as follows:

 Net Fixed Assets

 ---------------------------

 Tangible Net Worth

Potential creditors will generally check the amount of equipment

that the firm has leased since such arrangements will lower the

ratio. Since some leased equipment does not appear on the balance

sheet an analyst must pay extra attention to these items.

Profitability Ratios: A contractor's long-term solvency is

contingent upon its being capable of earning satisfactory income. 

An analysis of a contractor's prior profitability may help to

predict the future profit margins. Creditors look at profitability

because it also affects a firm's liquidity. The greater the

profitability, the greater will be the firm's ability to settle

short and long-term debts. The three primary ratios used to

evaluate profitability are: Profit Margin, Return On Assets, and
Return On Equity.

 48

Profit Margin is determined by dividing net income by net sales.

 Net income (after taxes)

PROFIT MARGIN = ------------------------ X 100

 Net Sales

it is a measurement of how much income is produced by each dollar

of revenue. The greater the value of this ratio, the better. If

the trend of this ratio is upward, then a surety will be more

likely to approve a bonding request.

 Return on Assets is the best gauge of the overall earning

power of a company. It quantifies the amount of money earned on

each dollar of assets employed. The return on assets is determined

by dividing net income (after taxes) by average total assets.

 Net Income (after taxes)

RETURN ON ASSETS = -------------------------- X 100

 Average Total Assets

It is considered to be an outstanding measure of profitability

because it blends the Profit Margin and Equity Turnover ratios

(Needles, 1989).

 If the contractor is organized in the form of a corporation,

an important measure of profitability is Return on Equity. This

ratio determines how much money was generated for each dollar that

was invested by the owners. It is computed by dividing net income

(after taxes) by net worth.

 Net Income (after taxes)

RETURN ON EQUITY = ----------------------------

 Net Worth

Its distinguishing characteristic from Return on Assets is that it

will vary in accordance with the amount of debt that the company

has. If the money generated from borrowing earns more than it

costs, then Return on Equity will increase at a greater rate than

Return on Assets. A novice to financial analysis should use this

ratio with caution. A high ratio would seem to indicate that

management is effective, but it is possible that a high ratio

reflects an overreliance on debt.

 While there are many ratios available for analysis of

financial statements, the foregoing are the most commonly used by

surety professionals. Each ratio must be evaluated in light of
industry averages and the contractors historical values. Moreover,

the data employed in the ratios is often re-classified by

underwriters to fine tune their evaluation. For example, goodwill

will be eliminated from the asset account because it cannot be used

to satisfy debts. Certain inventory items will be eliminated if

they cannot be sold within a reasonable amount of time. Slow

Accounts Receivable and Notes Payable to officers or owners will be

discounted for similar reasons. The surety companies that we

interviewed did not take similar approaches to ratio analysis. 

While some worked with these ratios intensely, others emphasized

their relationship

 49

with and knowledge of the specific contractor requiring bonds. The

quantity, type, and relative weight of the ratios employed varied

from surety to surety.

 The one thread that joins all bonding companies in contractor

analysis is that they are interested in the contractors ability to

satisfy losses quickly. If a contractor does not appear to have

the capability to rapidly settle claims upon default, then the

surety will most likely decline the bonding request. Also what

surety perceives to be acceptable ratios would vary from contractor

to contractor depending on their past performance and capabilities. 

For evaluating certain contractors some of these ratios are more

critical. For example, ff the surety wants to bond a

subcontractor, it will analyze receivables carefully as there would

be some concern about how soon the subcontractor would be paid for

the work performed. Debt to Equity Ratio seems to be very

important to some sureties as it would indicate the contractor's

financial stability and strength. Table 4.2 summarizes the trends

of the above financial ratios for the group of constructors

classified as Bridge, Tunnel, and Elevated Highway Contractors.

Contractor's Bonding Capacity: After a surety has evaluated the

three C's of a construction company, it will proceed with a

determination of the contractors bonding capacity. As a general

rule-of-thumb, the bonding limit will be the contractor net worth

times 10 to 20. Alternately, capacity may be determined by summing

cash and accounts receivable and then multiplying the sum by 20. 

These multipliers will vary from surety to surety.

 The surety will test to see whether the contractor has

sufficient bonding capacity remaining to take on the work. 

Remaining bonding capacity is calculated as follows:

 Remaining Bonding Capacity = Maximum Total Bonding Capacity -
 (Total Jobs + Total Bids Pending - Work Completed to Date

 on Jobs)6

It should be noted that the contractor's backlog may not be all

bonded (private projects for example). Despite this, all the

contractor's projects will be included in the formula given above.

Project-Specific Risks

 Prior to bidding on a job the contractor informs the surety

agent about its decision to bid on a project. The surety will

evaluate each proposed project individually. Among the project

characteristics that will be examined will be the following:

 - contract price

 - contract type

 - nature of the project

-------------------------

 6Interview with D. McCarter, ITT Hartford, November 1992.

 50

 - contract duration

 - liquidated damages clauses

 - retainage provisions

 -insurance coverage

 - potential for exposure to hazardous wastes

 - the amount of soil and underground related activities, such 

 as tunneling, pile driving, and steel sheeting

As can be seen items enumerated above are mainly project-related

issues. The surety should be comfortable with the contractor's

three C's to provide the bid bond. The surety will also check the

contractor's remaining bonding capacity by considering the

contractor's backlog to ensure that by bonding the contractor for

this project, the capacity limit will not exceed. This process was

described earlier. The face value of the bid bond will vary

between 5 to 20 percent of the amount of bid. The surety may

provide the contractor with the bid bond. The owner's

understanding would be that the surety will be providing the

payment and performance bonds if the contractor turns out to be the

low bidder (Halpin and Woodhead, 1980). Despite this expectation,

the surety is not committed to providing performance and payment

bonds. If the contractor is awarded the project, then the surety

may issue the remaining bonds prior to the start of construction. 

When the award is made, the governmental agency securing the work

will announce the bid values of all competitors. The surety that
provided the bid bond to the winner will have an interest in these

figures. In the event that the lowest bid is below the second

lowest bid by a large margin (for example by more than 10%

according to Russell (1990), but this figure will vary from surety

to surety) the bonding company will inquire why their client's bid

was abnormally low. The surety is concerned that the contractor

may have erred in his estimate and that he may be subjecting

himself to financial losses if he takes on the work. If no

reasonable explanation is given by the contractor, then the surety

may decline to provide the performance and materials bonds7.

 Surety companies are interested in the type of contract that

will be formed between the contractor and the owner. They are most

comfortable with conventional fixed price competitive and

negotiated cost plus contracts because these formats have been

thoroughly tested by the courts7. In recent years, design-build

and turnkey contracts have gained some acceptance by government

agencies. Section 3019 of the Federal Transit Act Amendments of

1991, incorporated into the Intermodal Surface Transportation

Efficiency Act (ISTEA) defines Turnkey as "A project under which

recipient contracts with a consortium of firms, individual firms,

or a vendor to build a transit system that meets specific

performance criteria and which is operated by the vendor for a

period of time" (Luglio, 1992). Turnkey contracts are riskier than

the conventional contracts because in turnkey the contractor will

be responsible for both design and construction. in fact the

contractor has to commit itself to a fixed price at a stage when

the design is incomplete and the scope is not perfectly clear. 

While this contracting strategy may prove to be an effective mode

for risk sharing between contractors and owners, it is viewed with

a bit of skepticism by the

-------------------------

 7Interview with D. McCarter, ITT Hartford, November, 1992.

 51

surety industry. This is due to the fact that it is a novel

approach with many unknown outcomes that could seriously harm the

surety.

SUMMARY

 In this chapter we reviewed the surety industry as it relates

to public works construction contractors. First, we provided

information about the surety industry and how it differs from the
insurance industry. We then provided some background on surety's

performance in the past decade. Surety's main concern is an

accurate assessment of the probability of the contractor's failure

and its main objective is to either accept or to decline to provide

bonds to the contractor. In this chapter we have elaborated on the

methodologies and procedures used by the surety in order to arrive

at the decision of whether to bond or not to bond a contractor. 

Contractor's financial health, character, capacity, the volume of

backlog, the type of work performed in the past and its future

plans all play a role in surety's decision. Typical financial

ratios analyzed by the surety are also covered. Although the

surety does not formally evaluate the project risks and complexity,

its approach in evaluating the contractor is valuable. As can be

observed from the checklist provided in this report, many of the

risk items contributing to the project uncertainty are related to

the contractor. Surety's approach can be useful in developing or

improving procedures for contractor prequalification. Because of

decades of the surety's experience in this process, we think that

familiarity with their approach will be beneficial to the sponsor

or the owner of capital intensive transit projects.

 52

 CHAPTER 5 - RISK MODELING AND ASSESSMENT

 This chapter deals with the issue of risk modeling and

measurement. In order to quantify the impact of risk one needs to

develop a logical model for risk measurement. This model should be

used in conjunction with the identified risk items described

previously in this report. Two major approaches to risk

measurement are covered: deterministic approach and probabilistic

approach. Most of the concepts presented are described using case

studies and examples.

 Keeping projects on time and within budget are two of the most

important functions of project management Estimates of project cost

and duration are based on the knowledge of the estimators and

schedulers, experience and data from similar projects completed

previously, and a large number of assumptions made regarding

productivity rates and material prices.

 Almost every project component that consumes time and/or money

is prone to some chance variations. Some items such as material

prices, when a vendor has guaranteed his prices, have a lower

chance of variability. Other items such as various labor

productivity rates that can be sensitive to many factors such as

weather, temperature, state of economy, unions involved, and
location, have a much higher chance of variation and can impact the

project duration and cost. Risk measurement and analysis, at least

in the context of this report, is the process of developing a

logical vehicle for predicting the extent of these variations and

possibly forecasting the worst case and the best case scenario for

the project budget and schedule.

OWNER'S RISK

 Almost every party involved in the project needs to perform

its own kind of risk analysis. While the owner has to look at risk

issues at a more macro or aggregate level, the contractor would be

wise to consider chance variations at a more detailed level. The

owner, public or private, needs to assess the amount of uncertainty

in the project cost and schedule in order to make plans for seeking

project funding. Multi-year megaprojects are particularly

sensitive to variations in project duration. The cost of money

needed to finance these projects become prohibitively high as the

project duration increases. Because of these issues, financial

risks become of paramount importance to the owner. If the sponsor

is the Federal government, legislative issues such as funding

authorization and appropriation have to be considered also. 

Sources of funding and its composition, the commitment and

reliability of local sources, the accuracy of estimating funding

levels over project life, and the probability of project failure

due to optimistic assumptions all add to the project's financial

risks. The owner should also concern

 53

itself with the contractor selection process, the stability and

strength of the contractor in executing a large transit project,

and expected loss levels in case the contractor fails to complete

the project. Even if the contractor does not default, the owner or

the sponsor (for example, FTA funding of a transit project) has to

evaluate the probability and the potential loss in the case of

project delay and cost overrun.

CONTRACTOR'S RISK

 The traditional contractor on the other hand, looks at a

project's risks from a different angle. Although financial risks

are very important and the contractor would want to be sure that

the owner has sufficient funding to finance the project, he will be

concerned with the amount of funding that would be needed for

interim financing. Interim financing fills the gap between the

contractor's spending and income in a project. The smaller this
gap, the less expensive it would be to finance the difference

between the contractor's expenditures and progress payments. The

cost of interim financing cuts through the contractor's profit

margin and because of this the contractor should carefully study

the expected levels of needed financing. Also, with the emergence

of innovative contracting arrangements, contractors have been asked

to provide financing for some public projects. For example, on

several new correctional facilities, the contractor has been asked

to finance, design, and build the facility. In some recent transit

projects, the contractors were required to come up with financing

schemes. If this trend continues, many of the major construction

companies have to start looking at project's financial risks in

much the same way as a private owner. Also the contractor needs to

pinpoint areas of risk and uncertainty in the project and assess

the impact of those areas on the project cost and duration in order

to include a reasonable contingency in the bid, especially in

competitive lumpsum contracts. Careful evaluation of this

contingency is important. A low estimate of the required

contingency may get the contractor the job but may cost him dearly

after the project starts as the time and cost variations may

develop an unfavorable impact on the project. A high or

conservative estimate of contingency on the other hand, will put

the contractor at a disadvantage because his bid may not be

competitive enough to get him the job.

TURNKEY

 Recently, there has been a renewed interest in turnkey

projects at the Federal level. Department of Transportation has

started implementing pilot projects using a fixed-price turnkey

approach. Turnkey has several benefits from the owner's point of

view. Because the con gets involved in the design phase, he can

bring the construction expertise to the design team. This will

hopefully make the project more constructable. The concept of

constructability has been the focus of considerable research in

private industrial construction (Constructability, 1986). 

Constructable projects are easier and more economical to build. 

More recently, attention is also being paid to building the

projects in a way that they would be easier to maintain. Again,

having the constructor's feedback during the design phase helps in

project's long-term maintainability. Another important advantage

of turnkey project is that it reduces the possibility for the

 54

contractor's claims for the changed conditions because the

contractor was responsible for design. This will help to keep the

project's estimated budget on target. Moreover, the owner will be

able to establish a firm estimate of the required budget much
sooner as the con r will have to commit itself to a fixed-price

before the final design is complete. For example, on the Honolulu

Transit Program, the contractor submitted a hard-dollar estimate at

the end of the Conceptual Design phase (FEIS, Honolulu, 1992). So

the sponsor and the local agency had a cost estimate several months

sooner compared to the case where the project has to go to bidding

with a complete design. For various phases of a capital transit

project development and their typical duration refer to Project

Development Process, FTA (undated) (Figure 5. 1).

Click HERE for graphic.

 Turnkey advantages come at a price. The contractor that has

to bid on a project after the Preliminary Engineering or even at

the end of Alternatives Analysis phase will increase the

contingency accordingly to protect itself in case the project

design and construction do not proceed as expected. As Figure 5.1

shows, in earlier phases of the project life cycle, uncertainties

regarding project cost and duration are larger. The owner pays for

these contingency sums whether they are actually being used or not. 

Based on the foregoing discussion, it is clear that

 55

depending on who is interested in risk analysis, the objective may

be different but the general approach is the same; i.e., identify

areas that are prone to uncertainty and develop a model that can

predict the combined effect of these areas on the project's budget

and schedule.

APPROACH

 There are two general approaches to evaluation of variations

of project components. Some approaches are based on some

deterministic safety margin for critical items based on expertise

of the seasoned personnel or historical data compiled from similar

projects. In some cases these deterministic methods tend to work

well because of the nature of the available data and the experience

of the analysts. For example, in many cases a well-designed

sensitivity analysis is all that is needed for assessing the risk

impact on a project. Other approaches are based on some

probabilistic model where the variability of important parameters

are formally introduced into the predictive models. With the

recent developments in risk analysis software and the increasing

familiarity of engineers and analysts with probabilistic approach,

we feel that it is time to use these methods much more extensively. 
The probabilistic method provide the user with much more

information compared to deterministic method and helps the user

make informed decisions as will be described in this chapter.

1. DETERMINISTIC APPROACH

 In the deterministic approach, the potential cost overrun for

the project is estimated based on the experience of the personnel

and all the information that can be obtained from similar projects

and the project under study. It is common to see a contingency

rate of around 10% added to the total project cost in order to cope

with project uncertainties. This approach, especially if taken by

the owner can lead to problematic results. Pickrell (1990)

suggests that the contingency funds used for Federally funded

transit projects seem to be insufficient The contingency for

projects studied by Pickrell ranged from 5% to 15%.

An Overall Contingency Rate

 The contractor bidding on traditional contracts based on final

design, is anxious to become the lowest bidder. He may anticipate

that his contingency may not be sufficient but he knows that he may

count on changes, considered to be inevitable in the traditional

lumpsum contracts. No matter how much time is spent on design and

scope definition, there is always the possibility that the

contractor may be able to claim some changes and to receive

additional reimbursements. The price of changes are arrived at on

a non-competitive basis and can be higher than what the owner

expects. In the interviews conducted with contractors for this

research, it became evident that many contractors bid on several

projects anticipating that they may lose money on some contracts. 

Their main objective is to be able to earn an acceptable rate of

return on the portfolio of the projects that they are executing. 

If based on years of experience, they feel that a 10 or

 56

15% contingency is appropriate for maintaining their profitability

and their success in obtaining the jobs, then they see no reason

for changing that. Also, most of the estimators consider many of

the risk elements (listed in the risk checklist in this report)

while preparing the detailed estimate for the job. So by the time

the estimate is complete, it y includes certain allowances for

contingency. The contractor will be well-advised not to take this

approach especially on turnkey projects where his chances of

obtaining change orders are small. It is also clear that this

approach cannot be utilized by the owner or the sponsor of a public

project.
 There are several reasons for the owner to calculate

contingency using a systematic approach to risk identification and

assessment. Many times the contingency rate is added arbitrarily

and not without elaborate analysis. Also, some risk elements are

counted twice as they have been considered in the estimating phase. 

Adding an overall contingency rate only considers the potential for

loss as it increases the project costs. It many cases though, the

probability of underrunning certain cost elements is reasonably

large and has to be incorporated into the model (Hayes, et al,

1987). Furthermore, often it is not clear that the contingency

gives the expected value of cost overrun, the most likely value of

the cost overrun, or the worst case scenario for the project cost. 

The likelihood of arriving at a certain project budget cannot be

assessed with this method. Even if its definition is clearly

given, still the owner may not be able to decide on the actual

level of reserve funds. For example, is it reasonable to provide

for the worst possible scenario and hence possibly jeopardize

project's viability when the probability of realizing such a cost

is extremely low?

Assigning Various Contingency Rates to Different Project Components

 A more reasonable approach is to identify major risk elements

in the project and assign reasonable contingency rates to these

various items. These contingency rates may not be the same from

area to area. For example, in a transit project, the planner may

assign a 15% contingency rate to the cost items that relate to

underground construction and a 10% contingency rate to the budget

for train purchase. The total contingency budget will be the sum

of the products of the individual contingency rates and respective

component estimates. This approach has the added benefit of

earmarking contingency budget for various project components. This

will allow for a more efficient contingency drawdown policy and can

alert the management if a certain component is using too much of

the reserve funds. In these approaches it is important that costs

be estimated as realistically as possible. In other words, based

on the information at the time of preparing the estimate a fair

cost of the component should be calculated without trying to

safeguard against risk elements. The impact of uncertainty shall

then be considered when arriving at the contingency rates by

carefully evaluating the risk checklist and drawing upon the

experience of the people involved in the project and historical

data from similar jobs.

Case: One example of using weighted averages in calculating

contingency rate is the ongoing Central Artery/Third Harbor Tunnel

Project in Boston. In this multi-billion dollar project, the owner

has assumed responsibility for a number of risky components of the

project. This will discourage bidders from inflating their bids

with large contingencies. The owner will pay for
 57

project risks only if they actually happen. The total project has

been broken down to several construction packages or subprojects

and are bid separately. seven areas of risk have been identified

for each subproject. These areas include 1) design difficulty, 2)

geological conditions, 3) joint occupancy of site, 4) schedule

constraints, 5) project duration, 6) economic stability and

escalation factors, and 7) urban environment. Contribution of each

of these seven areas to the total project cost risk have been

assessed and range from 5% to 30% (Table 5.1). The project has a

12% contingency budget not including cases where the owner expects

several change orders will be issued due to the nature of the work. 

For each subproject, a group of the owner's experts evaluate the

severity of each of these seven areas and assign a weight to each

area ranging from 0 to 0.12. For example, if the contractor on a

specific subproject is faced with several milestone dates on the

critical path in a relatively short duration project where the

staging and sequencing of the operations are assessed to be very

critical, then a value close to 0.12 is assigned to the area

schedule constraints. On the other hand if the same subproject has

a duration of less than one year then the escalation factor is

assumed to be ). The product of these assigned values and their

respective area weights are summed up to give the total contingency

for the subproject (Instructions, Construction Contract Risk

Analysis, 1992).

 Table 5.1 shows a contingency analysis for a hypothetical

construction contract. Column (2) gives the percent contribution

of each risk area to the contract contingency. The range of values

in the "weight" column is 0 to 0.12. The owner's experts have

established a contingency budget of 8.35% of the total bid price

for this contract. As can be seen, geological conditions and

schedule constraints (probably several milestones in a tight

schedule) are high risk areas while other areas seem to be of

average difficulty. The owner will only expense this fund if

necessary. The contractor on the other hand, is protected against

these seven risk areas and he will not add these in his bid,

resulting in a lower bid.

 TABLE 5.1 - Construction Contingency Assessment

 (1) (2) (3) (4)

 Area Percent Weight Value

 Contribution (2)x(3)

 1. Design difficulty 25% 0.05 1.25%

 2. Geological conditions 30% 0.12 3.6%
 3. Joint occupancy of site 15% 0.06 0.9%

 4. Schedule constraints 15% 0.12 1.8%

 5. Project duration 5% 0.04 0.2%

 6. Escalation 5% 0.06 0.3%

 7. Urban environment 5% 0.06 0.3%

 TOTAL 100% 8.35%

 58

Schedule Contingency

 Project cost and schedule are interrelated. Pickrell (1990)

shows that on several transit projects investigated, major portions

of cost overruns were attributable to project delays. Given the

shear size of transit projects and large amounts of financing

required, project delays drive up the cost of money drastically. 

Setting realistic objectives for project milestones and the

completion date is one of the first steps in calculating the

project financial needs. The project financial needs in turn impact

the budget and the cost contingency. A logical approach in

schedule risk analysis is to refer to a carefully developed CPM

schedule. Through the CPM one will be able to see the

interrelationships between various elements of the project and to

evaluate the impact of an activity delay on various milestones and

the completion date.

 The schedule for the owner/sponsor will be different from the

contractor's schedule in that it will encompass planning and design

phases in addition to the construction phase. Reasonable

contingencies can be built into project schedule in terms of floats

for various milestones. The larger the amount of these floats and

the smaller the number of milestones that carry liquidated damages

clauses, the less risky the project from the constructor point of

view. Including stiff liquidated damages in a tight schedule with

several milestones will result in bids with high contingencies. An

important benefit of using. CPM schedule is that it ranks

activities (or the project components) according to their impact on

project milestones and the final completion time. The activities

that have higher floats are less likely to create schedule delays.

2. SENSITIVITY ANALYSIS

 Sensitivity analysis can and should be applied to both

deterministic and probabilistic approaches in risk measurement. 

The basic principle is to vary a certain cost or schedule parameter

while keeping other parameters fixed and to study the impact of

this change on total project cost or schedule. In other words,

sensitivity analysis lets the analyst perform "what if' scenarios. 
For example, in a financial risk analysis, one may not be sure

about the interest rate promised on revenue bonds that are going to

be issued for a transit project. Let us assume that the interest

rate may be anywhere from 5 to 7 percent. The financial

spreadsheet can be analyzed several times, every time changing the

interest rate by 0.25%. The analysis has to be performed 9 times

and every time the impact on the total project cost can be

evaluated. In every scenario it is assumed that the parameter

takes the value assumed in that specific case. So although the

effect of the parameter on the project can be evaluated, there is

no information regarding the likelihood that the parameter takes

such a value. For example, there is no indication that with what

probability the interest rate will be 5%.

 Sometimes it is convenient to use a spider diagram (Hayes, et

al. 1987; Toumn and Ladick, 1989) to show the impact of variations

of several parameters on total project cost (or viability). Figure

5.2 shows a simple spider diagram prepared for a hypothetical

tunneling project. It shows the effect of varying labor rates, TBM

down-time and groundwater inflow on the total cost of

 59

the project. The slope of the lines representing each parameter

indicates the model's sensitivity regarding that parameter.

Click HERE for graphic.

The milder the slope, the higher is the effect of variations of the

parameter value on total project cost. Note that the sensitivity

analysis depicted in Figure 5.2 does not consider the effect of

combined parameter changes on project costs. For every scenario,

only one parameter is changed and the result calculated. 

Sensitivity analysis can also be performed on project schedule. 

CPM also allows convenient sensitivity analysis. By changing the

duration of an individual activity (or a group of activities) while

keeping other activity durations constant, one can easily compute

the impact of these changes on project milestones and the

completion time.

3. PROBABILISTIC APPROACH

 A deterministic risk analysis can at best provide an upper

limit and/or a most likely value (or in some cases an expected

value) for the risk of performing a project. The user will not have

information about the likelihood of needing a certain level of
contingency. The importance of relating various levels of exposure

(or contingency) with probability of their realization cannot

 60

be overemphasized. Without knowledge of this relationship, the

effectiveness of decision making will become random. On the other

hand, if uncertainty of various variables are formally introduced

into the cost and schedule models, then one can arrive at a

distribution for the outcome of the analysis. This distribution

allows the analyst or the decision maker to make informed decisions

regarding the project's management, budget and schedule. Indeed,

many may suggest that there is no such thing as "deterministic risk

analysis" because risk by definition is derived from uncertainty

which in turn is a probabilistic concept.

 Implementing a probabilistic approach in risk assessment is

generally more complex than the traditional deterministic

approaches and requires more input data. Conveying the results of

a probabilistic approach to the top decision makers may be more

difficult as well. Despite these issues, we feel that every effort

should be made that a probabilistic analysis be conducted to assess

the levels of risk in a project. Without a probabilistic approach

a complete profile of project risks cannot be developed. In this

section some of the more common probabilistic approaches in

construction management are described.

 In general, the probabilistic approach in assessing risk or

measuring probability of cost or schedule overrun/underrun is to

treat various components of the project, especially those

components that are expected to vary greatly, as random variables. 

The underlying assumptions in both probabilistic scheduling and

estimating arc so similar that we can discuss both subjects at the

same time. In almost every case, a model is developed for

predicting the project cost or schedule. As this model is a

function of several random variables (those components of cost or

schedule that have a fair chance of variation and are expected to

contribute to the total project uncertainty), it is itself a random

variable. If one can estimate the distribution of the random

variable that is used to model total project cost or total project

duration, then one can compute probabilities associated with

various levels of confidence regarding meeting a specific deadline

or a prescribed budget level. The problem is that in many cases it

would be very difficult if at all possible, to analytically find

the distribution of the random variable representing total project

cost or schedule. That is why in many cases a simulation analysis

is conducted to arrive at the Cumulative Distribution Function

(CDF) of the total cost or schedule.

 The following factors may affect the analysis outcome:
- The choice of statistical distributions and parameters used to

 model individual project components

- The choice of the mathematical model for the total project

 cost or schedule

- The choice of analytical technique used to solve the

 predictive model

In this report, these issues are described using a number of

examples.

 61

Statistical Distributions

 As mentioned earlier, the general approach in assessing

uncertainty in construction projects is to treat project components

with a high potential for variability as random variables. So an

activity's duration traditionally estimated with a single number,

or a unit cost item that the estimator usually estimates based on

the information available deterministically, are modeled as random

variables with specified means and variances. In most cases,

specification of a distribution type is also needed in order to be

able to conduct a probabilistic analysis. Almost always, a wellknown theoretical statistical distribution is used to model the

item's variability. This is due to the fact that these statistical

distributions are well-known, usually fully documented, and

therefore easier to work with and to evaluate. Given the variety

of statistical distributions available, one is generally able to

choose a reasonable distribution for modeling a certain parameter's

variability.

 In the past three decades research has been conducted on the

nature of construction cost and duration distributions. Several

features of cost and duration distributions have been identified. 

For example, it is understood that the distribution should

preferably have confined limits, should only take positive values

in the ranges of interest, should be unimodal, and may be skewed

(unsymmetrical) (Spooner, 1974). For example, developers of PERT

(Program Evaluation and Review Technique), a probabilistic networkbased scheduling technique (PERT Cost Systems Design, 1962), have

suggested using a beta distribution to model activity duration

times. Beta is a unimodal distribution with confined lower and

upper bounds (Fig.5.3) and can take several shapes depending on the

distribution's shape factors. It provides a flexible means for

modeling activity duration times. PERT has been in use since the
late fifties.

 Teicholz (1964) found out that the cycle times of construction

equipment (e.g. scrapers) follow a lognormal distribution. This

was later supported by observations of O'Shea el al (1966) and

Gaarslev (1969). Lognormal (Fig.5.4) is a unimodal distribution

that can take only positive values, and is skewed to the right.

Click HERE for graphic.

 62

Click HERE for graphic.

 In a more recent study, it was found that the cost items (such

as overhead, concrete, electrical mechanical, etc.) in low-rise

office buildings (2-4 stories) are lognormally distributed (Touran

and Wiser, 1992). Other researchers have considered uniform (Fig

5.5) and triangular (Fig.5.6) distributions for modeling cost or

duration (Makar and Bryant, 1990).

 Regarding financial risks, one of the most important items is

the interest rate used in the analysis. Interest rate is a

function of the inflation rate, economic growth, and loan duration. 

Both inflation and economic growth can be closely modeled by a

normal distribution. The additional premium associated with loan

duration may be modeled as a linear function of time. So the

interest rate can also be modeled as a distribution. Figure 5.7

shows a histogram of inflation rates in the United States. As can

be observed, a normal distribution can probably model the inflation

and the interest rate reasonably accurately. For other economic

indicators such as growth rate a large number of dam is available

in various financial references (Bodie, et al, 1993).

Click HERE for graphic.

 63

Click HERE for graphic.

Click HERE for graphic.

General Guidelines for the Selection of Distribution: The
following guidelines can be used for specifying distributions: if

the amount of dam regarding a component is very limited, or if the

component is expected to vary within a very narrow range, then a

uniform distribution can be used since there is no preference

regarding the most likely value of the distribution. An advantage

of uniform distribution is its simplicity and its ease of

visualization. If the range is appreciable and some dam is

available regarding the most likely value of the distribution, then

a triangular distribution may be advantageous. For example, if the

estimator feels that the cost of ready-mix concrete is $65/cy but

may vary between $60/cy and $72/cy, then a triangular distribution

with a minimum value of 60, a maximum value of 72 and the most

likely value of 65 may be a proper choice. If on the other hand,

the estimator thinks that the same unit cost varies between $65 and

$69, then one may consider using a uniform distribution with a

minimum value of 65 and a maximum value of 69. This would mean

that it is equally likely that the unit cost of ready-mix concrete

takes any value between $65 and $69 per cubic yard.

 Both beta and lognormal distributions resemble the triangular

distribution in the sense that the data is grouped around a mode

and the distribution is not necessarily symmetrical. In fact,

 64

in PERT scheduling, the scheduler defines a beta distribution for

each activity duration by specifying a lower bound, an upper bound,

and a most likely value (Touran, 1992).

 Another approach sometimes employed is to use an empirical

distribution to model a random component In this case, a histogram

of data collected previously on the component is used to model the

component's variation. The use of empirical distributions

generally requires a computer simulation for arriving at the

function representing the total cost or schedule.

PROBABILISTIC MODELING OF THE PROJECT SCHEDULE

PERT Approach

 The most common approach in probabilistic scheduling is PERT

where every activity is modeled as a random variable distributed

according to a beta distribution. The total project duration is

computed along the network's critical path (the longest path) by

adding the means of the activities on the critical path. According

to Central Limit Theorem (CLT), the sum of several independent and

identical random variables is a random variable with an

approximately normal distribution. The mean of this normal random

variable is the sum of the means of the individual random variables
and the variance of the total is the sum of the variances of the

individual random variables. In this way, the total project

duration is modeled as a normal distribution and its parameters can

be conveniently estimated from the activity data. If activity

durations are not independent then the use of Central Limit Theorem

is not theoretically justified. For further explanation of PERT

refer to Moder, et al (1983).

 The CLT can be used if the number of activities contributing

to the total project duration (i.e. activities on the critical

path) is relatively "large". Although some statisticians have

suggested that the number of random variables should be larger than

30 (e.g., Devore, 1991), experience shows that with numbers larger

than 10 (Miller, 1963), reasonable approximations to normal

distribution can be expected.

 The other concern in applying CLT to PERT is that in some.

cases, several paths in the project are almost as long as the

critical path. In these cases it is possible that the shorter

paths that happen to have larger variances than critical path will

become critical. In such cases, the question is to what path the

CLT should be applied and which path is actually going to be the

longest? One suggested solution has been to use the Monte Carlo

simulation in analyzing these cases. This issue has been discussed

under merge event bias problem in various publications (Moder et

al, 1983).

Monte Carlo Simulation Technique

 In the Monte Carlo simulation approach, a random number is

generated on a computer to generate a duration for each activity

using its distribution. These numbers are used to schedule

 65

the network and the total project duration is computed. In this

process the activities on the critical path (the sequence of

activities with the longest total duration) are identified. This

process of generating random numbers according to various activity

distributions is repeated many times (from several hundred times to

several thousand times) and every time the critical activities are

identified. Then a criticality index is computed for each activity

that reflects the probability of the specified activity becoming

critical. This criticality index is simply the ratio of the number

of times an activity was on the critical path to the total number

of simulation runs. In this way, the activities with a high

probability of becoming critical are identified. This can help the

management to allocate a proper level of attention to these

components of the project.
Software

 The analyst has the option of using either a general purpose

simulation language such as SLAM (Pritsker, 1986) or SIMAN (Pegden,

et al, 1990) to develop a model of the project schedule, or use a

specially designed software package that allows conducting Monte

Carlo simulation on a scheduling network. The first approach is

much more flexible but requires more time and the user has to have

expertise in modeling probabilistic systems. In such an approach,

risk measurement can be done either using traditional network-based

schedules or utilizing any appropriate relationship that

realistically defines a duration or productivity rate. Using a CPM

schedule has the advantage that depicts activity precedence and can

serve as a convenient environment for developing a schedule risk

study.

 The traditional network lacks the flexibility needed in

modeling complex yet quite probable situations. One such

flexibility is the possibility of probabilistic branching. As an

example, consider a transit project where the source of local

funding is uncertain. Maybe the local agency or the owner is not

sure if the public is ready to foot the bill required for the local

contribution. In developing a schedule for the project, it would

be wise to consider two paths. Each path has a certain probability

of realization. For example, the analyst may think that there is a

75% probability that the public will support a new tax to pay for

the local share. There is a 25% probability however, that the

proposed tax will not be accepted and this can direct the project

schedule through a loop consisting of several activities (further

negotiations, study, etc.) with a duration of several months. If

the network can be modeled such that it allows probabilistic

branching after every milestone, this uncertainty can be

incorporated into the model and proper actions anticipated. Other

potentially useful information would include but not be limited to

activity criticality indices, the distribution of time between any

two milestones in the network (Pzitsker, et al, 1989), and

flexibility in modeling correlations between activities.

 The second and easier option is to use a software package

specifically designed to perform Monte Carlo simulation on a CPM

network. Because of the increasing interest in probabilistic

scheduling, software, companies have developed such computer

programs. In one such example (Monte Carlo, 1992), the software

allows the user to.either define an empirical distribution for an

activity or choose from a number of distributions (triangular,

negative exponential, empirical) for modeling activity duration

times. The software allows the user to model activity correlations

 66
by using the same percentile values when sampling from correlated

distributions. This assumption reduces the system's flexibility

somehow, but is an improvement over the assumption of independence

that PERT uses. The software also permits probabilistic branching. 

It is expected that many more software developers will market

software in this area in the near future.

 Many factors affect the choice of methodology in network

analysis. Two examples are presented in the following sections to

illustrate some of these concerns.

EXAMPLE I

 In order to illustrate the application of probabilistic

scheduling we have chosen a transit project currently underway. 

Old Colony Railroad Rehabilitation Project (Old Colony DEIS, 1990)

involves the restoration of about 60 miles of railroad tracks,

construction of 14 new stations and the construction of a 1,200 ft

long bridge over the Neponset River in the south of Boston. The

area served by the Old Colony Project has seen rapid growth in the

past two decades and the existing highway and transit facilities do

not meet existing and especially future needs for access to Boston. 

The main objectives of this project are to improve transportation

services, provide cost-effective transit services, and provide a

more equitable distribution of transportation benefits to the

residents of the area covered by the project (D'Eramo and Martinez,

1991). The project is funded locally and by the Federal Transit

Administration (FTA). The owner is Massachusetts Bay

Transportation Authority (MBTA).

 The module chosen for this study is "South Bay Undercrossing". 

This is a construction module with an estimated cost of $18 million

involving building an underpass structure under the existing MBTA

Red Line. The major problem is that the Red Line service should

not be disrupted under any circumstances. This will require that

the contractor work on the Red Line relocation activities only in

the weekends in restricted hours. This requirement complicates

accurate estimation of these activity durations and creates

uncertainty regarding the schedule. A CPM network of the project

consisting of 44 activities was developed by the Engineer. Table

5.2 shows activities affected by the Red Line relocation operation

and their possible duration ranges.

 Ranges provided in Table 5.2 were furnished by the experienced

Engineer's personnel. Further, it was felt that although it was

possible that an activity might take anywhere between the minimum

and maximum durations given above, the duration distributions would

have a modal point or a most likely value. Estimates of the most
likely durations are provided in Column (2) of Table 5.2. Because

of this observation is was decided to model activity duration times

according to a triangular distribution (Fig. 5-6). Other

activities of this 44-activity network were modeled with

deterministic durations because a large variance was not expected

for their durations.

 Monte CarloTM software package by Primavera, Inc. was used to

conduct a risk analysis for this construction project. The

objective was to assess the impact of activity duration uncertainty

on total project duration. Figure 5.8 shows the CDF and the PDF of

the total project duration.

 67

The expected duration of the project is 588 days but the duration

range is from 525 to 625 days. By looking at the PDF one can see

that the most likely range for the duration is between 565 and 605

days. The probability of duration exceeding 617 days is extremely

and can be reasonably disregarded

Click HERE for graphic.

This information can help in assessing the impact of this module on

other construction packages in this transit project. Depending on

the Master Schedule for the project, if the module studied here is

on the critical path and can cause delay in the final project

completion time, then it would be wise to study alternatives for

schedule compression. Otherwise, a project duration of

approximately 605 days (with a probability of exceeding being only

20%) seems to provide a reasonable margin of safety for the

schedule.

 This example illustrated the process of performing a schedule

risk analysis. The process of systematically studying a schedule

and identifying activities that may cause delays and modeling the

potential delays using statistical distributions, one can assess

the extent of the potential delay. The impact of this potential

delay on the project budget and master schedule can then be

investigated and mitigating measures can be adopted.

 68

Click HERE for graphic.
Example II

 This example is taken from Touran (1992). It illustrates the

fact that risk assessment and analysis for project duration do not

necessarily have to be tied to a scheduling network. Large

portions of the schedule may not be of interest to top management

or may not show a large potential for variability. In such cases

it will be wise to focus on c areas where variations in duration

can have a strong impact on the project. As an example, we will

examine a risk model that was developed as part of the Concept

Design Report for the MWRA Inter Island and Outfall tunnels (Tunnel

Risk Assessment, 1989).

 One objective of the study was to develop a CDF for the total

duration of tunnel boring for Inter Island and Outfall tunnels. It

was argued that within the Deer Island Treatment Plant and

Facilities, the Outfall tunnel was on the critical path and

moreover the activity with highest potential for variability was

tunnel boring. So it was sensible to conduct a risk analysis on

the tunnel boring operation. The tunnel duration consisted of

several components all of which were computed according to the

following procedure:

Time to tunnel in certain rock type, with a certain quality, with a

certain water inflow is equal to the length of the tunnel segment

divided by TBM achieved rate in the same type of rock with the same

quality and water inflow (Eq.1). TBM achieved rate is defined as

the product of TBM utilization rate (the time machine is boring as

a proportion of the total working hours) and

 69

the TBM penetration rate (instantaneous penetration rate) in the

same type of rock with the same quality and water inflow. We have

simplified the model so that it can be discussed here in a

reasonable space and at the same time have preserved the essentials

of the approach taken in the actual study.

The following criteria are considered:

 Lijk

 Tijk = ---------- . . . . . . . . . . (1)

 Pijk Uijk

In Eq.(I), Tijk is the time required to tunnel segment denoted by

ijk, i is the rock type, j is rock quality (excellent, good, fair,

poor, or altered based on Rock Quality Designation (RQD)), k is

water inflow rate (high, medium, low based on permeability), Lijk is
the length of the tunnel in a certain rock, with a certain quality

and water inflow rate, Pijk and Uijk are TBM penetration rate and

utilization rate at the given conditions.

 Lijk = L Wijk Ri Qij . . . . . . . . .(2)

In Eq.(2), L is the total tunnel length, Ri is the probability that

rock type i is encountered, Qij is the probability that rock of

quality j is encountered given rock type is i, and Wijk is the

probability of having water inflow rate k, given rock type is i and

rock quality is j.

From this it is clear that 䗩jk = 1 and also 䤤Lijk = L.

 k ijk

 In Eq.(1), Pijk and Uijk are both random variables that provide

ranges for the utilization and penetration rates under assumed i,

j, and k conditions. Every random variable has to be identified

with a distribution and the relevant parameters. In the actual

study, two sets of computations have been carried out. In one,

uniform distributions have been assumed for every random variable. 

In the second, triangular distributions have been assumed for every

random variable. For the uniform distributions, ranges of

distributions have been estimated based on the available

information, experience and expert opinions. For the triangular

distributions, the most likely value of every distribution was

estimated in addition to the distribution range.

 For example, TBM penetration rate in Argillite, in excellent

rock conditions (RQD>96), was estimated to vary between 10.1 and

14.1 ft/hr. The most likely value for this rate was estimated as

12.1 ft/hr. Also, it was assumed that water inflow will only

affect the utilization rate rather than the penetration rate. So

the specified ranges for TBM penetration were assumed to be valid

regardless of water inflow conditions. In this way a triangular

distribution or a uniform distribution was completely specified for

penetration rate in Argillite in excellent conditions. The same

approach was used to estimate ranges of distributions to model

penetration rates with other qualities of Argillite or with other

types of rock expected to be encountered in the tunneling

operation. It is clear that a large number of random variables had

to be specified in order to estimate various Tijk's.

 70

 For computing the CDF of the total tunnel duration, a Monte

Carlo simulation approach was utilized. A computer program was

developed that sampled various statistical distributions specified

by the modelers to pick up values used in Eq.(1). Every random
variate specified was sampled once. Values of Tijk's were computed

depending on the i, j, and k that was sampled. The Ttot = 䠔ijk's

were computed to provide total number of hours required for tunnel

boring. This process of sampling the distributions was repeated

100,000 times and every time a Ttot was computed. These Ttot's were

used to construct a CDF for the total tunnel duration. Using this

CDF, various confidence levels could be computed for the completion

of the tunneling operation. It is apparent that any existing

correlations among model parameters in adjacent tunnel segments

were neglected. Given the nature of the project, one would expect

that it would be natural to expect correlation in tunneling

conditions in the adjacent tunnel segments. The impact of

disregarding these correlations, is that as most of the time these

correlations are positive, the actual variance for project duration

will be higher than the calculated variance from the model. This

can give a false sense of security to the planner regarding the

chances for schedule delay. Readers interested in further

discussion of tunnel risk analysis are referred to Kim (1984). In

this report we shall address the issue of correlation among random

variables in the cost section where its impact is more obvious.

 In order to illustrate the process of risk assessment, a much

simplified scenario of the above problem is presented and a

simulation approach is used to calculate the distribution of the

project duration. Touran (1992) provides an alternative solution

to this problem using a direct analytical approach in lieu of

simulation.

Monte Carlo Simulation Approach: A Monte Carlo simulation study is

conducted on a simplified version of Example 2 and computations are

carried out with hypothetical data. It is assumed that one is

interested in estimating the duration time required for tunneling a

1,000 ft segment in a certain rock under specific conditions. The

duration time can be modeled as Eq.(3):

 L

 T = ------- . . . . . . . . . . . . (3)

 P U

In Eq.(3), L = 1,000 ft, and P and U are random variables that

portray variations in the expected TBM penetration rate (P) and

utilization rate (U). Further it is assumed that both P and U are

independent and both follow a uniform distribution. The bounds of

the distributions may be estimated by doing a literature search,

examining historical data, or consulting experienced personnel. It

is assumed that P may be any number between 8 ft/hr and 12 ft/hr

and U may be between 40% and 60%.

 A simple Monte Carlo simulation model was developed using

SLAM-II software package. The simulation was run for 10,000 times. 

At every run T was computed. Table 5.3 shows the result of the

simulation experiment.
 71

 TABLE 5.3 - Tunnel Duration (Example II)

 Duration (hours) Probability of finishing the project

 by the duration in Col.(1)

 (1) (2)

 140 0

 160 0.08

 175 0.20

 190 0.36

 205 0.55

 220 0.70

 235 0.80

 250 0.88

 265 0.92

 280 0.95

Using this Table various confidence levels can be investigated. 

According to analysis results, the average time to bore the tunnel

was 205 hours with a standard deviation of 33.8 hours. From Table

5.3 it can be deduced that there is a 70% chance that the project

can be completed within 220 hours. On the other hand, the

probability of finishing the project in 175 hours is only 20%.

 Examples discussed so far have illustrated typical

applications of probabilistic analysis to duration estimation. All

the examples cited above assume independence among variables. 

Analysis of correlated random variates is significantly more

complicated than independent variates. General concerns in this

regard are explained in the next section of this chapter when cost

risk analysis is discussed.

PROBABILISTIC MODELING OF THE PROJECT COST

 A common application of risk analysis in construction is to

compute the CDF of the total project cost. This in turn can help

the owner specify margins of safety needed for the levels of

funding required. The CDF developed by the contractor can help him

arrive at a reasonable contingency sum and to allocate contingency

to various project activities (Diekmann, et al, 1988; Hackney,

1985; Jackson, et al, 1985). Again Monte Carlo simulation

technique is continuously used in cost risk assessment. At this

point we will examine the typical cost functions that are used for

risk modeling.
 The total project cost is modeled as a random variable that is

the sum of several cost items, themselves being random numbers. In

Eq.(4), Ctot is the total project cost, and Ci's are various project

cost components.

 72

 n

Ctot = 䠃i . . . . . . . . . . . . . . . . .(4)

 i=1

Obviously, if one wants to consider cost variations in every small

cost component that goes into a detailed estimate, the approach

would be impractical. Because of this, the Ci's considered are

major items that generally appear on the estimate summary sheets

and ;he recap sheets. Also, it is understood that most of the

total cost variation is due to the variability of a limited number

of components (Management of risk, 1989; Curran, 1989). So only

those items with high potential for variation are considered as

random variables and the Test of the items am assumed to be fixed. 

Curran (1989) defines a critical variance for the bottom line. Any

single component that has the potential of changing the project

bottom line by more than this critical variance is considered a

critical component and should be modeled as a random variable. 

Curran suggests the critical variance to be 0.5% of the project

bottom line for conceptual estimates and 0.2% of the bottom line

for detailed estimates. So, for example, in a $10,000,000

conceptual budget estimate, if any single component has the

potential of changing the total cost by more than (0.5%)($10m) =

$50,000, then this component is considered critical. Furthermore,

Curran (1989) suggests that in over 90% of projects of all types,

the number of critical items was fewer than 30. Other cost items in

the project then, can be established as fixed values. Ctot in Eq.(4)

is then composed of a fixed and a random component. As various

Ci's can have various distributions, accurate computation of Ctot

involves the computation of a number of convolution integrals and

becomes very lengthy.

 Monte Carlo simulation can simplify the process if a computer

and the relevant software are available. It consists of generating

random numbers according to q distributions, adding up these items,

adding the fixed costs to these, and computing the total project

cost. This procedure is repeated at least several hundred times,

and every time a value for Ctot is computed. The number of

iterations needed depends on the complexity of the model and how

quickly the results of the analysis converge. It should be chosen

sufficiently large so that the outcome of the analysis does not

change by further increasing the number of iterations. A

histogram, and later a Cumulative Distribution Function (CDF) can
be constructed with the values of Ctot. The CDF can then be used to

estimate the probability of completing a project at or below a

certain budget.

Problems with Monte Carlo Approach

 Although the Monte Carlo approach provides a straight forward

means for probabilistic estimating, there are major limitations in

its application. First, one needs to establish statistical

distributions for various cost components. Second, if the random

numbers are not independent, their correlations should be fully

documented for the correct implementation of the Monte Carlo

technique.

 73

Underlying Statistical Distributions: One logical method for

investigating the distribution type is to collect data from similar

projects, assume a distribution, and perform a proper test of

goodness of fit to evaluate the hypothesis. In the absence of

historical data, the same general guidelines regarding the choice

of distribution mentioned earlier in the report can be used.

Correlation between project cost components: One of the more

common sources of error in Monte Carlo simulation is that it is

assumed that cost components are independent and changes in one

cost component do not affect any other cost component. This is

clearly inaccurate in typical construction projects; however, it is

assumed that if the correlation between variables is sufficiently

small, the assumption of independence does not create large errors. 

Generally, disregarding the correlation between variables in a

Monte Carlo simulation results in an underestimation of the total

cost variance as the effect of covariances (that are mostly

positive) in computing the variance is neglected. In a study,

Toumn and Wiser (1992) analyzed the cost data for more than one

thousand low-rise apartment buildings. It was found that by

neglecting the effect of correlations among variables, the variance

of the total cost was underestimated by 50%. This is clearly an

error in the unsafe direction as larger variances mean higher

probability of cost deviation.

Click HERE for graphic.

An Approximate Method for Incorporating Correlations: The accurate

method of incorporating correlations is time-consuming and requires
a great deal of data that is not always available. In some cases,

if the underlying distributions are not normal, it is not possible

to make an accurate analysis. One suggested method (Curran, 1990)

involves combining highly correlated cost items into a single cost

item such that all the remaining cost items (some of which are a

combination of several correlated cost items) can be considered

independent. For example, assume that a project cost consists of

ten cost items C1 to C10 (Touran and Wiser, 1992). So we have,

 74

 10 

 Ctot = 䠃i . . . . . . . . . . . . . . (7)

 n=1

Further, assume that we have reason to believe that C4, C5, and C6

are highly correlated and that C9 is correlated with C10. Define C'

and C" such that:

 C' = C4+C5+C6 . . . . . . . . . . . . . (8)

 C" = C9+C10 . . . . . . . . . . . . . . (9)

If the estimator can specify underlying distributions and

parameters of C' and C", and if the rest of cost components can be

assumed to be independent, then by rewriting Eq.(7) as Eq.(10). one

can conduct a Monte Carlo simulation.

 Ctot = C1+C2+C3+C'+C7+C8+C" . . . . . .(10)

In Eq.(10) all the items are assumed to be independent.

 Curran (1990) presents a hypothetical example to show the

application of the method described above. The problem is that in

many cases it will be difficult and even unnatural to lump together

various cost components and estimate their combined range,

parameters, and distribution.

The Accurate Method for Incorporating Correlations: For conducting

an accurate analysis of total cost variance, the joint density

functions of the correlated cost components are needed. The PDF

that the estimator or risk analyst specifies for a certain cost

component is actually the marginal distribution of that cost

component In general, if different cost components are not

independent, knowing the marginals of these random variables is not

sufficient to obtain their joint density functions. Without the

joint density function, the correlated random numbers cannot be

generated for Monte Carlo simulation. The case of multivariate

normal distribution is an exception, however. If one has marginals

of the multivariate normal distribution and the covariance matrix,
then one can generally find the joint density and conduct the

analysis. This means that the cost components have to be normally

distributed. Multivariate normal distribution can be transformed

to multivariate lognormal (Johnson and Ramberg, 1978). Also, in

special cases, one can use approximations to analyze the correlated

random variates at the cost of reduced accuracy (Touran and Wiser,

1992; Touran, 1993). This level of detail in conducting risk

analysis in construction however, is almost never attempted in

practice and the assumption of independence or the simpler method

described above is all that is actually used.

The Use of Rank-Order Correlations in Simulation: Although it is

not generally possible to generate correlated random numbers

according to non-normal marginal distributions, Iman and Conover

(1982) have presented a method for generating variables with

specified rank-ordered

 75

correlation coefficients (Morgan and Henrion, 1990). Rank

correlation coefficient between two random variables measures the

correlation between the of the values of the two random variables. 

Many of the software packages developed for risk analysis (@RISKTM,

for example) allow the user to specify correlation coefficients

between several random variables and then generate correlated

random numbers. It should be noted that these specified

correlations are rank correlations rather than the more familiar

Pearson correlation coefficients. Although several authors have

claimed that rank correlations are indeed very good measures for

describing the degree of association between variables, we believe

that this assertion requires further study, especially in the

domain of cost and schedule risk analysis.

Comprehensive Cost Functions

 Eq.(4) is the simplest form of function that may be used for

cost risk analysis. A more general model was suggested by Diekmann

(1983) and is presented with slight modification in Eq.(11):

 Ctot = 䛱i( mi + wi li )] + 䠃j . . . . (11)

 i j

where the total cost is composed of i categories of work and j

indirect cost items. qi is the work quantity in category i, mi is

the unit material cost of category i, li is the labor productivity

rate (man-hours/q) for category i, wi is the wage rate related to

labor li, and Cj is the indirect cost item j.
 Again the Monte Carlo approach can be used to develop a CDF

for Ctot. Any of the parameters described above may have variations

that have to be considered in the analysis. An analytical solution

may not be always convenient or even feasible depending on the

shape of the cost function. Computations become cumbersome

especially if reasonably complex and realistic distributions such

as lognormal or beta are assumed for the parameters.

Commercial Software

 Most project cost functions can be modeled in a format similar

to Eqs.(4) and (11). Several software packages are available that

allow the user to conduct risk analysis on a personal computer

(generally using a simulation approach). In using these packages,

the user loses some flexibility in modeling but the process becomes

convenient and fast. Understanding underlying assumptions used in

the development of these packages are important if one wants to

avoid errors in the interpretation of results. Many of these

packages are designed as add-in modules to popular spreadsheet

programs for personal computers (either IBM compatible or

Macintosh) and are relatively inexpensive (e.g., @RiskTM(1991) or

Crystal BallTM(1992)). So the user that is familiar with a

computer spreadsheet will now have the capability of modeling any

cell value in the spreadsheet as a random variable. There is a

wealth of distributions to choose from and some

 76

graphics capability is available. Furthermore, as noted above,

these software systems allow the user to specify different values

of correlation between various random variables.

Example III

 Assume a fixed guideway transit project's budget (or target

estimate) was estimated at $1,205 million. Further, assume that

the project's critical components have been identified, their

distributions and parameters specified and a Monte Carlo simulation

was conducted using the general format of Eq.(4). A histogram and a

Cumulative Distribution Function (CDF) for the project has been

developed as presented in Figs. 5.9 and 5.10.

Click HERE for graphic.
Click HERE for graphic.

 77

Click HERE for graphic.

Table 5.4 gives statistics for the total costs. The computation of

the CDF by Monte Carlo simulation technique is very similar to the

method described in Example 11 and will not be repeated here. 

Table 5.4 shows that there is a 49.3% chance of having a cost

overrun for the 

 TABLE 5.4 - Total Project Costs Statistics

 Simulation Iterations 2,000

 Mean ($millions) 1,202.47

 Maximum ($millions) 1,497.80

 Minimum ($millions) 800.85

 Total Cost (80% point on CDF of Fig.5.10)($m) 1,291.60

 Probability of Cost exceeding Target ($1,205m) 49.3%

project with the estimated or desired budget. If the owner is not

comfortable with this likelihood level and would prefer a

confidence level of, say, 80%, then the budget required would be

about $1,291.6 millions. In other words an $86.6 million

contingency reserve is needed to assure with

 78

a level of confidence of 80% (Table 5.4) that the project will not

suffer cost overrun. Some practitioners prefer to arrange the CDF

of Fig.5.10 in a slightly different way and develop a so called

overrun profile for the project cost (Curran, 1989; CII Publ.6-8,

1989) (Fig. 5.11). In this figure, the values of the y-axis are

simply the complements of the values of y-axis of Fig.5.10. The

same conclusions can be drawn from Fig.5.11. There is a 49.3%

chance of budget overrun if the target estimate is $1,205 million

and there is a 20% (100% - 80%) chance of budget overrun if the

target estimate is $1,291.6 million.

 The same approach can be used by the contractor for arriving

at a reasonable contingency sum for the project. The contractor

can develop a CDF for project cost (excluding contingency or

profit) and then choose a markup such that the probability of

losing money on the project falls below a certain threshold
acceptable to him.

INTEGRATION OF FINANCIAL AND CONSTRUCTION RISKS

 So far we have discussed project construction cost and

schedule risks, and financial risks separately. These risks all

impact the project. A better picture of project's overall risks

can be constructed if financial and construction risks arc

incorporated in a single analysis. While separate analyses

described earlier can pinpoint specific problem areas, this

combined impact shows the overall project's chance of success. It

is especially useful from the sponsor and the owner's point of view

as it evaluates the adequacy of funding, the impact of the shortage

of local funds or the increase of construction costs on the

project's fate.

EXAMPLE IV

 In order to illustrate the implementation of both financial

and construction risks in an analysis, we have developed a

hypothetical case. The hypothetical case involves a major fixed

guideway transit program consisting of 12 miles of elevated tracks

and the related stations and equipment.

Construction Costs

 Construction costs for a fixed guideway transit project are

estimated as described in EXAMPLE III above. The project spans

over a five year period and the total cost including escalation

factors is estimated as $1,205 million. Furthermore, the project

budget has been distributed between years using the project

schedule and is as given in the spreadsheet of Table 5.5. Each of

these annual budgets are assumed to follow a normal distribution

and for every year a contingency budget has been calculated such

that the probability of cost overrun is kept to less than one third

(33%). The total project contingency is $97.5 million that

provides a confidence level of about 83% against cost overrun. In

other words, there is a one chance in six that a cost overrun will

occur. A CDF of the total project cost was given in Fig. 5.10

above.

 79

Project Financing

 The project is financed from three primary sources of funds:

federal grants, excise tax revenues, and proceeds from bond issues. 
The amount derived from federal sources is assumed to be certain

and is distributed as displayed in Table 5.5. The serial bonds

issued here are considered revenue bonds. In other words, the

sales tax revenues assumed here win be used to service the

repayment of principal and interest of the bonds issued.

 Sales tax revenues in later years will be used to repay the

debt and interest expense associated with the bond issues. These

revenues are assumed to grow at a mean annual rate of 2.5%. Growth

rates are drawn from a truncated normal distribution with a mean of

2.5%, standard deviation of 2.5% between -2.5% and 7.5%. This

growth rate reflects assumptions regarding income of underlying

regional economy, population trends, and expansion of the regional

job base.

Interest Rates: Interest rates are modeled as the inflation rate

plus a time premium that increases with the bond's maturity. The

inflation rate itself is assumed to follow a truncated normal

distribution with a mean of 3.25% and a standard deviation of 3.25%

truncated between 0 and 6.5% (Bodie, et. al., 1992). Mean interest

rates for the serial bond issues used in this example are displayed

in Table 5.6. Another relevant interest rate is the rate the owner

can achieve from the surplus cash balances generated during the

project's life. This rate is modeled as the inflation rate plus

1.0%.

Timing of Bond Issues: In this example, three serial bond issues

are employed in years 1995, 1997, and 1999. These issues are timed

to provide positive cash flows during the construction phase of the

project. Bonds are issued according to the schedule displayed in

Table 5.6 and have a total face value of $490 million. Interest

rates for the bond issues are tied to their longevity and to

variations in inflation rates. An upward sloping yield curve is

assumed. This means that longer term bonds carry a higher interest

rate than shorter term bonds. Tax revenues are not large enough to

provide sufficient financing during construction. After

construction, bond principal and interest are offset by sales tax

revenues. The cash flows that result from this financing strategy

are robust in early years and sufficient in later years. In

practice, more complex bond issues would be used to minimize the

surplus cash balances in early years. However, the simplified

financing structure in this model captures the essence of cash flow

management reasonably well.

 80

Click HERE for graphic.
Simulation Analysis

 It is assumed that FTA will provide $765 million distributed

over a period of 5 years as given in the spreadsheet of Table 5.5.

This amounts to about 60% of the total construction estate plus

contingency. This ratio appears to be reasonable given current

circumstances. $490 million is to be raised by issuing a series of

revenue bonds.

Random Variables: Several items in the spreadsheet of Table 5.5

show potential for chance variations. Construction expenditures

for every year are modeled according to normal distributions as

discussed earlier Sales tax is a function of growth rate and

inflation; interest income and debt service are modeled as

functions of interest rate which itself is a function of inflation. 

As the inflation and growth rates are modeled probabilistically,

sales tax, interest income, and debt service become probabilistic

variables too.

Analysis of Results: A Monte Carlo simulation analysis was

conducted on the spreadsheet. This was accomplished by generating

random numbers according to specified probabilistic models for

2,000 iterations. The number of iterations was chosen sufficiently

large to allow the simulation results to converge to their

theoretical values. There are several important issues that have

to be studied in this spreadsheet. First the planners have to make

sure that the construction budget is sufficient and the contingency

reserve is sufficient to meet unexpected cost variations. This

issue was discussed throughout this paper and specifically in

EXAMPLE III above.

 Second, the ending cash balances should be positive throughout

the spreadsheet. A negative value in any year means a cash

shortfall that can create financial hardships and complications in

the construction process. Simulation helps to assess the

probability of having negative cash

 81

balances throughout the project. Fig. 5.12 shows a Distribution

Summary Graph for ending cash balances.

Click HERE for graphic.

Click HERE for graphic.

 82
 Table 5.7 provides summary statistics for this parameter. As

can be seen the probability of having a negative cash balance

increases in the later years. This is expected because of the

modeling approach used in this example. For every iteration, a

random value for inflation and growth rate is generated for the

first year. In subsequent years, the generated values for the

previous year will serve as the mean of the normal distribution

used to model growth rate and inflation rate. In other words, the

value of growth rate and the inflation will depend on their values

in the previous year and will show a variance around the previous

year's value. Tax revenues, interest income and bond proceeds are

calculated m every iteration based on the generated growth and

inflation rates. There are several alternatives to this approach;

one can generate the values of tax revenues independently for

various years or one can model inflation and growth rates as

functions of an initially specified random variable that increases

every year at a constant rate. More complicated models based on

probabilistic treatment of population trend, local income, etc. can

be conceived. It should be noted that one should set a limit to

model complexity, otherwise interpretation and analysis of results

may become difficult. Also the model may become intimidating to

the experienced personnel that may be contribute to the planning

effort by drawing upon their knowledge and past experience.

 As can be seen (Table 5.7) there is a 31.3% chance that the

project may sustain a cash shortfall in Year 2005. This

probability is 24.6% for the Year 2004. For earlier years this

probability is significantly lower and never exceeds 8.9%. Fig.

5.13 gives the ending cash flow distribution for the Year 2005. 

Depending on the planners' tolerance for risk, they may have to

deal with this situation. One option would be to consider issuing

more bonds when needed. This option should be considered in

conjunction with the ability of the local economy to repay the

debt. Another option would be to increase the sales tax rate. 

Either option could be pursued before the project is undertaken or

during the project when the funds are needed.

Click HERE for graphic.

 83

 Another item of interest can be the growth of sales tax and

its variations. As the sales tax is the major source of servicing

the debt in this example, the project's sensitivity regarding the

variations in growth rate should be studied. This can be done at
two levels. In one method, one can deterministically change the

values of growth rate and for each scenario study the impact on the

project's viability. In another method, a sensitivity analysis can

be conducted while assuming a probabilistic model for the growth

rate. This second model, though a bit more complex, is more

realistic because it provides a measure of uncertainty for every

scenario studied.

Click HERE for graphic.

SUMMARY

 The objective of this chapter was to introduce methods and

procedures for quantifying cost and schedule risks. First, the

risk perception from the viewpoint of the owner and the contractor

was discussed. Then, the concept of project contingency was

covered. The techniques used in risk and modeling were divided

into two major categories: deterministic and probabilistic. 

Deterministic contingency and sensitivity analysis were described. 

Then probabilistic risk measurement using analytical and Monte

Carlo simulation approaches were explained. Issues and

difficulties involved in probabilistic risk measurement such as the

choice of statistical distribution and the mathematical model used

for predicting total project cost or schedule were covered. Also

the problem of variable correlation was addressed and some

 84

guidelines were suggested. Several tools and software systems used

in risk measurement were introduced and their strengths and

shortcomings reviewed. Application examples were provided to show

how the procedures presented were applied in practice. These

examples covered schedule and cost risks. One example in

particular, analyzed the interaction between financial and

construction risks. It was shown that while probabilistic approach

is in general mom complicated than the traditional methods of risk

measurement, the additional information that results from an

effective probabilistic analysis clearly makes it the better

choice. Furthermore, availability of easy to use software and

recent increase in the use of these methods have improved the

understanding of the professional community.

 85

 CHAPTER 6 - RISK ALLOCATION AND MITIGATION
 The objective of this chapter is to help the owner to allocate

the risks identified in the first step of the risk management

process (Fit. 1.1) to various parties involved in the project. The

owner should be doing this with a knowledge of the magnitude of

risk (quantifies in step two, Fig. 1.1), because the risk magnitude

can impact its optimal distribution.

 In this chapter, we have considered most of the items

identified in the risk checklist (Chapter 2). While many items

deal with project planning, a large number of risk factors pertain

to the construction process. These construction related items

are usually allocated through clauses of the construction contract. 

Because of this, developing a fair and careful construction

contract is of utmost importance for effectively distributing risks

and keeping the probability of cost and schedule overruns low.

INTRODUCTION

 One risk have been identified and measured, the process of

risk allocation amongst the parties involved in the construction

project may begin. Since the owner is the one who provides the

money, it is his privilege to assign responsibilities. 

Accordingly, he has the opportunity to reduce the total project

cost through effective allocation of financial, design, and

construction risks. 

 Publicly funded projects are usually awarded on a lumpsum

basis through competitive bidding. Although objectives and

specific requirements of major fixed guideway transit systems are

generally defined carefully, not all of the project details are

known in advance. A good portion of these contracts involve

construction of underground facilities and tunnels where ground

behavior cannot be predicted with great accuracy. Also, some of

these projects are so complex that there are few eligible

contenders to bid on the job. The traditional lumpsum approach

where the total risk is placed on the contractor's shoulders

through rigid contractual language is not necessarily optimal

(Business Roundtable, 1982; CII Publ. 5-3, 1988). Contract clauses

that place an inequitable risk share on the contractor are not cost

effective for the owner (Dunlop, et al, 1988). Gross inequities in

risk sharing promote negative working relationships and increase

disputes (CII Publ. 5-3, 1988).

 One example of risk allocation is the handling of contaminated

material. This is especially relevant in underground construction

and tunneling, where quantity and extent of contamination is not

clear until the project is underway. Massachusetts Bay Transit

Authority (MBTA) for example, uses a unit-price contracting method
where the contractor is required to submit separate unit-prices

 87

for disposal of contaminated and uncontaminated material. In this

way, the contractor would be compensated for the handling of the

contaminated material and does not have to include a large

contingency in the bid to cope with the potential high cost of

dealing with an unknown quantity of contaminated material. 

Although the owner does not have the benefit of a fixed price, it

only pays the extra cost if and when excessive amounts of

contaminated material are detected. So both parties, contractor

and the owner, benefit from this contractual agreement.

 Construction Industry Institute (CII), a research group at the

University of Texas, conducted a study in 1988 to examine various

aspects of risk allocation in construction projects. In lumpsum

construction contracts, the following clauses were found to be

extremely important:

 - Indemnity

 - Consequential damages

 - Differing conditions

 - Delay

Depending upon who will be held responsible for each of the above

issues, project performance (cost, schedule, quality, and safety)

and the working relationship between owner and the contractor will

be greatly affected. The study was concluded by making a number of

specific recommendations on the preparation of contract clauses

regarding risk allocation. Most of these recommendations pointed

to some middle ground between the extreme cases of either placing

the total risk on the contractor or keeping him completely

insulated from risk. The study was conducted by collecting

questionnaires from 36 contractors (many were

designer/constructors) and interviewing them later to fine tune the

results of the analysis. Another similar study (CII, Publ. 51,

1986) has shown that owners and contractors frequently interpret

risk allocation clauses differently and this also leads to dispute. 

So it is be important to spend effort clarifying any ambiguity and

promoting a spirit of cooperation and understanding among the

parties to the contract.

PRINCIPLES OF RISK ALLOCATION

 Experience has shown that it is the owner who ultimately bears

the burden of risks, whether he originally accepts them, whether he

assigns them to the contractor and receives them back in the form
of higher bid contingencies and change orders, whether he receives

no proposals because he transfers all risk to the contractor, or

whether he pays for them via court decree (Riggs, 1979; Kuesel,

1979). Contract documents should be prepared by the owner's legal

staff with full knowledge of construction management and

engineering as to how the risks will be allocated with adequate

time for the selection of the appropriate language, and with

sufficient time for review (Riggs, 1979). With reference to

optimal risk allocation, there are several tenets which owners

should follow when instructing the legal staff. The primary

doctrines of risk allocation are:

 88

 - Allocate the risk to the party who is in the best

 position to control it 1(Diekmann et al, 1988; Thompson &

 Perry, 1992; Bramble et al, 1990, Wideman, 1992)

 - Which party is in the best position to accept the risk if

 it cannot be controlled? (Mompson & Perry; Wideman, 1992)

 - Consider the ability of the party receiving the risk to

 survive the consequences if the risk occurs (Bramble et

 al, 1990; Thompson & Perry, 1992; Diekmann et al, 1988;

 Nadel, 1979)

 - Consider whether the dollar premium charged by the

 transferee will be acceptable and reasonable (Thompson &

 Perry, 1992)

 - Do not penalize a party for accepting a risk; for

 example, do not use a no damages for owner caused delay

 clause in conjunction with a liquidated damages clause

 (Bramble et al, 1990)

 - Evaluate the potential for new risks being transferred

 back to the owner when initial allocations are made

 (Thompson & Perry, 1992; Wideman, 1992)

RISK MANAGEMENT STRATEGIES

Background

 Various experts have developed risk management strategies to

help the owner select the most suitable option for a given risk. 

Since many options appear simultaneously in various references, we

first delineate each recommendation in a succinct form and then

explain the common interpretation of all possible options. 

Subsequently, we shall present our selection of the best options

and the reasons why they were chosen. The references chosen here

have used several references themselves, so the following is the

result of numerous studies, projects, and individual expertise. In

short, this synthesis conveys the state of knowledge on risk

allocation at this time.

 Diekmann et al, (1988) propose the following alternative risk
mitigation tactics and suggest that the owner select the most

appropriate alternative(s):

 "- Eliminate the risk by banning the activity, process, or

 material

 - Reduce the risk by substituting a less risky method,

 process or material

 - Transfer the risk to another party

 - Share the risk

 - Retain the risk uninsured."

 Wideman (1992) classifies risk mitigation measures as follows:

-------------------------

1Who is in the best position to control the events that may lead to

the risk event? For example. when a railway alignment is proposed

to transverse a densely populated urban area, vibrations from a

passing train are likely to impact adjacent buildings. Since the

designer is in the best position to minimize the likelihood of

these vibration, he should be allocated such a responsibility.

 89

 "- Unrecognized, unmanaged or ignored (by default)

 - Recognized but no action taken (absorbed as a matter of

 policy)

 - Avoided (by taking appropriate steps)

 - Reduced (by an alternative approach)

 - Shared (with others, e.g., by joint ventures)

 - Transferred (to others through contract or insurance)

 - Retained and absorbed (by prudent allowances)

 - Handled by a combination of the above."

 Al-Bahar and Crandall (1990) suggest that the project risks

can be mitigated through risk avoidance, loss reduction and risk

prevention, risk retention, risk transfer (noninsurance or

contractual) and insurance.

 Lasdy, the C.I.I. publication 6-8 "Management of Project Risk

and Uncertainties" (1989) proposed that risk control actions fall

into two wide categories: Advanced Planning Actions and Risk

Containment Actions, the first of which is applicable here and

consists of risk avoidance, risk sharing, risk reduction, risk

transfer, insurance, risk acceptance with contingency, and risk

acceptance without contingency.

RISK MITIGATION MEASURES
 Based on the foregoing studies and other extensive research,

we have concluded that risks may be allocated by one or more of die

following options:

 - Risk acceptance

 - Risk reduction

 - Risk sharing

 - Risk transfer

 - Risk avoidance

 Thee list has been organized such that responsibility and

ultimate control that the owner retains for a particular risk

changes from high to low. For example, if the owner accepts the

risk of inflation, he has relieved the contractor of the risk

burden altogether. He has placed himself in the position of

controlling the inflation risk and must consider options such as

contingency, currency futures, or interest bearing investments. At

the other end of the spectrum, an owner may choose to avoid a risk. 

As a result, he will hope to have no responsibility for it and have

little control over it (other than to continue to avoid it). These

five options, while covering all methods of risk mitigation,

consolidates some mitigation measures suggested by others. For

example, insurance is generally considered as a risk transfer

measure. So there is no need to have both insurance and risk

transfer as independent mitigation measures; rather, insurance is

treated as a subcategory of risk transfer. Similarly, risk

acceptance with contingency and risk acceptance without contingency

are both methods of accepting the risk and can be treated under one

mitigation measure. Now, we further elaborate on each of these

alternatives. It should be noted that in many cases, a combination

of these measures are called for to properly allocate and mitigate

a certain risk.

 90

Risk Acceptance: Risk acceptance connotes that the owner will

assume the whole or a portion of the monetary impact of the risk. 

Note that acceptance may be planned or uncontemplated. A planned

risk acceptance indicates that. the owner has thoughtfully

investigated and deliberately chosen to retain an identified risk

(Al-Bahar & Crandall, 1990). In order for a risk to be accepted it

will generally comply with one of the following conditions:

 "A. It is voluntarily assumed

 B. No alternative is available

 C. The risky outcome is unknown with certainty

 D. Exposure is essential

 E. The negative consequences are ordinary" (Diekmann et at,

 1988)
 An uncontemplated risk acceptance occurs when the owner fails

to identify or recognize the risk, and therefore unknowingly

accepts the risk that may happen. Generally, such instances occur

when the owner fails to perform a thorough risk identification

analysis, and by default, passively retains the risk and this is

when it is most costly to the owner. Alternately, uncontemplated

risk acceptance occurs when the owner correctly identifies a risk,

but fails to or cannot properly assess the size of the potential

losses. (Al-Bahar & Crandall, 1990)

 Risk acceptance may be made with contingency or without

contingency. Contingency is a sum of money or period of time set

aside from the general construction funds to pay for losses that

actually occur. As described in Chapter 5, the total contingency

budget will be the sum of the contingencies calculated for various

risk components in the project. To the extent that total project

costs do not exceed the planned budget with the planned contingency

sums, the owner will not have to search for additional funding. 

Risk acceptance without contingency should only be considered when

funding limitations preclude a properly implemented contingency

account. This however, is a risky strategy. If such an instance

should occur, the accepted risk items should have a low probability

of occurrence or low potential impact.

Risk Reduction: In the context of this report, risk reduction

implies that the owner has accepted the risk but has taken certain

defensive planning actions to lower its potential impact. This may

be accomplished in two ways: 1) lowering the probability of a risk,

and/or 2) lowering the dollar impact of the risk if it does occur. 

Examples of specific actions that project management may pursue are

listed below:

 "- Qualified personnel

 - Qualified subcontractors

 - Safety/loss control program

 - Responsibility allocation

 - Strong project controls

 - Constructability analysis

 - Pareto's law control

 - Critical items reporting

 - Contingency account management

 91

 - Substance abuse program

 - Training programs

 - Project labor agreement

 - Risk re-evaluation

 - Crisis management" (C.I.I.- Pub 6-8,1989)
 Risk reduction may also be accomplished by selection of an

alternative which possesses a lower risk. The alternative may be a

different process, material, or method that still accomplishes the

same goal (Dielanann et al, 1988). Alternates are often engendered

by constructability reviews, alternative bids, and value

engineering.

Risk Sharing: When it is impossible or impractical for one party

to control a specific risk, the task may be better managed by

dividing it such that two or more parties manage the portion that

they are best able to control individually. An excellent example

of risk sharing is the development of a joint venture by

contractors. A joint venture is the result of the unification of

two or more contracting firms to build a single project. These

types of organizations are often extremely well suited for the

pooling of complimentary resources and facilities, for spreading

construction risks, and for accomplishing tasks greater than any

individual firm acting alone can undertake. For example, in a

major fixed guideway transit project, a heavy construction company

and a mechanical/electrical contractor may join forces to

accomplish the project.

 At a risk item level, an owner may share inflationary risks

with a contractor in projects with long durations. In this way

both parties will be exposed to a risk item none of whom have much

control over.

 At the contractual level, risks may be shared through the use

of a Guaranteed Maximum Price (GMP) Contract. With this type of

contract, the contractor is reimbursed for costs incurred plus a

fee up to the contract ceiling. If the project costs exceed the

guaranteed maximum, the owner is exposed to risks for the costs

below the ceiling. It should be noted however, that cost plus

contracts are not commonly used in public works contracting. 

Because of this, we will not be investigating this option in great

detail.

Risk Transfer: Risk transfer may be accomplished by allocating the

risk contractually to either of two major groups: 1) contractor,

designer, material supplier, subcontractor, etc., or 2) insurance

and bonding. When allocating risk to the first group, the owner

will achieve the best overall result by recognizing the doctrines

of risk allocation set forth earlier in this section. In those

instances where the amount of transferred risk results in low

competition or high bid prices, the owner should elect to utilize

the services of professional risk insurers. The following is a

list of risks which may be insured:

 92
 "1 DIRECT PROPERTY DAMAGE

 - Resulting from auto collision or other auto events

 - To equipment, in transit or handling, etc.

 - To project materials, including theft

 2 INDIRECT CONSEQUENTIAL LOSS

 - Cost of removing direct loss debris

 - Equipment replacement

 - Rental income loss

 - Business interruption

 - Increased financing

 3 LEGAL LIABILITY

 - Public bodily harm

 - Property damage arising from negligence of others

 - Damage to the project entity due to:

 Design errors

 Excavation errors

 Project failure to perform as specified

 4 PERSONNEL-RELATED

 - Employee bodily injury

 - Cost to replace employee

 - Resulting business loss" (Wideman, 1992)

Risk Avoidance: One obvious measure to avoid risks is not to

proceed with the project at all. This option may not be always

available. However, it is still possible to avoid certain risky

tasks, materials, or processes. For example, use of a new

technology, although potentially attractive, may result in costly

complications; a traditional technology in such a case would avoid

the risk of using that new technology altogether. As various

phases of project planning and design such an Alternatives

Analysis, Draft and Final Environmental Impact Statements are

completed and approved, the ability to avoid risks diminishes. In

such cases, other mitigation measures are usually used to limit the

owner's exposure to risk.

RISK ALLOCATION TABLE

 In our research, we found out that although a great deal of

effort had been expended on various methods of risk allocation and

mitigation, most of the research was fragmented and specific to a

single or a few risk items. The notable exception was tunneling

and underground construction. Because of the nature of these

projects and the extent of uncertainty involved, several concerted
efforts in this area have resulted in a few high quality

publications.

 93

 In our view, it is valuable to use these various references

and compile them in a tabular format; this will bring together the

results of the research and experience in the past two decades in

the area of risk allocation and mitigation.

 The following risk allocation table is a compilation of

numerous procedures employed and suggested by industry

professionals and educators. It is organized with the same format

as the risk checklist presented earlier in this report. 

Oftentimes, the reader is given more than one allocation option. 

This has been done because no one solution is appropriate for all

projects. Owing to the uniqueness of every project, management

must select from among the mitigation techniques for the most

appropriate. Every action or reason provided in the table is

referenced to one or more publication. A list of publications

referenced in the table is given at the end of this chapter.

 94

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__________________________

1 The numbers in parentheses refer to references given at the end

of the Risk Allocation Table.

2 One solution may be the inclusion of a specific "Suspension"

clause for political events.

 95

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_______________________________
3 By requiring labor agreements for the period of contract from the

contractor

 96

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__________________________

4 The owner may also require a detailed bid breakdown from the

lowest apparent bidder.

5 It is probably wise to accept the risk when project duration > 24

months.

6 Other measures may include issuing of interim NTP's and receiving

authorization for distinct project phases.

 97

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7 Use of Value Engineering clauses may also be effective.

 98

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8 The owner may require the contractor to provide alternate bid

prices with various completion times.

9 It is good practice to specigy a method for determing time

extensions.

10 Require that changed conditions be reported prior to proceeding

with affected work.

 99

Click HERE for graphic.
11 Assigning too much risk to Engineering may result in expensive

overdesigns.

 100

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___________________________

12 It is recommended that the site be videotaped prior to the bid to

reduce claims of changed conditions, etc.

 101

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___________________________

13 For example, in case where there is a potential for hazardous

materials, the owner may ask the bidders to provide unit prices

contingent on encountering such materials. This would generally

not affect the total bid but will come into effect if indeed the

contractor encounters hazardous material during construction.

14 It is prudent to clearly specify bases for bid rejection and

withdrawal

 102

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____________________

15 This method of contractinf is not common in public works

projects.

 103

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________________________
16 Some of the economic factors that contractors consider in

deciding on the level of markup in a lumpsum contract would be the

amount of their backlog (generally, the larger the backlog, the

higher the level of markup), the number and the identity of

competitors, and general economic conditions (in slow times markup

tends to be lower).

17 For example, the MBTA (Massachusetts) prequalifies bidders for

contracts over $1 million.

 104

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 105

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 106

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___________________

18 One has to make sure that using wrap-up insurance will not

benefit unsafe contractors.

 107

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 108

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________________________

19 Because it may not be cost effective to shift this risk to the

contractor.
 109

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________________________

20 The owner may consider establishing penalties for noncompliance

with DBE rules.

21 By using a turnkey approach all the weather risk could be

allocated to the contractor except where governed by state

laws(34).

 110

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 111

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 112

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___________________________

22 Defensive engineering refers to the situation where the Engineer,

feeling threatened by the perceived high level of risk in the

design contract, attempts to design the project conservatively and

hence often expensively.

23 XCU: collapse of buildings, blasting, damage to underground

property.

 113

Click HERE for graphic.
 114

Click HERE for graphic.

 115

12. Clough, R., Construction Contracting, 5th Ed., John Wiley and

 Sons, New York, NY, 1986.

13. "Contracting Practices for the Underground Construction of the

 Superconducting Super Collider," U.S. National Committee

 on Tunneling Technology, National Research Council,

 National Academy Press, Washington, D.C

14. Contract Risk Allocation and Cost Effectiveness, Construction

 Industry Institute, Publication 5-3, University of Texas,

 Austin, Texas, Nov. 1988.

15. Diekmann, James E., Sewester, E.E., and Taher, K., Risk

 Management in Capital Projects, University of Colorado at

 Boulder, Oct. 1988.

16. Hack, Samuel L, "Project Management and Contractual

 Relationships," Proc., Construction Risks and Liability

 Sharing Conference, ASCE, Scottsdale, Arizona, 1979.

17. Hanunond, David G., "Minimizing Risks and Mitigating Losses,"

 Proc., Construction Risks and Liability Sharing

 Conference, ASCE, Scottsdale, Arizona, 1979.

18. Hancher, Donn E., et. a]., "Bond and Insurance Coverages for

 Highway Construction Contractors," NCHRP Synthesis Report

 341, Transportation Research Board, National Research

 Council, Washington, D.C., 1991.

19. Hayes, Ross W., John G. Perry, Peter A. Thompson, and Gillian

 Willmer, Risk Management in Engineering Construction:

 Implications for project managers, Thomas Telford

 Limited, London, December 1986.

20. Hinze, J., Construction Contracts, McGraw-Hill, Inc., New York,

 NY, 1993.

21. "I.T.A. Recommendations on the Contractual Sharing of Risks,"

 Tunneling and Underground Space Technology, 1988.

22. Impact of Various Construction Contract Types and Clauses on
 Project Performance, Construction Industry Institute,

 Publication 5-1, University of Texas, Austin, Texas, July

 1986.

23. Kuesel, Thomas R., "Allocation of Risks," Proc., Construction

 Risks and Liability Sharing Conference, ASCE, Scottsdale,

 Arizona, 1979.

24. Management of Project Risks and Uncertainties, Construction

 Industry Institute, Publication 6-8, University of Texas,

 Austin, Texas, Oct. 1989.

25. Nadel, Norman A., "Allocation of Risks - A Contractors View,"

 Proc., Construction Risks and Liability Sharing

 Conference, ASCE, Scottsdale, Arizona, 1979.

 117

26. Owner's Guide to Saving Money by Risk Allocation, Associated

 General Contractors of America, Inc., Washington, D.C.,

 1991.

27. Ribakoff, Solomon, "Construction Contract Arrangements," Proc.,

 Construction Risks and Liability Sharing Conference,

 ASCE, Scottsdale, Arizona, 1979.

28. Riggs, Louis W., "Contractual Arrangements For Construction,"

 Proc., Construction Risks and Liability Sharing

 Conference, ASCE, Scottsdale, Arizona, 1979.

29. Ryland, V. Wallace, "Minimizing Risks/Mitigating Losses,"

 Proc.,Construction Risks and Liability Sharing

 Conference, ASCE, Scottsdale, Arizona, 1979.

30. "Standard Insurance Specifications for MBTA Construction

 Contracts," MBTA, Boston, Mass., February, 1992.

 

31. Strauss, M.W., "Risk and Liability Sharing: The Owner's View,"

 Proc., Construction Risks and Liability Sharing

 Conference, ASCE, Scottsdale, Arizona, 1979.

32. Thompson, P., and J. Perry, Engineering Construction Risks,

 Thomas Telford, London, UK, 1992.

 

33. Wideman, R., Max, Project and Program Risk Management, Project

 management Institute, Drexel Hill, Pa., 1992.

 

34. Yarema, G.S., "The Next Step in the FTA Turnkey Demonstration

 Program: Developing an Effective Contract," FTA/APTA

 Turnkey Workshop, USDOT/FTA, Miami, Florida, June 10,

 1993.
 118

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Yarema, G.S., "The Next Step in the FTA Turnkey Demonstration

 Program: Developing an Effective Contract," FTA/APTA Turnkey

 Workshop, USDOT/FTA, Miami, Florida, June 1993.

 A-8

 APPENDIX B - SUPPLEMENTARY COMMENTS ON

 THE RISK CHECKLIST

 This Appendix contains supplementary comments on most of the

risk items presented in Chapter 2. These comments are included to

further clarify risk items and to highlight important issues. Not

every item in the checklist is explained here; rather, we have

focused on more sensitive items or those that we felt needed

clarification. Although the risk checklist was developed from the

owner's point of view, many of the comments given here reflect

contractor's concerns also.

I. PROJECT FEASIBILITY

A. Technical Feasibility

 The degree to which the plans call for specialized personnel,

methods, and equipment will impact the risks inherent in the

project.

 1) Is the technical process or design mature?

 2) Are there portions of the project which contain non-

 standard design technology or highly technological

 elements with strict tolerances?

 3) Will the design require the contractor to employ highly

 trained personnel and will the contractor be able to

 control the quality of their work?

 4) Does the contract require the use of specialized

 equipment? For example, will such equipment be needed for

 excavation, shoring, survey and layout, measuring,
 concrete formwork, concrete placement, erection, lifting,

 testing or safety? Moreover, what is the availability and

 reliability of such equipment?

 5) Does the contract call for specialized methods to achieve

 the desired goals? Such methods may entail earth

 stabilization, underpinning methods, specialized

 excavation, environmental controls, steel erection and

 tensioning, marine specialties, all which may be beyond

 construction practice. Alternately, is the contractor

 allowed to select a method with which he is most familiar

 and still able to reach the chosen goal?

 B-1

 6) What is the magnitude to which the contract calls for

 several different craft disciplines to be working in

 close proximity to each other (i.e. electricians,

 laborers, mechanical, HVAC, millwrights, instrumentation,

 operating engineers, etc.)?

B. Long term viability

With the increasing budgetary constraints, the self-sufficiency of

transit systems may become an increasing important issue.

 1) To what extent will the project require long-term

 operating and maintenance subsidies?

 2) What are the demographic projections for this area? That

 is, will the project serve smaller and smaller

 populations?

 3) What is the future capacity of the system? Is the project

 designed such that it can be expanded easily?

 4) Has a rigorous Alternatives Analysis been conducted?

C. Political Circumstances

 1) Will there be unusual government intervention in any of

 the following?

 a. design standards

 b. environmental issues

 c. site location

 d. pricing

 e. reporting requirements

 f. permit issuance

 g. inspections

 h. customs
 2) What are the chances for: riots, strikes, etc.?

 3) What are the long term plans for the community?

II. FUNDING

A. Funding Sources

 1) Federal share

 2) Local government contribution

 B-2

 3) State contribution

 4) Private Financing

 5) Right of way development rights

 6) Tax exemptions or concessions

 7) Farebox revenues

How reliable am the sources of funding mentioned above? Can any

surprises be expected in obtaining funds from any of the above

sources that can drastically impact the project fate? How much

coordination between various funding agencies will be required? Is

joint development a viable alternative?

B. Inflation and growth rates

 1) Will the work be performed during periods of economic

 stability or will it be executed when the economy is

 experiencing variations? During the times of economic

 growth, the possibility of raising taxes and meeting

 project's financial obligations is greater.

 2) Will the project last beyond the time that accurate

 predictions can be made about inflation?

 3) Are suppliers willing to give fixed prices for goods and

 services that may not be delivered for several years?

 4) Have reasonable allowances been made for inflation? How

 the regional growth rate is going to affect the local

 source of funding?
C. Accuracy of Cost and Contingency Analysis

 1) Is the contingency amount simply added as a fixed

 percentage of the total project cost or has a serious

 effort been made to determine risks?

 2) Is there a wide spread in the bids received?

 3) Is there a large discrepancy between the engineers

 estimate and the bids received?

D. Cash Flow

 1) Are the cash flow estimates reasonable and fundable?

 B-3

 2) Are there large discrepancies between the budget cash

 flow and the project construction expenditure plan? If

 so, who would be responsible for interim financing?

E. Exchange Rates

 1) If foreign contractors are involved in the project, have

 fluctuations in "change rates been planned for?

F. Appropriation

 1) Have the funds been appropriated or only authorized.?

 2) Will there be adequate funding until completion? How is

 the allocated funds distributed throughout the project

 construction period? Also see issues under Cash Flow.

III. PLANNING

A. Scope

 1) Is the scope clearly defined and understood by all

 parties involved so that chances for additional work

 orders are minimized?

B. Complexity of the Project

 1) Is the project so complex that it will be difficult to

 see how all the parts fit together?

C. Technical Constraints
 1) Refer to Technical Feasibility under Project Feasibility.

D. Sole Source Material or Service Providers

 1) What is the possibility of project completion if a sole

 source supplier ceases operations? Have contingency

 plans been made to create a new company to replace a sole

 source supplier?

E. Constructabilty

 1) Is an effort being made to make the design as

 constructable as possible? Are there plans to formally

 study design in order to improve and enhance construction

 process?

 B-4

F. Milestones (Schedule)

 1) How crucial is the completion of milestones with respect

 to the entire project?

 2) How many critical paths have been created as a result of

 milestones?

 3) What is the level of liquidated damages associated with

 project milestones?

G. Time To Complete (Schedule)

 1) Condensed Schedule

 a. What is the extent to which schedule completion

 times have been shifted from the ideal to the

 minimum?

 b. How does the contract address multiple shift work

 due to schedule compression?

 c. Have allowances been made for changes in

 productivity due to compression?

 2) Normal Schedule

 a. Will the project be of such a long duration that the

 risk of exposure to unknown conditions is high?

H. Synchronization of Work and Payment Schedules

 1) Is there the possibility of front-end loading?
 2) Is there any benefit to provide mobilization fund to the

 contractor? Is it possible to reduce retained

IV. ENGINEERING

A. Design and Performance Standards

B. Unreliable Data

 1) Is any aspect of the project information or technical

 data available to the engineers unreliable, incomplete,

 or inadequate?

C. Complexity

 1) Does this project have any components which have never

 been designed before?

D. Completeness of Design

 1) To what extent is design complete? This can be very

 important when soliciting turnkey proposals. What effect

 will this have on the contingency sums that the bids

 contain?

 B-5

E. Accountability For Design

 1) Is the owner or the engineer willing to accept

 responsibility for errors and omissions in design?

 2) What is the extent and rigorousness of the design review

 process?

F. System Integration

 1) Are design interface points being studied? Are these

 interface points compatible so that there will be 'a

 smooth transition?

V. TYPE OF CONTRACT

A. Lumpsum

The primary risk factors to the owner with this type of contract

are:
 1) Changes in scope resulting in payment adjustments on a

 non-competitive basis.

 2) Unforeseen complexities in field conditions that may

 result in change in quantities.

 3) Differing site conditions (DSC) i.e. conditions that have

 changed materially from those manifested by the contract

 documents and could not have been reasonably foreseen.

 4) Excusable delay conditions - i.e. delays which are

 allowed within the contract, allowing the contractor more

 time and possibly more money.

 5) If quality expectations are not clearly defined, the

 contractor will be tempted to take short cuts in order to

 complete the project as soon as possible.

B. Unit Price

The primary risk factors to the owner with this type of contract

are:

 1) Payment adjustments for quantity over-runs

 2) Differing site conditions

 3) Excusable delay conditions

 4) Termination for convenience

 B-6

C. Cost Plus

Although this type of contracts have not been widely used on public

projects, they may provide vehicles for innovative procurement

involving public-private partnerships.

VI. CONTRACTING ARRANGEMENT

A. Turnkey - when the contractor will design, build and start up

 the project.

B. Joint Venture - i.e. when two or more contractors pool their

 resources to build a project under one organization.

C. Single Prime Contractor - owner contracts with one company to
 build the project

D. Several Prime Contractors - owner contracts with two or more

 distinct constructors.

E. Innovative Procurement Methods - a wide range of contracting

 arrangement related to involving public-private financing such

 as super turnkey, build-operate-transfer, etc. have been

 proposed that can be used under special circumstances and will

 have profound risk implications for the project.

VII. Regional and Local Business Conditions

A. Number of Bidders

B. Unemployment Rate in Construction Trades

C. Workload of Regional Contractors

These conditions directly impact the bid value submitted by the

contractor. The traditional contractor decides on his markup based

on his existing backlog, the competition, and the economic

conditions. In times of economic hardship there is generally an

increase in the number of bidders with a sharp decrease in the bid

values. This can benefit the owner and can be considered as an

important factor in planning and timing of major projects.

VIII. CONTRACTOR RELIABILITY

A. Contractor's Capability

 1) How much experience does the contractor have on projects

 with the same goals and size?

 B-7

 2) What was the contractor's profit margins on similar

 projects (if possible)?

B. Contractor's Capacity

 1) What is the contractor's work in progress?

 2) What percentage of the contractor's total work volume

 will this project account for?

 3) What else is the contractor bidding on and what are his

 chances for the award?

 4) Does the contractor have the bonding capacity for this
 project?

C. Contractor's Credit Worthiness

 1) Profitability trend

 2) Depth of bank support

 3) Total Assets and equity

 4) Aging of accounts receivable

 5) Debt levels

D. Experience of Personnel

 1) Years of experience of key personnel

 2) What is the number of P.E.'s and the people with advanced

 degrees on the contractor's payroll?

 3) What is the contractors reputation for integrity and

 quality of workmanship?

 4) What is the background of the owner(s) of the contracting

 company? Are there any character issues with the owners

 or the contractor's key personnel?

IX. OWNER INVOLVEMENT

The extent to which the owner needs to become involved with any of

the following factors in order to control risk.

 B-8

A. Management of Project

 1) How much time and effort will be required in the overall

 supervision of design, construction, scheduling, quality

 control, cost and scope may depend on the type of

 contract selected.

B. Supplying of Material

 1) The owner may reduce project costs by purchasing some

 items directly from suppliers. This benefit is derived

 from mass purchasing power and the ability to make large

 payments without affecting cash flow.
 2) What are the consequences if owner-furnished materials or

 equipment are late or unsuitable.

C. Testing and Inspection

 1) What are the gains in time and quality if the owner

 utilizes his own testing and inspection facilities?

D. Safety Programs

 1) Does owner involvement in worker and site safety minimize

 claims and risks? How does the contractor view this?

E. Communications and Problem Solving

 1) To what extent is the owner willing and able to resolve

 problems rapidly, to avoid delays and antagonistic

 relationships?

 2) Is a Dispute Resolution Board (DRB) being planned,

 especially for projects involving underground

 construction?

F. Partnering - This is a relatively new management approach that

 attempts to reduce adversarial relationship between project

 parties.

 1) Are there any plans for utilizing partnering concept in

 the project?

G. Start-up Operations

 1) What are the plans for the project start-up period? Do

 the owner's operating personnel have to interface with

 the contractor? Will this interface period be smooth?

 B-9

X. REGULATORY CONDITIONS

A. Licenses and Permits

 1) Obtaining permits in advance of construction will

 minimize delay claims. Permits required for the

 construction operations can best be obtained by the

 contractor though.

B. Environmental Regulations and Requirements
 1) Are existing regulations overly conservative and require

 the use of extensive and expensive remedies?

C. Patent Infringement

 1) Will the use of an existing patent create undue royalty

 payments or litigation? Is the cost of such use known in

 advance of the start of the project?

D. Taxes and Duties

 1) Will an existing tax or duty unfairly rule out a superior

 foreign contractor or supplier?

E. DBE Involvement

 1) What are the DBE requirements?

 2) What is the probability of finding an adequate number of

 competent DBE firms that are available for work in the

 area?

 3) What has been the experience of potential bidders with

 DBE firms in the region?

XI. ACTS OF GOD

XII. SITE

A. Access

 1) Is the existing infrastructure capable of handling the

 construction traffic along with the normal volume?

 2) How many times will the traffic have to be rerouted

 during the course of construction?

 B-10

 3) Do the existing roads and bridges have the weight

 capacity to handle construction tonnages?

 4) Are the existing roads wide enough to accommodate the

 materials and equipment that must be moved into the area?

 5) Is site access restricted by owner or prior contracts?
 6) What is the nature and number of alternative routes

 available to the contractors?

 7) Is access to the site limited to certain times of the

 day?

B. Congestion

 1) Is there sufficient acreage for work staging and

 materials storage?

 2) How much coordination between contractors will be

 required when the joint occupancy of the site increases?

 3) Who will be responsible for coordinating the contractors?

 4) Will any of the contracts have to be accelerated just to

 satisfy turn-over requirements for the storage area?

 5) What is the proximity of the adjacent contractors work

 area? Who will make sure that the abutting contractor

 will provide a clear working area for the next contractor

 when his work starts?

 6) What is the exposure to interaction with the public? i.e.

 how much distraction will there be for the workmen?

C. Underground Conditions

 1) What is the extent of deep excavations or tunnels with

 complex support systems?

 2) What is the history of the area for burying massive

 objects? This is especially important in older cities

 such as Boston.

 3) What do the test borings reveal? Were there sufficient

 borings taken to extrapolate with any degree of accuracy

 the conditions between test holes? Were the holes drilled

 as deep as the proposed excavation?

 B-11

 4) What is the potential for encountering adverse

 groundwater conditions? If groundwater is known to be

 present, what are the acceptable means of removing it

 from the work area and where will it be pumped?

 5) What is the extent of underground utilities at the

 construction site? Do the local utilities have accurate
 records of abandoned lines as well as active lines?

 6) What is the possibility of finding historical artifacts,

 ancient cemeteries, or other archeological finds?

 7) What is the potential for encountering hazardous wastes?

 8) What is the potential for encountering hazardous wastes

 that ut not identified or specifically located in the

 contract documents?

D. Noise, Fumes, Dust

 1) How will the site location and soil type affect the need

 for noise, fume and dust abatement procedures?

E. Abutting Structures

 1) As the number of abutting buildings owned by third

 parties increases, the potential for damage to these

 edifices may increase.

 2) If buildings adjacent to the construction right-of-way

 begin to show signs of damage, the project may be subject

 to delays until such time that the causes of the damage

 are determined.

 3) Are there any historical buildings near the site? Are

 these buildings on the National Register of Historic

 Places?

 4) What is the nature and level of vibration mitigation

 requirements specified by the contract?

 5) If the abutting structures are too close, the contractor

 may lose efficiency due to restricted site conditions.

F. Security

 1) Will extra care be required to secure the site, as well

 as the storage of materials and equipment?

 B-12

G. Disruption to Public

 1) Is there potential for restricted work hours because of

 proximity to residential or business districts?
XIII. LABOR

Most of the issues enumerated in the checklist will be of prime

concern to the contractor. The owner should have an overall

understanding of the potential impact of these parameters on

project cost and schedule.

XIV. LOSS OR DAMAGES

XV. GUARANTEES

A. Schedule - delay clauses demarcate the time and money

 supplements to which either party may be due for delays

 created by the accountable party or force majeure.

B. Performance - performance clauses demarcate the time and money

 supplements to which either party may be due for failures to

 perform created by the accountable party or force majeure.

C. Consequential Losses - These are damages that originate as an

 indirect consequence of construction activities. Examples

 include loss of production, loss of goodwill, loss of profit

 or sales, and interest on debt service.

D. Liquidated Damages - These clauses define the monetary

 penalties to be assessed against the contractor in the event

 of failure to meet certain schedule criteria.

 B-13

 APPENDIX C - LIST OF CONTRIBUTORS

 Several individuals from FTA, engineering firms, construction

companies, sureties, and State agencies have contributed to this

effort by providing information. We would like to thank Marina

Drancsak and Elizabeth Solomon of FTA for supporting us in all

administrative aspects of grant management. Their prompt response

and effective support are greatly appreciated. Edward Thomas of

FTA, the technical director of the grant, cooperated and supported

us throughout this effort by providing insight, feedback, and

information about the functions and procedures of the FTA and the

Agency's concerns and objectives. Without his support, this work

would have not materialized. We appreciate his enthusiasm and

energy and hope that we have been successful in addressing the

FTA's needs in the area investigated.
 The following is a listing of the individuals who have

provided information or offered valuable comments on the findings

of this project. Involvement of each individual varied in context

and extensiveness. We sincerely thank them and apologize to anyone

inadvertently not included in the list. We accept full

responsibility for any errors or inaccuracies in the report.

David B. Ashley, Professor, University of California, Berkeley,

California.

William R. Barry, Chief Estimator, Stone and Webster, Boston, Mass.

Anthony Branca, PI Assoc., independent consultant, Sharon, Mass.

Peter Butler, Budget Office, MBTA, Boston, Mass.

Mark Campa, Moody's Investors Service, New York, New York.

Jane Chmielinski, Director, Environmental Management Group, MBTA,

Boston, Mass.

Domenic E. D'Eramo, Vice President, Sverdrup Corp., Boston, Mass.

James E. Diekmann, Professor, University of Colorado, Boulder,

Colorado.

David J. Forkenbrock, Director, Public Policy Center, University of

Iowa, Iowa City, IA.

Donna Hixon, Bond Underwriter, Reliance Insurance, Boston, Mass.

Michael Hurley, Construction Manager, Sverdrup Corp., Boston, Mass.

Thomas J. Luglio, Jr., EG&G Dynatrend, Bryn Mawr, Pa.

Donald McCarter, Underwriting Manager, Hartford Insurance Co.,

Boston, Mass.

Timothy C. McManus, Principal, PMA, Boston, Mass.

L.P.(Bud) Morrill, Chief Engineer, Estimating and Cost, Stone and

Webster, Boston, Mass.

Joseph Philips, Underwriting Manager, SafeCo, Framingham, Mass.

John Powers, Project Manager, MBTA, Boston, Mass.

Sidney J. Wanel, Attorney at Law, Davis, Malm, and D'Agostine,

Boston, Mass.

Glenn R. Whitehouse, Chief Estimator, Perini Corp., Farmingham,

Mass.

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Department of Transportation in the interest of information

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The United States Government does not endorse manufacturers or

products. Trade names appear in the document only because they are

essential to the content of the report.

This report is being distributed through the U.S. Department of
Transportation's Technology Sharing Program.

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