Question

Agenda Item #5: The Spread Network L.L.C. Story. – Capital Budgeting

Speed of information has always played a key role in history, and this also applies equally to financial markets. Legend has it, that in 1815 Nathan Rothschild was able to exploit the early information he received (by way of pigeon it is said) of the victory against Napoleon at Waterloo to make a tidy sum. A few ₤100,000 when the average annual salary was just ₤50. Fast-track 184 years to 2009, and the Spread Network has concocted a plan to build the first and fastest, dedicated fibre optic route between two stock exchanges[1].  It plans to connect the Chicago Mercantile Exchange with the NASDAQ exchange in New Jersey, roughly 1400 km’s one way or 2800km return trip. It will require signal boosters every 100 km or so. To elaborate on ‘speed’, they aimed to reduce the time it took to submit a purchase order (offer) for financial assets (like shares), and receive confirmation of the offer price (acceptance of offer), from 14.65 milliseconds to 12.9 milliseconds[2]. About 1/10th of the time it takes to blink. This was unprecedented at the time, and it was hoped that by shaving around 1 and a half thousandths of a second off the travel time it could be leased to high frequency traders and investment banks for millions of dollars per month.

You snagged an internship at J.P. Morgan investment bank within the corporate finance division, and it is up to you to determine the viability of this project. So, what is speed worth?

The project will last for 8 years, beginning in 2011 (year 0) and ending in 2019 (year 8). Depreciation is straight line to zero, and taxation (at the time) is 35% in the United States. In any year with a negative EBIT, there is no tax. The capital investment for the fibre line project is $350,000,000 (invested in year 0), including costs of amplification sites, earthmoving equipment, easements etc. Working capital is expected to be $60,000,000, returned at the end of the project. A 24 hours a day, 7 days a week maintenance team is required to ensure 99.99% operational capacity, costing $60 million per year, and increasing at 3% per year. The project success hinges on access to the fibre ports in the exchanges, they know this and charge $50,000,000 per year (combined), declining by 5% p.a. as demand declines.          A team of surveyors and builders who inspected the 1400 km path cost $1.5 million. At the end of the project, the technology is obsolete for its purpose in investment banking, but it can be sold to a telecom provider (contributing to the revenue for year 8) for $127,000,000. Revenue is subscription based at $3,600,000 per year, per subscription. In year 1 there will be 200 subscriptions, year 2 is 150, year 3 is 100, year 4 is 50. In year 5, 6, 7, 8 only 20 subscriptions are taken in per year. The all-important discount rate is 14.5%.

Your manager’s guidance: In addition to presenting the NPV and IRR (and associated advice), your manager likes to scope out as many dimensions of a potential business decision as possible before providing the report. They might like to know how changes to revenues or costs might affect the viability of the project, including how this may impact the NPV and IRR. Another factor is the sensitivity of the cost of capital. Ensure your spreadsheet can cope with changes to these variables on the fly.

Answer 1

To analyze the given problem, we need to perform a rather simple cash flow analysis.

Going by the analysis, we have an IRR of 75% & an NPV of $32,76,21,779

An Increase in discount rate of 1%, can reduce the NPV by 3%

An increase in revenue by 10%, can increase the NPV by 27% and increase the IRR to 90%

An increase in cost by 10% (maintenance & Fibre cost) can reduce the NPV by 14% and drop the IRR to 72%