Question

Atlantic Megaprojects has a contract to build a tunnel connecting two Atlantic provinces. The tunnel should be completed in three years and requires a total investment of $220,000: $80,000 during the first year and $70,000 during each of the second and third year. If they wish, Atlantic Megaprojects could complete the project in two years by subcontracting part of its work. In this case the required investment would be $115,000 during each of the first and the second year. In either case, the government would pay to Atlantic Megaprojects a total of $350,000: $150,000 one year after the project is completed and $ 200,000 two years after the project is completed. The opportunity cost of capital for the company is 15%.

a) For each of the two cases, construct a table containing the cash flows and discounted cash flows.

(b) Using the NPV method, decide if Atlantic Megaprojects should sub- contract, complete the project by themselves or none of the two. [Sub- contract, NPV is larger]

(c) Now suppose that the cost of capital is only approximate. What is the maximum discount rate for which the project is still attractive? [IRR, 22.47%]

Answer 1

*Answer

Pls see table below for the construction of cash flows, calculation of NPV and IRR.

*a)

Year	Option 1 - no subcontracting	Option 2 - subcontracting
Investment	Revenue	Net CF = Investment + Revenue	NPV = Net CF / 1.15^Year	Investment	Revenue	Net CF = Investment + Revenue	NPV = Net CF / 1.15^Year
1	-80,000.00		-80,000.00	-69,565.22	-1,15,000.00		-1,15,000.00	-1,00,000.00
2	-70,000.00		-70,000.00	-52,930.06	-1,15,000.00		-1,15,000.00	-86,956.52
3	-70,000.00		-70,000.00	-46,026.14		1,50,000.00	1,50,000.00	98,627.43
4		1,50,000.00	1,50,000.00	85,762.99		2,00,000.00	2,00,000.00	1,14,350.65
5		2,00,000.00	2,00,000.00	99,435.35
IRR			19.1%	16,676.92			22.5%	26,021.56

*b)

Since the NPV is positive and higher in case of subcontracting teh project shoudl be subcontracted

*c)

In case of subcontracting IRR is 22.5% and hence this is the highest discount rate that makes this project vialbel. Also note that for a discount rate between 19.1% and 22.5%, the project is not viable if not subcontracted.

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