Question

The United Nations has decided that it would be nice to construct a tunnel across the Bering Strait to connect Russia to Alaska, allowing for a road trip across the world(!) and thereby promoting a global sense of greater understanding, unity, and peace. To this end, the UN has solicited your firm to build this tunnel. If you build the tunnel, you will receive $20 for each car that passes through the tunnel. Upon hearing this, you hired a team of consultants, at a cost of $100,000, to help you analyze the scope, costs, and overall operations/infrastructure associated with this project. Their complete report/analysis is attached below: Overall, it should take three years to complete construction of the tunnel. The project would require the upfront purchase (t=0) of a $100 million Blade Digger, a huge machine to drill the tunnel. The Blade Digger has a useful life of five years, and can be depreciated at a rate of $20M/year. Based on our analyses, we anticipate that, at any point in time, The Blade Digger can be sold at book value. We expect annual construction expenses of $50M / year for 3 years (from t=1, 2, 3) and annual maintenance expenses of $25M / year throughout the 30‐year life of the tunnel, with maintenance expenses to be paid beginning at time t=4. We expect that the tunnel has no salvage value at the end of its useful life. The NWC requirement during the construction phase of this project is $15M (from t=0, 1, 2). We anticipate a $5M NWC requirement from t=3 and on. We estimate that, throughout life of tunnel, about 3.5 million vehicles will use the tunnel per year. Your relevant marginal tax rate is 35%, and based on the risks involved, the opportunity cost of capital is assessed to be 15%.

Question: Should you accept this project? Provide a full report/analysis along with your ultimate valuation of this project. I’d like to see a full cash‐flow timeline, detailing the accounting information each period (like how we did in class), so that I can follow how you derive your final cash flows, and ultimately, your final decision.

Answer 1

The expense of 100000 for the analysis of the project is considered as sunk cots as the the cost is incurred and will not change whether we select the project or not. so this is an irrelevant cost

Tax rate ==> 35%

Discount rate ==> 15%

So PV annuity factor for 27 years @15%

==> [1-(1+r)^-n]/r= [1-1.15^(-27)]/15%

==> 6.5135

PV annuity factor for 3 yrs @15% ==> 2.283

	Cash flow Ananlysis
1	Initial Investment in Year 0	All Amt in $M
	Details	Year 0 amt	PV Factor	PV of Cash flows
	Cost of Blade digger	(100)	1	(100)
	Investment in NWC	(15)	1	(15)
	Total Year 0 cash flows			(115)
2	Return of NWC	Amt	PV Factor	PV of Cash flows
	NWC Returned on year 3	10	0.658	6.580
	NWC Retuned at the end of 30 years	5	0.0151	0.0755
	PV of Cash flows from NWC Return			6.6555
3	Depreciation Tax shield
	Depreciation per year	20
	Depreciation Tax shield per yr @35%=	7
	PV Annuity factor @15% for 3 yrs =	2.283
	PV of Depreciation Tax shield =	15.98
4	Salvage value of Blade digger after 3 yrs=Book value
	after three years =	40
	PV Annuity factor @15% for 3 yrs =	2.283
	PV of Salvage value =	91.32

5	Cash flow from Yr 1-3
	Annual revenue car passes ($20 /car for $3.5M car/yr)	70
	Less Annual construction expense	50
	Pretax income	20
	Less Tax @35%	7
	Earning After Tax	13
	PV Annuity factor @15% for 3 yrs =	2.283
	PV of cash flow for Three years	29.679
6	Cash flow from Year 4-30
	Annual revenue car passes ($20 /car for $3.5M car/yr)	70
	Less Annual Maintenance	25
	Pretax income	45
	Less Tax @35%	16
	Earning After Tax	29
	PV Annuity factor @15% for 27 yrs =	6.6555
	PV Of cash flows from Tr 4-30=	194.673
	NPV of the Project =Sum of PV of Cash flows in 1+2+3+4+5+6=		$               223.31
	As the NPV of the Project is positive and PI Index (2.23) is >1 , the project should be accepted.

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