Question

A sports team has a stadium that holds a maximum of 36,000 fans. The league has suggested that the owners of the team consider expanding its seating to 40,000. The cost of permits, project management, and construction is expected to be $40,000 per seat. Work can be accomplished over two years, at which time the club will have 4,000 additional seats to sell. Assume the investment would occur equally over years 0 and 1.

Each seat will generate an additional $3,500 of revenue per year for the first three years after completion, $4,000 per year for the next four years, and $5,000 per year for the next four years, at which time a replacement or major renovation of the park will be necessary.

a. If the cost of capital is 15%, will this project be economically feasible, given the information provided? What is the NPV? IRR?

b. The team has approached city officials to seek a subsidy from the city to guarantee a 10% return on the project. How much would the city have to advance at the beginning to accomplish this?

c. What steps might management consider to make the project more economically attractive? Show your analysis.

Answer 1

Given:

Existing capacity  =  36,000 seats

Proposed capacity  =  40,000 seats

Increased capacity  =  40,000 - 36,000  =  4,000 seats

Cost of the project  =  4,000*$40,000  =  $ 160,000,000

The cost has been distributed over the two years (50% in year 0, 50% in year 1)

 

a.

We construct the cash flow table as:

(In this calculation we have not considered about the depreciation and tax, and salvage value had been considered as  =  zero)

	A	B	C  =  B-A
Year	Project cost	Expected revenue (Price per seat* number of additional seat)	Net cash flow
0	$ 80,000,000		-$ 80,000,000
1	$ 80,000,000		-$ 80,000,000
2		$ 14,000,000	$ 14,000,000
3		$ 14,000,000	$ 14,000,000
4		$ 14,000,000	$ 14,000,000
5		$ 16,000,000	$ 16,000,000
6		$ 16,000,000	$ 16,000,000
7		$ 16,000,000	$ 16,000,000
8		$ 16,000,000	$ 16,000,000
9		$ 20,000,000	$ 20,000,000
10		$ 20,000,000	$ 20,000,000
11		$ 20,000,000	$ 20,000,000
12		$ 20,000,000	$ 20,000,000
13		$ 20,000,000	$ 20,000,000

 

Calculation of NPV:

NPV(15%) = - $80,000,000 - $80,000,000/(1 + 15%) + $14,000,000/(1 + 15%)2 + $14,000,000/(1 + 15%)3 + $14,000,000/(1 + 15%)4 + $16,000,000/(1 + 15%)5 + $16,000,000/(1 + 15%)6 + $16,000,000/(1 + 15%)7 + $16,000,000/(1 + 15%)8 + $20,000,000/(1 + 15%)9 + $20,000,000/(1 + 15%)10 + $20,000,000/(1 + 15%)11 + $20,000,000/(1 + 15%)12 + $20,000,000/(1 + 15%)13NPV(15%)

                  =  - $80,000,000 - $80,000,000/(1 + 15%) + $14,000,000/(1 + 15%)2 + $14,000,000/(1 + 15%)3 + $14,000,000/(1 + 15%)4 + $16,000,000/(1 + 15%)5 + $16,000,000/(1 + 15%)6 + $16,000,000/(1 + 15%)7 + $16,000,000/(1 + 15%)8 + $20,000,000/(1 + 15%)9 + $20,000,000/(1 + 15%)10 + $20,000,000/(1 + 15%)11 + $20,000,000/(1 + 15%)12 + $20,000,000/(1 + 15%)13

                  = - $73,735,434

 

Calculation of IRR:

We calculate the IRR as the discount rate (R) that makes NPV as zero.

So,

NPV = 0 =  - $80,000,000 - $80,000,000/(1 + R) + $14,000,000/(1 + R)2 + $14,000,000/(1 + R)3 + $14,000,000/(1 + R)4 + $16,000,000/(1 + R)5 + $16,000,000/(1 + R)6 + $16,000,000/(1 + R)7 + $16,000,000/(1 + R)8 + $20,000,000/(1 + R)9 + $20,000,000/(1 + R)10 + $20,000,000/91 + R)11 + $20,000,000/(1 + R)12 + $20,000,000/(1 + R)13.......................(1)

 

Solving from equation (1) for R (by trial and error method or by using the IRR formula in Microsoft Excel )we get:

R = 3.54%R = 3.54%

 

So IRR of the project  =  3.54%

 

b.

We calculate the NPV of the project at @10%

From the equation (1) we replace R  =  10% to get the NPV of the project @10% cost of capital as:

NPV(10%) =  - $51,066,857.......................(2)

So get the NPV  =  0 the subsidy will be required  = $ 51,066,857

 

c.

Option (1) : The project can be completed in one year, so that the revenue can be generated from year 1.

In such case the cash flow will be as below:

	A	B	C  =  B-A
Year	Project cost	Expected revenue (Price per seat* number of additional seat)	Net cash flow
0	$ 160,000,000		-$ 16,00,00,000
1		$ 14,000,000	$ 14,000,000
2		$ 14,000,000	$ 14,000,000
3		$ 14,000,000	$ 14,000,000
4		$ 16,000,000	$ 16,000,000
5		$ 16,000,000	$ 16,000,000
6		$ 16,000,000	$ 16,000,000
7		$ 16,000,000	$ 16,000,000
8		$ 20,000,000	$ 20,000,000
9		$ 20,000,000	$ 20,000,000
10		$ 20,000,000	$ 20,000,000
11		$ 20,000,000	$ 20,000,000
12		$ 20,000,000	$ 20,000,000

In such case the IRR will be increased to 3.81%

 

Option (2): Consideration of the salvage value:

The analysis has been done considering there is no salvage value, but in reality it is not true because the operation will be continue even after 13 years subjected to additional renovation. If we consider the salvage value  =  50% of the project cost, the cash flow will be:

	A	B	C	D  =  B-A  + C
Year	Project cost	Expected revenue (Price per seat* number of additional seat)	Salvage Value	Net cash flow
0	$ 80,000,000			-$ 8,00,00,000
1	$ 80,000,000			-$ 8,00,00,000
2		$ 14,000,000		$ 14,000,000
3		$ 14,000,000		$ 14,000,000
4		$ 14,000,000		$ 14,000,000
5		$ 16,000,000		$ 16,000,000
6		$ 16,000,000		$ 16,000,000
7		$ 16,000,000		$ 16,000,000
8		$ 16,000,000		$ 16,000,000
9		$ 20,000,000		$ 20,000,000
10		$ 20,000,000		$ 20,000,000
11		$ 20,000,000		$ 20,000,000
12		$ 20,000,000		$ 20,000,000
13		$ 20,000,000	$ 80,000,000	$ 100,000,000

In such case, the IRR will be increased to 7.16%

 

Option (3): Consideration of the incremental income from other seats:

 We have considered that there will be no incremental revenue from existing seats , however if there is any incremental revenue from the old seating arrangements, the project will also be more attractive.

a. So IRR of the project  =  3.54%

b. NPV  =  0 the subsidy will be required  = $ 51,066,857