Question

Hemisphere Corp. is considering a Build-Operator-Transfer (BOT) contract to construct and operate a large dam with a hydroelectric power generation facility in a developing nation in the southern hemisphere. The initial cost of the dam is expected to be $30 million, and it is expected to cost $100,000 per year to operate and maintain. Benefits from flood control, agricultural development, tourism, etc., are expected to be $2.8 million per year. At an interest rate of 8% per year, should the dam be constructed on the basis of its conventional B/C ratio? The dam is assumed to be a permanent asset for the country.

Answer 1

Answer:

The dam should be constructed. The investment discounted payback is 25 years.  

Explanation:

We have to make a cash flow for this case with the given data.  See the document attached.  

We consider an Initial cost of 30 millions in period 0,  then we have every periods benefit of 2.800.000 and 100000 direct cost.  

With those,  is obtained net cash flow for each year (period),  if we consider the given rate of interest, can be calculated the discounted cash flow

To know when this project covers all the investment,  we have to consider the cumulative discounted cash flow.  We have to see in the cash flow chart when the cumulative discounted cash flow break the 0 (became higher than 0).  

In this case ,  that will be at period 25. So we have to wait 25 years to recover the initial cost. Considering that the dam usually has a lifetime higher than that time,  the project at this scenario,  should be done.  

Answer 2

The conventional B/C ratio for the given dam is more than 1 if the company's rate of return is 8% per year. The conventional B/C ratio is 1.12. Hence, the dam should be constructed.

Further explanation:

Conventional Benefit-Cost Ratio: The Benefit-Cost ratio refers to the ratio, which represents the relationship between the benefits arising out of the project and the cost incurred on the project. This ratio is used for making a financial analysis of various projects. It is helpful in the evaluation of both public and private projects. The project can be chosen when its benefits are exceeding its cost. Conventional B/C ratio is computed by dividing the net benefits arriving out of the project with the net cost of the project. The net value of benefits is computed by subtracting the value of losses from the benefits. The net cost includes the initial and operating cost after subtracting the salvage value.

Compute the conventional B/C ratio:

$\text{Conventional B/C ratio}=\dfrac{\text{Present value of benefits}}{\text{Initial cost + Present value of operating and maintenance cost}}\\=\dfrac{\ 35,000,000}{\ 30,000,000+\ 1,250,000}\\=\dfrac{\ 35,000,000}{\ 31,250,000}\\=1.12$

Therefore, the conventional B/C ratio for the given dam is more than 1 if the company's rate of return is 8% per year. The conventional B/C ratio is 1.12. Hence, the dam should be constructed.

Working note 1:

Compute the present value of benefits:

$\text{Present value of benefits}=\dfrac{\text{Annual benefits}}{\text{Interest rate}}\\=\dfrac{\ 2,800,000}{0.08}\\=\ 35,000,000$

Hence, the present value of the benefits from dam is $35,000,000.

Working note 2:

Compute the present value of operating and maintenance cost:

$\text{Present value of operating and maintenance cost}=\dfrac{\text{Annual operating cost}}{\text{Interest rate}}\\=\dfrac{\ 1,000,000}{0.08}\\=\ 1,250,000$

Hence, the present value of the annual operating cost of dam is $1,250,000.

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Answer details  

Grade: Senior School

Subject: Financial Accounting

Chapter: Time value of money

Keywords: Hemisphere Corp., Build-operator-transfer (BOT), contract to construct, hydroelectricity power generation station, developing nation, $30 million, expected to cost, benefits from flood control, agricultural development, tourism, dam be constructed, conventional B/C ratio, dam is assumed to be constructed, permanent asset, for the country, southern hemisphere, large dam, time value of money, present value of money, contract to construct, developing nation, cost ratio, expected to be $2.8 million, operate and maintain.