Infrastructure Finance: The Sydney Cross City Tunnel Net Present Value (NPV) / MBA Resources

Introduction to Net Present Value (NPV) - What is Net Present Value (NPV) ? How it impacts financial decisions regarding project management?

NPV solution for Infrastructure Finance: The Sydney Cross City Tunnel case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Infrastructure Finance: The Sydney Cross City Tunnel case study is a Harvard Business School (HBR) case study written by Frederik Pretorius, Mary Ho. The Infrastructure Finance: The Sydney Cross City Tunnel (referred as “Tunnel Infrastructure” from here on) case study provides evaluation & decision scenario in field of Strategy & Execution. It also touches upon business topics such as - Value proposition, .

The net present value (NPV) of an investment proposal is the present value of the proposal’s net cash flows less the proposal’s initial cash outflow. If a project’s NPV is greater than or equal to zero, the project should be accepted.

NPV = Present Value of Future Cash Flows LESS Project’s Initial Investment

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Case Description of Infrastructure Finance: The Sydney Cross City Tunnel Case Study

This case explores events surrounding the development of the Sydney Cross City Tunnel, an innovative infrastructure project developed by the New South Wales government in Australia in conjunction with Cheung Kong Infrastructure, Cheung Kong's Hong Kong infrastructure investment arm. The tunnel opened for traffic in 2005. This case analyzes three matters: the political and institutional background that led to the decision to develop the Cross City Tunnel; the general economic assumptions upon which the venture had been based; and the build-operate-transfer project finance arrangements put into place to develop and finance the tunnel venture. The case explains the project finance arrangements surrounding a typical road transport infrastructure which seems to have failed, and raises questions about estimates of demand for the tunnel and traffic management arrangements surrounding access to the tunnel.

Case Authors : Frederik Pretorius, Mary Ho

Topic : Strategy & Execution

Related Areas :

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Calculating Net Present Value (NPV) at 6% for Infrastructure Finance: The Sydney Cross City Tunnel Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10003746)	-10003746	-	-
Year 1	3468852	-6534894	3468852	0.9434	3272502
Year 2	3953557	-2581337	7422409	0.89	3518652
Year 3	3960992	1379655	11383401	0.8396	3325725
Year 4	3229379	4609034	14612780	0.7921	2557971
TOTAL			14612780		12674849

The Net Present Value at 6% discount rate is 2671103

In isolation the NPV number doesn't mean much but put in right context then it is one of the best method to evaluate project returns. In this article we will cover -

Different methods of capital budgeting

What is NPV & Formula of NPV,
How it is calculated,
How to use NPV number for project evaluation, and
Scenario Planning given risks and management priorities.

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Capital Budgeting Approaches

Methods of Capital Budgeting

There are four types of capital budgeting techniques that are widely used in the corporate world –

1. Profitability Index
2. Payback Period
3. Internal Rate of Return
4. Net Present Value

Apart from the Payback period method which is an additive method, rest of the methods are based on Discounted Cash Flow technique. Even though cash flow can be calculated based on the nature of the project, for the simplicity of the article we are assuming that all the expected cash flows are realized at the end of the year.

Discounted Cash Flow approaches provide a more objective basis for evaluating and selecting investment projects. They take into consideration both –

1. Magnitude of both incoming and outgoing cash flows – Projects can be capital intensive, time intensive, or both. Tunnel Infrastructure shareholders have preference for diversified projects investment rather than prospective high income from a single capital intensive project.
2. Timing of the expected cash flows – stockholders of Tunnel Infrastructure have higher preference for cash returns over 4-5 years rather than 10-15 years given the nature of the volatility in the industry.

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Formula and Steps to Calculate Net Present Value (NPV) of Infrastructure Finance: The Sydney Cross City Tunnel

NPV = Net Cash In Flowt1 / (1+r)t1 + Net Cash In Flowt2 / (1+r)t2 + … Net Cash In Flowtn / (1+r)tn
Less Net Cash Out Flowt0 / (1+r)t0

Where t = time period, in this case year 1, year 2 and so on.
r = discount rate or return that could be earned using other safe proposition such as fixed deposit or treasury bond rate. Net Cash In Flow – What the firm will get each year.
Net Cash Out Flow – What the firm needs to invest initially in the project.

Step 1 – Understand the nature of the project and calculate cash flow for each year.
Step 2 – Discount those cash flow based on the discount rate.
Step 3 – Add all the discounted cash flow.
Step 4 – Selection of the project

Why Strategy & Execution Managers need to know Financial Tools such as Net Present Value (NPV)?

In our daily workplace we often come across people and colleagues who are just focused on their core competency and targets they have to deliver. For example marketing managers at Tunnel Infrastructure often design programs whose objective is to drive brand awareness and customer reach. But how that 30 point increase in brand awareness or 10 point increase in customer touch points will result into shareholders’ value is not specified.

To overcome such scenarios managers at Tunnel Infrastructure needs to not only know the financial aspect of project management but also needs to have tools to integrate them into part of the project development and monitoring plan.

Calculating Net Present Value (NPV) at 15%

After working through various assumptions we reached a conclusion that risk is far higher than 6%. In a reasonably stable industry with weak competition - 15% discount rate can be a good benchmark.

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 15 %	Discounted Cash Flows
Year 0	(10003746)	-10003746	-	-
Year 1	3468852	-6534894	3468852	0.8696	3016393
Year 2	3953557	-2581337	7422409	0.7561	2989457
Year 3	3960992	1379655	11383401	0.6575	2604417
Year 4	3229379	4609034	14612780	0.5718	1846408
TOTAL					10456675

The Net NPV after 4 years is 452929

(10456675 - 10003746 )

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Calculating Net Present Value (NPV) at 20%

If the risk component is high in the industry then we should go for a higher hurdle rate / discount rate of 20%.

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 20 %	Discounted Cash Flows
Year 0	(10003746)	-10003746	-	-
Year 1	3468852	-6534894	3468852	0.8333	2890710
Year 2	3953557	-2581337	7422409	0.6944	2745526
Year 3	3960992	1379655	11383401	0.5787	2292241
Year 4	3229379	4609034	14612780	0.4823	1557378
TOTAL					9485854

The Net NPV after 4 years is -517892

At 20% discount rate the NPV is negative (9485854 - 10003746 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Tunnel Infrastructure to discount cash flow at lower discount rates such as 15%.

Acceptance Criteria of a Project based on NPV

Simplest Approach – If the investment project of Tunnel Infrastructure has a NPV value higher than Zero then finance managers at Tunnel Infrastructure can ACCEPT the project, otherwise they can reject the project. This means that project will deliver higher returns over the period of time than any alternate investment strategy.

In theory if the required rate of return or discount rate is chosen correctly by finance managers at Tunnel Infrastructure, then the stock price of the Tunnel Infrastructure should change by same amount of the NPV. In real world we know that share price also reflects various other factors that can be related to both macro and micro environment.

In the same vein – accepting the project with zero NPV should result in stagnant share price. Finance managers use discount rates as a measure of risk components in the project execution process.

Sensitivity Analysis

Project selection is often a far more complex decision than just choosing it based on the NPV number. Finance managers at Tunnel Infrastructure should conduct a sensitivity analysis to better understand not only the inherent risk of the projects but also how those risks can be either factored in or mitigated during the project execution. Sensitivity analysis helps in –

What are the key aspects of the projects that need to be monitored, refined, and retuned for continuous delivery of projected cash flows.

Understanding of risks involved in the project.

What will be a multi year spillover effect of various taxation regulations.

What can impact the cash flow of the project.

What are the uncertainties surrounding the project Initial Cash Outlay (ICO’s). ICO’s often have several different components such as land, machinery, building, and other equipment.

Some of the assumptions while using the Discounted Cash Flow Methods –

Projects are assumed to be Mutually Exclusive – This is seldom the came in modern day giant organizations where projects are often inter-related and rejecting a project solely based on NPV can result in sunk cost from a related project.

Independent projects have independent cash flows – As explained in the marketing project – though the project may look independent but in reality it is not as the brand awareness project can be closely associated with the spending on sales promotions and product specific advertising.

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Negotiation Strategy of Infrastructure Finance: The Sydney Cross City Tunnel

References & Further Readings

Frederik Pretorius, Mary Ho (2018), "Infrastructure Finance: The Sydney Cross City Tunnel Harvard Business Review Case Study. Published by HBR Publications.