Nowhereton is a coastal town with a small population, mostly known for being home to the now almost extinct seven fingered Deliciosa Treefrog. Other than by sea, the only way of accessing the town is via a rough dirt road off a main expressway. Recently the local council has been considering making the town more accessible by improving the condition of the road. In the past two years, there have been several instances where critically ill or injured residents have had to be airlifted out of the town because driving out was not viable. Other likely benefits from having a better road include higher land values, greater potential for revenue from tourism related activities, and convenience for residents who may have to leave town for things such as supplies or routine medical treatment. However, one major drawback would be the increased likelihood of damage to the environment and native wildlife due to a larger tourist population and more movement throughout the area.
The following financial information has been provided to the council in order to help with the decision. While the road itself would last many years, the council has decided to analyse the costs over a 5 year time horizon, and apply its usual hurdle rate of 12% for capital expenditure projects. The tax rate is 30% (we're going to assume the council pays tax!).
Please note: assume that the one-off costs of developing the road (other than the cost of the new machine) are not depreciated.
Cost of clearing land
Cost of levelling the ground
Cost of tarring the new road
Cost of sealing the road
Cost of lighting and signage
Cost of new machine, to be fully depreciated for tax purposes over 5 years
Annual operating costs of new machine
Annual maintenance cost of road
Annual revenue from road tolls
1. What is the net present value of the proposed road project? (Please keep discount factors to 4 decimal places). Should the road be approved given current investment criteria?
2. Discuss two (2) potential issues with the council using discounted cash flow analysis to make a decision about this road into Nowhereton, i.e., what other factors might you want to consider before making any recommendations?
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