Agenda Item #5: The Spread Net
Agenda Item #5: The Spread Network L.L.C. Story. –Capital Budgeting
Speed of information has always played a key role in history,and this also applies equally to financial markets. Legend has it,that in 1815 Nathan Rothschild was able to exploit the earlyinformation he received (by way of pigeon it is said) of thevictory against Napoleon at Waterloo to make a tidy sum. A few₤100,000 when the average annual salary was just ₤50. Fast-track184 years to 2009, and the Spread Network has concocted a plan tobuild the first and fastest, dedicated fibre optic route betweentwo stock exchanges[1]. It plans to connect the ChicagoMercantile Exchange with the NASDAQ exchange in New Jersey, roughly1400 km’s one way or 2800km return trip. It will require signalboosters every 100 km or so. To elaborate on ‘speed’, they aimed toreduce the time it took to submit a purchase order (offer) forfinancial assets (like shares), and receive confirmation of theoffer price (acceptance of offer), from 14.65 milliseconds to 12.9milliseconds[2]. About 1/10th of the time it takes to blink. Thiswas unprecedented at the time, and it was hoped that by shavingaround 1 and a half thousandths of a second off the travel time itcould be leased to high frequency traders and investment banks formillions of dollars per month.
You snagged an internship at J.P. Morgan investment bank withinthe corporate finance division, and it is up to you to determinethe viability of this project. So, what is speed worth?
The project will last for 8 years, beginning in 2011 (year 0)and ending in 2019 (year 8). Depreciation is straight line to zero,and taxation (at the time) is 35% in the United States. In any yearwith a negative EBIT, there is no tax. The capital investment forthe fibre line project is $350,000,000 (invested in year 0),including costs of amplification sites, earthmoving equipment,easements etc. Working capital is expected to be $60,000,000,returned at the end of the project. A 24 hours a day, 7 days a weekmaintenance team is required to ensure 99.99% operational capacity,costing $60 million per year, and increasing at 3% per year. Theproject success hinges on access to the fibre ports in theexchanges, they know this and charge $50,000,000 per year(combined), declining by 5% p.a. as demanddeclines. Ateam of surveyors and builders who inspected the 1400 km path cost$1.5 million. At the end of the project, the technology is obsoletefor its purpose in investment banking, but it can be sold to atelecom provider (contributing to the revenue for year 8) for$127,000,000. Revenue is subscription based at $3,600,000 per year,per subscription. In year 1 there will be 200 subscriptions, year 2is 150, year 3 is 100, year 4 is 50. In year 5, 6, 7, 8 only 20subscriptions are taken in per year. The all-important discountrate is 14.5%.
Your manager’s guidance: In addition to presenting the NPV andIRR (and associated advice), your manager likes to scope out asmany dimensions of a potential business decision as possible beforeproviding the report. They might like to know how changes torevenues or costs might affect the viability of the project,including how this may impact the NPV and IRR. Another factor isthe sensitivity of the cost of capital. Ensure your spreadsheet cancope with changes to these variables on the fly.
Answer:
To analyze the given problem, we need to perform a rather simplecash flow analysis.
Going by the analysis, we have an IRR of 75% & an NPV of$32,76,21,779
An Increase in discount rate of 1%, can reduce the NPV by 3%
An increase in revenue by 10%, can increase the NPV by 27% andincrease the IRR to 90%
An increase in cost by 10% (maintenance & Fibre cost) canreduce the NPV by 14% and drop the IRR to 72%
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