Araba town council plans to build a bridge over the local river to replace the existing ferry

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Question:

Araba town council plans to build a bridge over the local river to replace the existing ferry service. Building will start in one year's time, that is 2006 and will take 4 yrs. It has planned to sub contract the building work to a major construction company and the best tender will involve the council in a cash expense of N10m at the start of building and further payments of N5m each year until 2010 once completed, the annual maintenance cost for the bridge will be N1m per annum according to today's prices; the annual cost is expected to rise with the general inflation rate of 7% p.a. In addition, a major overhaul is expected to be required after the first 15years of use, this will comprise N10m of material plus wage costs of a further N10m in current prices.

Material prices are expected to rise with the general rate of inflation for the next 16years and then remain constant; wage cost is expected to increase by 6% over the general inflation rate for the next 3years and then increase in line with general prices. The market interest rate the council consider relevant for the whole life of the project is 17.7%. You can assume that for calculation purpose the life of the bridge is infinite. The expected use of the bridge is 20,000 vehicles per day and toll charge is expected to increase in line with general inflation.

Required

a.Calculate minimum toll charge in the first year of operation necessary for the bridge to break even over its life, and explain your treatment of inflation. Note: Assume all annual cash flows arise on the last day of the relevant year.

b.What other factors do you think the council should consider when deciding upon the toll charge? Note: The statement that "in addition, a major overhaul is expected to be required after the first 15yrs of use" should be interpreted to mean at the end of the first 15years of use (i.e. year 20.5 +15) (ICAN , 1993)