Background

Part A

You work for ConstCo, a medium-sized engineering and construction company with annual profits of about $100 million. You recently entered as a contractor into a bidding process for a large construction project.

The total (projected) cost for the project will be about $500 million. The project will have a duration of 5 years, and the following estimated cost will occur throughout the five years (assume all cash flows occur at the end of a year):

Year 1: $200 million

Year 2: $100 million

Year 3:$100 million

Year 4:$50 million

Year 5:$50 million

The project is auctioned on a lump-sum turnkey contract, i.e. you as the contractor will receive a fixed payment for the project. Your sales manager is convinced that you can win the bidding process for a bid of about $650 million, with 20% being paid after the first year, 10% after years 2-4, and the final 50% being paid upon completion. Your finance department suggests using an interest rate of 15% for this project, since it represents considerable risks, like your client defaulting or actual costs being very different from your estimates.

Calculate the Net Present Value for this project.

Part B

Upon successfully bidding for the project (and obtaining the conditions specified in Part A), your client approaches you with an alternative arrangement. Instead of a lump-sum turnkey contract, they are willing to convert the project to a regular Engineering and Construction contract, where you bill the client for your cost (no profit).

To align incentives, the client proposes that to ensure your profitability, they give you a 10% stake in the company that controls the project (called ManCo), a company that basically oversees construction, manages the facility afterwards and distributes the profits from the project to its owners. You will be awarded this stake during year 5 (at the end of the project). ManCo's CFO sees the current value (as of today) of the company at $600 million, so your 10% stake of that as of today would be worth $60 million. Your auditors have checked this estimate and consider it a fair value. But your auditors also warn you that there is considerable risk in this value over the next 5 years at the end of the project, ManCo may be worth as little at $20 million or as much as $1.2 billion dollars. Cost variations are a key reason for this risk. They expect that the probability distribution of the value of your stake in ManCo in year 5 is a uniform one (i.e. equal probabilities) for each of the 60 possible values from $2 million, $4 million, $6 million, ... to $120 million.

After some negotiations, your CEO is able to obtain a guarantee from ManCo that you can convert this 10% stake into a $40 million lump-sum payout, also paid at the end of the project. For simplicity, assume that you would find out very quickly after signing the contract (i.e. within the first year) what the final value of your stake is, so you could immediately switch to the $40M fixed amount option if desired.

Evaluate this alternative contract from a financial perspective. Should you consider this alternative contract?