Roadworthy Inc. is a bridge construction company. It has been contracted on a $75 million bridge building project in Edmonton. The contract terms specified that the company must complete the project within three years, and the company will be paid at the end of each year according to the percentage completion on the bridge. For example, at the end of the first year of construction, the company will be paid 25% x $75 million = $18.75 million, as per the company’s submitted bid, which indicated the following completion schedule:
Year 1: 25% completion
Year 2: 75% completion
Year 3: 100% completion
The contract terms also specified that should the project fall behind schedule, Roadworthy will be assessed a penalty of $15 million for each year of delay. The discount rate on this project is 15%
a. Assuming the company completes the project on schedule, what is the present value of this project to the company?
b. If the company completes the project on time, what is the future value to the company at the end of the project (i.e., at the end of Year 3)?
c. During the second year of construction, part of the bridge collapsed due to incorrect construction. Fortunately, the collapse occurred at night, and there were no injuries or casualties. However, new parts and equipment needed to be purchased, and the project had to restart from scratch. The adjusted schedule of completion of the entire project became
Year 3: 25%
Year 4: 75%
Year 5: 100%
Roadworthy would not be receiving any payment in Years 2 and 3, as payment has already been received for 25% completion of the project. If the company’s bridge construction went according to the new schedule, it would receive the next payment at the end of Year 4, and the last payment at the end of Year 5.
Furthermore, due to the delay in the project, the City of Edmonton will assess the company $15 million for each year of delay, with the penalties due at the end of Years 4 and 5.
What is the future value of this project at the end of Year 5?
d. What is the minimum penalty that the city of Edmonton should charge Roadworthy in order to force it to complete the project by Year 4, with the following completion schedule?
Year 3: 50%
Year 4: 100%
(Hint: At the minimum penalty level, the future value of the project to the company will be $0 at end of Year 4.)