Financial Modelling

BACKGROUND
A local authority in an East European city is looking at privatizing the bus network. The proposed new
company will take over the existing assets from the authority and will invest heavily in modernizing the
bus fleet and in the infrastructure (bus station, depot, bus stops and shelters, signage, etc.). A central
government grant has been made available, and the sponsor is seeking a loan to support the initial
investment. A base case financial model is required to test the underlying robustness of the business
case; the results will determine if the project has sufficient merit to require further analysis.

Objective
You are to prepare a financial model to calculate the net present value (NPV) and the internal rate of
return (IRR) of the project. The project sponsor uses a nominal discount rate of 15%. They also accept
that the basic fare may need to increase in order to break even, and your analysis should provide this
information. It may be helpful to prepare basic financial statements, but these are not seen as necessary
at this stage.

Assumptions
The project sponsor has provided the following assumptions. At this stage, assume that everything is in
the local currency (EUR), and that inflation will be applied to the forecast assumptions unless otherwise
indicated:

Forecast period should be 10 years, starting next year.

• There are 15,000,000 journeys each year.
• The average fare for next year is EUR 1.50 per journey.
• Growth is forecast at 5% each year (applicable on fare only).
• The central government subsidy is EUR 200,000 each year (other revenue).

Operating costs are simplified as follows:

– Variable costs: EUR 0.5/journey.
– Fixed costs: EUR 5,000,000 each year.
• Local council rates are EUR 100,000 each year (other expenses).
• Transfer of existing assets of EUR 20,000,000 (investment to be done now, i.e. year 0)
• Investment in new bus fleet: EUR 1,000,000 in the first 2 years, decreasing to EUR 500,000 for the
remaining 8 years.
• Investment in infrastructure: EUR 10,000,000 in the first 2 years, decreasing to EUR 1,000,000 for the
remaining 8 years.
• Depreciation uses the declining balance method, with the following rates:
– Existing assets: 15% per year.
– Fleet: 20% per year.
– Infrastructure: 10% per year.
• The proposed financing is a term loan, of EUR 12,000,000, drawn down at the start of year 1.
• The loan will be repaid over 10 years, with an annual interest rate of 10%.
• The tax rate is 30%; in the case of losses, assume zero tax.

(Please note that interest and loan payments are not to be considered in calculating NPV).