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Imagine that you have been hired by the Maine Department of Natural Resources to assess a proposal for constructing a new dam that is expected to last for 50 years. The initial cost of the dam is $425 million, while the annual net benefits (annual benefits less annual maintenance costs) will depend on the amount of rainfall: $18 million is a “dry” year, $29 million in a “wet” year, and $52 million in a “flood” year. Meteorological records indicate that over the past 100 years there have been 86 “dry” years, 12 “wet” years, and 2 “flood” years. Assume that construction occurs this year (t=0) and the annual net benefits begin to accrue at the start of next year (t=1) and continue for 50 years (i.e., until t=50).
a. Assuming that the historical data are good predictors of future weather conditions, what are the expected net benefits of the dam project if the social discount rate is 5%? (Hint: Homework 2 Data [in Moodle] provides a template that you can use.)
b. Would you recommend that the state go forth with the dam project? Why or why not?
Management expects that this will lead to additional cash flows of $1,130,000 for the next six years. What is the IRR of this project?
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What is the amount of the change in the firm's operating cash flow resulting from this project?
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