Western Harbor

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In order to answer the question of how much we would be wiling to pay for 100% participation owned by the existing deal holders we first constructed a financial model for the WHC venture in order to estimate the value of the venture until 2023 when it would be handed back over to the government.  The model we used for coming up with a valuation of the project is:

Equity Value = PV (FCF) + PV (TV) + PV (ITS) + Excess Cash - Debt. 

We made several assumptions during this process as outlined below.  We assumed that the leverage ratios will remain stable until 2023 and used the unlevered cost of equity to discount.  The base of prices we used were the prices from 2004 in Exhibit 10 provided in the case.  Maximum price increases were determined from the information in the case on the dates specified in Exhibit 6, with increases of HKD10 in 2009 and subsequent increases of HKD15 until 2021.  We are also assuming the terminal value is zero since we have to hand this over to the HK government in 2023.  We are assuming interest of 2% going forward.

The first input in this formula is FCF which we estimated by coming up with several scenarios for different revenues which were forecasted based on expected growth of traffic in the tunnel and expected prices of tolls. This was the most interesting and variable part of the calculation because the change in our predicted price for the toll had a direct effect on the expected toll volumes per year. In Scenario 1, we assumed a price increase only based on inflation (which we assumed was 2% based on the previous year’s inflation).  We used an annual volume growth of 0.5%, which is the same as the CAGR of the total traffic in the WHC tunnel between 2000-2006.  This is a fairly conservative assumption given that our price increase during this time was 5%.   In Scenario 2, we assumed a maximum price increase on the predetermined dates mentioned above and assumed a volume decrease of 5%, which also assumes that competitors are not raising prices at a similar rate.  In Scenario 3, we maintain a stable price over the time horizon, which is essentially lowering prices by the inflation rate every year.  In this scenario we expect volume to increase by 2%, in line with the inflation rate, and therefore the inflation adjusted price, we forecasted for this period.  In Scenario 4, we would lobby the government to raise their prices on the Cross-Harbour tunnel in order to move more traffic to the WHC, which would increase WHC’s attractiveness to drivers and alleviate traffic on the Cross-Harbour tunnel.  We forecast a 5% increase in demand per year under this scenario.  We assign these scenarios probabilities of 25% each.  The

In order to determine the present value of these cash flows we needed to discount the FCF using the unlevered cost of equity.  In order to determine the unlevered cost of equity we followed the steps below:

1. We gathered related industries unlevered betas from 2006 from “Damodoran” in the US because there was no directly comparable industry (toll roads or transport). We chose the industries below as they were most similar to the toll roads industry:

We then used the arithmetic average of the unlevered beta of these industries, thus BetaIND = 0.83.   (Unlevered Beta Industry = BetaIND).  A beta lower than 1 made sense as the toll road industry should be less sensitive to market changes than the average market, as people still have to drive whether or not there is a recession.