Part A Capital Budgeting

Background:

Electro Motors (Electro) is considering a new project to produce electric vehicles for the

Australian domestic market and international markets. It has identified a property/plant that was formerly used to build petrol fuelled motor vehicles that could be refitted at minimal cost to manufacture the new electric vehicles. Electro is targeting Australian metropolitan centres for initial sales and expanding into regional centres over the next five years. International demand for electric vehicles is being driven by China and Electro has been in negotiation to provide vehicles to the Chinese market in 2025.

Electro has made the following projections:

• In the first year 2,000 units will be sold and growing at 10% pa.
• The price for each unit in the first year will be AU$50,000. This price will increase by 5% pa.
• Variable costs are 70% of the sales price in the first year's total revenue and grow by 8% each year.
• Fixed costs are $5 million pa, which are expected to grow by 4% each year.
• The project is for a term of 5 years. The projected growth of the electric cars line is expected to outgrow the plant at this time, hence the plant will be sold at the end of 5 years.
• Initial investment into manufacturing equipment will be $100 million.
• The equipment may be depreciated at 20% straight-line (prime cost) method to zero.
• In 5 years, the plant will be worth 10% of the purchase price.
• Working capital will be $3 million.
• Electro's required rate of return is 10%.
• The tax rate for Electro is 30%.
• Required payback is three (3) years.

a.Prepare an excel spreadsheet calculating:

1. After-tax cash flows (in table format)(15 marks)
2. Payback period(3 marks)
3. Net present value(5 marks)
4. Profitability index(2 marks)

b.You are asked to present a report on your findings regarding the upgrade proposal. Make a recommendation to management on whether they should proceed with the project or not. Explain the criteria on which you have based your decision.(10 marks)

c.It has come to your attention that variable costs are anticipated to rise by 12% per annum due to the prospective growth within the industry. Would you recommend to proceed with the project? (Show all calculations).(5 marks)

d.You have been asked to provide a further evaluation regarding the alternative use of the plant for the purpose of manufacturing electric self-driving cars, however the project life will be for 10 years. Explainhow financial managers may evaluate both projects that are of unequal lives.(10marks)