LM is a supermarket chain that operates 500 stores. The company?s sales have fallen behind its competitors as it currently does not offer its customers an online shopping service.It is considering a proposal to establish an online shopping service using the technology of PQ, an existing online retailer.

Sales revenue and gross profit

The number of customers using the online delivery service in the first five years is estimated to be as follows:Year 1 ........................100 000 customers per weekYear 2 ........................120 000 customers per weekYear 3 ........................150 000 customers per weekYear 4 ........................160 000 customers per weekYear 5 ........................170 000 customers per weekCustomers are expected to spend an average of $200 per week.Delivery to customers will be free of charge. The expected gross profit margin is 20 percent of selling price.

Loss of existing in-store salesIt is estimated that 30 percent of customers purchasing online would have purchased in store if the online facility was not available. The sales revenue per customer and gross profit margin on online sales will be the same as that for in-store sales.Capital expenditureLM will purchase a fleet of delivery vehicles costing $15 million.The vehicles will have a useful life of five years and will be depreciated on a straight line basis. They will have no residual value at the end of the five year period. The vehicles will be eligible for tax depreciation.Contract with the online retailerThe contract with PQ will be for an initial period of 5 years. LM will pay $340 million to buy one of PQ?s existing warehouses. LM will also invest $90 million to expand the facility. The expanded warehouse will then be leased back to PQ for five years for a fee of $20 million per annum. The cost of purchasing the warehouse and the expansion costs will not be eligible for tax depreciation.The warehouse will have a realizable value of $350 million at the end of the five-year period.LM will pay 1 percent of gross profit from the online business to PQ. LM will also pay a fee of $30 million per annum to license the technology and as a contribution towards PQ?s research and development costs.Other operating costsThe online operation will result in additional costs in the first year of $60 million, including delivery costs but excluding depreciation. This amount will rise by $5 million each year as the customer numbers increase.

TaxationLM?s financial director has provided the following taxation information:? Tax depreciation: 25 percent per annum of the reducing balance, with a balancing adjustment in the year of disposal.? Taxation rate: 30 percent of taxable profits. Half of the tax is payable in the year in which it arises, the balance is paid in the following year.? LM has sufficient taxable profits from other parts of its business to enable the offset of any pre-tax losses on this project.Other information? A cost of capital of 12 percent per annum is used to evaluate projects of this type.? Ignore inflation.

Required:(a) Evaluate whether LM should go ahead with the proposal to establish an online shopping service. You should use net present value as the basis of your evaluation. Your workings should be rounded to the nearest $ million.(b) Explain TWO other factors that LM should consider before deciding whether to go ahead with the contract.

(c) LM is concerned that replacing the delivery vehicles every five years will result in breakdowns and customer complaints. It is therefore considering whether toreplace the vehicles on a one, two or three-year cycle.The proposed contract with the online retailer expires after five years, however at the end of this period LM will continue to operate the online business. The delivery vehicles will therefore require to be continually replaced.Each vehicle costs $25 000. The operating costs per vehicle for each year and the resale value at the end of each year are estimated as follows:

Calculate, using the annualized equivalent method, whether the vehicles should be replaced on a one, two or three year cycle. You should assume that the initial investment is incurred at the beginning of year 1 and that all other cash flows arise at the end of the year. Ignore taxation and inflation and use a cost of capital of 12 percent.

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Year 1 Year 2 Year 3 Operating costs Resale value 6000 8000 12000 16000 10 000 4 000