Carlton plc is considering two alternative investment projects one for the expansion of its existing business, and another for diversification into petroleum products. These are mutually exclusive projects. Carlton plc’s Managing Director has instructed the treasury team to calculate the company’s weighted average cost of capital based on the information provided above and use it to evaluate the petroleum products projects for

which the following estimates have been drawn up:

• The initial capital investment required would be £2 billion, and the residual value
of this investment at the end of the project’s life of six years is expected to be 7 ½
% of the original cost.

• A bill for £500,000 from the consultancy firm that was engaged to conduct the
market research and feasibility study for the new project has been received but is
yet to be paid.

• After allowing for inflation, revenue in the first year following the investment is
expected to be £25 billion. Thereafter it is expected to grow at a real rate of 6%
per year, and the rate of inflation is expected to be 2 ½% per year.

• The gross profit margin is expected to be 10%

• Other annual indirect operating expenses of the new project would amount to about 3 ½ % of its turnover.

• A further £50 million per year of Carlton plc’s existing indirect overhead costs are to be apportioned to the new petroleum products project.

• Interest charges on the loan capital that would be raised by the company to part
finance the investment are estimated at £80 million per year.

• The average level of working capital to be maintained during each year of the
project would be equal to approximately 12% of the sales for that year, and would need to be available at the start of year.

• Capital allowances would be available at the rate of 20% per annum on the reducing balance basis.

• Corporation tax would be payable at 19% in the year in which it arises.

• The project is to be evaluated over a time horizon of six years.

It has been suggested that a separate special director should be appointed to oversee the implementation of the new project, as it is estimated that there would otherwise be a loss of contribution of at least £25 million per year (at current prices) on the company’s existing business, due to top management time being diverted to the new project. However, no such appointment has been made and, although the argument is not considered unreasonable, the issue is regarded as irrelevant to evaluation of the petroleum products project.

Carlton plc’s Marketing Director is not in favour of the petroleum products as she believes that much greater value would be created by instead utilising the capital for expanding the company’s operations into India, where Marks & Spenser are already operating, and Walmart would also soon be making an entry. Her team has estimated that investment of 5 billion of capital for expansion into India and other South Asian countries would result in net after-tax cash flows of £3 billion per year in the first two years, £1 billion per year in the third and fourth years, and £500 million per year in the fifth and sixth years. She has expressed her confident view that this proposed expansion project would generate an internal rate of return over the six-year period that would be far higher than that of the petroleum products project.

Carlton plc’s chairman has instructed the treasury to evaluate both the petroleum products project and the proposed expansion project and to let him
know which one would be more value-enhancing. He particularly wishes to know whether the Marketing Director is correct in saying that the expansion project has a much higher internal rate of return and would therefore create greater shareholder value. Whichever project is selected the main source of finance would be debt – the chairman has therefore said that the coupon rate of 5% per annum on the company’s existing debt should be used as the cost of capital for the project evaluations. However, Carlton plc’s Financial Controller has suggested that the weighted average cost of capital would be more appropriate.
The company’s treasurer has reservations about using either of these as the cost of capital for the new petroleum products project but has reluctantly agreed to go by whatever the chairman and Financial Controller decide in this regard.

Requirements:

1. NPV for both projects
2. IRR for both projects
3. PayBack Period for both projects

Analyze the outcome from the perspective of Carlton Plc management