Question 1

Zhongshan Ltd is an international company making cars in the UK. You recently graduated from University of Greenwich and are now a financial analyst in the company.The company is considering two major projects, a new electric car equipped with the latest intelligent driving technologies, andan expansion project. Both project life is eight years. Due to the capital constraints, only one of these two projects can be chosen for implementation.

The new electric car project has the following estimates. The initial capital investment for the new project needs 2000 million. It is expected that the scrap value of the investment at the end of project life would be 11% of the original investment cost. This new project would bring annual sales revenue of 1500 million in the first year. After the first year, the annual sales is expected to grow at a real rate of 10% per year. The annual inflation rate is expected to be 2 % each year. It is expected that the gross profit margin is 30% every year. The new project will have other indirect annual operating expenses, which is estimated to be 2.5% of its annual sales. It is estimated that a further 85 million per year of Zhongshan Ltd's existing indirect overhead costs are to be apportioned to the new productproject. As part of the evaluation of the projects, the company had paid a consulting firm 1.5 million to perform a test marketing analysis of the electric cars. The expenditure was made last year but is yet to be paid. Corporation tax would be payable at 20% in the year in which it arises.

The company's marketing director, Sally Brown, thinks that the company should not invest in the expansion project and instead take new electric car project. She argues that research has shown that electric cars are better for the environment,and many discussions on environment improvement have been made in the recent COP26 climate summit, which is taking place in Glasgow. Sally also argued that as the company performed a test marketing analysis of the electric cars, the company should take on the new project. Otherwise it would be wasting the work of testing market analysis. However, the CEO of the company, Dongguo Sun, thinks that the company should expand its business into countries outside UK, for example, China. Dongguo estimates that the expansion needs similar amount of 2000 million initial investment. But this investment would bring in net after-tax cash flows of 750 million per year in the first two years, 350 million per year in the three, fourth and fifth years, and 150 million per year in the following three years. Dongguo is confident that the IRR from this expansion project over the eight yearswould be much higher than that of the new project.

To fund the projects, the company has decided to make a rights issue of ordinary shares. The company has a reliable history of dividend payments and is expected to pay dividends annually for the foreseeable future. The annual dividend paid by the company on its ordinary shares has grown from 0.10 per share ten years ago to the present level of 0.22 per share, and is expected to continue to grow at a similar rate in the future. The company's ordinary shares are currently trading at a price of 4.5 ex-dividend. In a board meeting, one of the company's directors has asked why the company is choosing to make a rights issue of ordinary shares instead of issuing preference shares.

At the company's board meeting, Dongguo asked you to evaluate both new project and the expansion project to identity which project can add more value to the whole company. The CEO asked you to use the subjective approach and applies an adjustment factor of + 1.5 per cent to the cost of capital for such risky new projects. Dongguo was concerned whether the new project would be more vulnerable to thefluctuations in the initial investment cost, the sales revenue, or the cost of capital. So Dongguo has asked you to address this concern by conducting appropriate analysis. The depreciation method applied for the project is decided to be straight line depreciation approach.

QUESTION:

1. Perform a comparative evaluation of both projects with the NPV and IRR approaches. You need to explain your reasons for including or excluding any of the information provided in this case study. After the evaluation of projects, you need to recommendan appropriatecourse of action for the company and also comment on what other aspects could be considered in the project evaluation. (40 marks)