Le Magasin plc Investment Project Evaluation

Le Magasin plc, a food and drug retailer, is considering two alternative investment projects - one for expansion of its existing business, another for diversification into petroleum products. Owing to certain constraints, only one of these projects is to be selected – it is not possible to implement both. The proposed petroleum products project promises higher earnings than could be achieved through expansion of the company’s existing line of activity. Le Magasin plc’s Managing Director is therefore strongly in favour of this diversification project into petroleum products. He has instructed the treasury team to use the company’s weighted average cost of capital to evaluate the petroleum products project, for which the following estimates have been drawn up:

o 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 7½% of the original cost.

o 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.

o 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 2½% per year.

o The gross profit margin is expected to be 10%.

o Other annual indirect operating expenses of the new project would amount to about 3½% of its turnover.

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

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

o 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 the year.

o Capital allowances would be available at the rate of 18% per annum on the reducing balance basis.

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

o 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 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 the issue is regarded as irrelevant to evaluation of the petroleum products project.

Le Magasin’s Marketing Director is not in favour of the petroleum products project 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 & Spencer and Walmart are already operating. Her team has estimated that investment of £5 billion of capital for expansion into India and other South Asian countries would result in net nominal 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.

Required:

1. Using the information provided in the case, estimate the annual incremental cash flows of the proposed petroleum products project, providing explanations of your reasons for including or excluding any of the information that has been provided.
2. Based on your cash flow estimation of the petroleum products project, and using the cash flows that have been provided in respect of the alternative project for expanding the company’s existing operations into India, perform a comparative evaluation of the two projects. [Note: The net nominal after-tax cash flows of the expansion project are already provided in the case – so no further cash flow estimation is required in respect of the expansion project]. Use whatever project appraisal techniques you consider to be useful and relevant to the problem.
3. Referring to your numerical evaluation of the projects where relevant, explain the problems that can arise in the use of investment appraisal techniques like net present value, internal rate of return and payback period. Your answer should provide a full and clear explanation of any such issues arising out of your evaluation in your own words, with reference to the case in question. You should specifically address and discuss the Marketing Director’s assertion that the expansion project has a much higher internal rate of return and would therefore create greater shareholder value.
4. Based on your chosen investment appraisal method(s) recommend an appropriate course of action for Le Magasin plc. Also comment on other aspects that the management team may wish to consider in respect of either of these investments (not just the one that you are recommending).

In addition to 75 marks for technical content as roughly indicated above, marks will also be awarded under the following heads:

o Demonstration of expertise and skills in producing and writing business reports containing financial analysis - essentially the preparation and presentation of a report to the top management of a company, using standard business software such as Word and Excel.

o Demonstration of researching, planning and organizational skills – evidence of background reading and adherence to the requirements of the assignment.