Question

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.

Question 1. 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. Explain how financial managers may evaluate both projects that are of unequal lives. (Only Explain theoretically with illustration whenever possible)

Answer 1

as you can see the payback for both projects are more than 3 years, and in 10 year project the payback increases dur to reduction in cash flows from salvage value. Though payback period doesnot account timing of cash floes, therefore this is not a good indicator for finding feasibility of project when time is important, by NPV this payback will even be greater than payback period.