Comparing mutually exclusive projects – such as retaining the old asset or replacing it with a new one – frequently involves the problem of assessing projects with different economic lives.
Allis plc is seeking to modernise and speed up its production process. Two propos- als have been suggested to achieve this: the purchase of a number of forklift trucks and the acquisition of a conveyor system. The accountant has produced cost savings fig- ures for the two proposals using a 10 per cent discount rate, shown in Table 6.10.
At first sight, the more expensive conveyor system appears more wealth-creating.
But it is not appropriate to compare projects with different lives without making some adjustment. Two approaches can be employed for this: the replacement chain approach and the equivalent annual annuity approach.
The replacement chain approachrecognises that while, for convenience, we usually consider only the time-horizon of the proposal, most investments form part of a replacement chain over a much longer time-period. We therefore need to compare mutually exclusive projects over a common period. In the example, this period is six years, two forklift truck proposals (one following the other) being equivalent to one conveyor system proposal. Assuming the cash flows for the original forklift trucks also apply to their replacements in Year 4 (a pretty big assumption, given inflation,
improvements in technology, etc.), the replacement will produce a further NPV of
£5,010 at the start of Year 4.
To convert this to the present value (i.e. Year 0) we must discount this figure to the present using the discount factor for 10 per cent for a cash flow three years hence:
The NPV for the forklift truck proposal, assuming like-for-like replacement after three years, is therefore This is well in excess of the NPV of the conveyor system proposal (£6,538) over the same time-period.
£5,010£3,764£8,774.
PV£5,010PVIF110,32£5,0100.7513£3,764
equivalent annual annuity (EAA) The constant annual cash flow offering the same present value as the project’s net present value
Allis plc NPV comparison
Year Forklift trucks Conveyor system
£ £
1–3 5,010
4–6 3,764
1–6 8,774 6,538
A second approach, the equivalent annual annuity (EAA)approach, is easier than its name suggests. It seeks to determine the constant annual cash flow that offers the same present value as the project’s NPV. This is found by dividing the project’s NPV by the relevant annuity discount factor (i.e. 10 per cent over three years):
For the forklift proposal:
For the conveyor system proposal:
The forklift proposal offers the higher equivalent annual annuity and is to be preferred.
Assuming continuous replacement at the end of their project lives, the NPVs for the proj- ects over an infinite time-horizon are found by dividing the EAA by the discount rate:
NPV conveyor£1,501>0.10£15,010 NPV forklift truck£2,015>0.10£20,150
EAA NPV
PVIFA110,62£6,538
4.3553£1,501 EAA£5,010
2.4869£2,015
EAA NPV
PVIFA110,32
£5,0100.7513
Questions with a coloured numberhave solutions in Appendix B on page 695.
1 Most capital budgeting textbooks strongly recommend NPV, but most firms prefer IRR. Explain.
2 A project costing £20,000 offers an annual cash flow of £5,000 over its life.
(a) Calculate the internal rate of return using the payback reciprocal assuming an infinite life.
(b) Use tables to test your answer assuming the project life is (i) 20 years, (ii) eight years.
(c) What conclusions can be drawn as to the suitability of the payback reciprocal in measuring investment profitability?
3 Your firm uses the IRR method and asks you to evaluate the following mutually exclusive projects:
QUESTIONS
Year
Cash flows (£) 0 1 2 3 4
Proposal L 20,000 20,000 20,000 20,000
Proposal M 47,23247,232 0 10,000 20,000 65,350
Existing machine Advanced model
Capacity p.a. 200,000 units 230,000 units
£ £
Selling price per unit 0.95 0.95
Production costs per unit
Labour 0.12 0.08
Materials 0.48 0.46
Fixed overheads (allocation of 0.25 0.16
portion of company’s fixed overheads)
Using the appropriate IRR method, evaluate these proposals assuming a required rate of return of 10 per cent.
Compare your answer with the net present value method.
4 State two ways in which inflation can be handled in investment analysis. Which way would you recommend and why?
5 Bramhope Manufacturing Co. Ltd has found that, after only two years of using a machine for a semi-auto- matic process, a more advanced model has arrived on the market. This advanced model will not only produce the current volume of the company’s product more efficiently, but allow increased output of the product. The existing machine had cost £32,000 and was being depreciated straight-line over a ten-year period, at the end of which it would be scrapped. The market value of this machine is currently £15,000 and there is a prospec- tive purchaser interested in acquiring it.
The advanced model now available costs £123,500 fully installed. Because of its more complex mechanism, the advanced model is expected to have a useful life of only eight years. A scrap value of £20,500 is consid- ered reasonable.
A comparison of the existing and advanced model now available shows the following:
The sales director is of the opinion that additional output could be sold at 95p per unit.
If the advanced model were to be run at the old production level of 200,000 units per annum, the operators would be freed for a proportionate period of time for reassignment to the other operations of the company.
The sales director has suggested that the advanced model should be purchased by the company to replace the existing machine.
The required return is 15 per cent.
(i)You are required to calculate:
(a)payback period (b)the net present value
(c)the internal rate of return (to the nearest per cent)
(ii)What recommendation would you make to the sales director? What other considerations are relevant?
6 Argon Mining plc is investigating the possibility of purchasing an open-cast coal mine in South Wales at a cost of £2.5 million which the British Government is selling as part of its privatisation programme. The company’s surveyors have spent the last three months examining the potential of the mine and have incurred costs to date of £0.2 million. The surveyors have prepared a report which states that the company will require equip- ment and vehicles costing £12.5 million in order to operate the mine and that these assets can be sold for
£2.5 million in four years time when the coal reserves of the mine are exhausted.
The assistant to the Chief Financial Officer of the company has prepared the following projected profit and loss accounts for each year of the life of the mine.
Projected Profit and Loss Accounts (£m)
Year
1 2 3 4
Sales 9.4 9.8 8.5 6.3
lessWages and salaries (2.3) (2.5) (2.6) (1.8) Selling and distribution costs (1.3) (1.2) (1.5) (0.6) Materials and consumables (0.3) (0.4) (0.4) (0.2) Depreciation and equipment (2.5) (2.5) (2.5) (2.5)
Head office expenses (0.6) (0.6) (0.6) (0.6)
Survey costs (0.4)
Interest charges (1.2) (1.2) (1.2) (1.2)
Net profit (loss) 0.8 1.4 (0.3) (0.6)
In his report to the Chief Financial Officer, the assistant recommends that the company should not proceed with the acquisition of the mine as the profitability of the proposal is poor.
The following additional information is available:
(i) The project will require an investment of £0.5 million of working capital from the beginning of the proj- ect until the end of the useful life of the mine.
(ii) The wages and salaries expenses include £0.5 million of working capital in Year 1 for staff who are already employed by the company but who would be without productive work until Year 2 if the proj- ect does not proceed. However, the company has no intention of dismissing these staff. After Year 1, these staff will be employed on another project of the company.
(iii) One-third of the head office expenses consists of amounts directly incurred in managing the new project and two-thirds represents an apportionment of other head office expenses to the project to ensure that it bears a fair share of these expenses.
(iv) The survey costs include those costs already incurred to date, and which are to be written off in the first year of the project, as well as costs to be incurred in the first year if the project is accepted.
(v) The interest charges relate to finance required to purchase the equipment and vehicles necessary to carry out the project.
(vi) After the mine has been exhausted, the company will be required to clean up the site and to make good the damage to the environment resulting from its mining operations. The company will incur costs of
£0.4 million in Year 5 in order to do this.
The company has a cost of capital of 12 per cent.
Ignore taxation.
Required
(a) Using what you consider to be the most appropriate investment appraisal method, prepare calculations which will help the company to decide whether or not to proceed with the project.
(b) State, giving reasons, whether you think the project should go ahead.
(c) Explain why you consider the investment appraisal method selected in (a) above to be most appropriate for evaluating investment projects.
7 Consolidated Oilfields plc is interested in exploring for oil near the west coast of Australia. The Australian government is prepared to grant an exploration licence to the company for a five-year period for a fee of
£300,000 p.a. The option to acquire the rights must be taken immediately, otherwise another oil company will be granted the rights. However, Consolidated Oilfields is not in a position to commence operations immedi- ately, and exploration of the oilfield will not start until the beginning of the second year. In order to carry out the exploration work, the company will require equipment costing £10,400,000, which will be made by a spe- cialist engineering company. Half of the equipment cost will be payable immediately and half will be paid when the equipment has been built and tested to the satisfaction of Consolidated Oilfields. It is estimated that the second instalment will be paid at the end of the first year. The company commissioned a geological sur- vey of the area and the results suggest that the oilfield will produce relatively small amounts of high-quality crude oil. The survey cost £250,000 and is now due for payment.
The assistant to the project accountant has produced the following projected Profit and Loss Accounts for the project for Years 2–5 when the oilfield is operational.
Year
2 3 4 5
£000 £000 £000 £000 £000 £000 £000 £000
Sales 7,400 8,300 9,800 5,800
Less expenses
Wages and 550 580 620 520
salaries
Materials and 340 360 410 370
consumables
Licence fee 600 300 300 300
Overheads 220 220 220 220
Depreciation 2,100 2,100 2,100 2,100
Survey cost 250 – – –
written off
Interest charges 650 650 650 650
4,710 4,210 4,300 3,160
Profit 2,690 4,090 5,500 2,640
The following additional information is available:
1 The licence fee charge appearing in the accounts in Year 2 includes a write-off for all the annual fee payable in Year 1. The licence fee is paid to the Australian government at the end of each year.
2 The overheads contain an annual charge of £120,000, which represents an apportionment of head office costs. This is based on a standard calculation to ensure that all projects bear a fair share of the central admin- istrative costs of the business. The remainder of the overheads relate directly to the project.
3 The survey costs written off relate to the geological survey already undertaken and due for payment imme- diately.
4 The new equipment costing £10,400,000 will be sold at the end of the licence period for £2,000,000.
5 The project will require a specialised cutting tool for a brief period at the end of Year 2, which is currently being used by the company in another project. The manager of the other project has estimated that he will have to hire machinery at a cost of £150,000 for the period the cutting tool is on loan.
6The project will require an investment of £650,000 working capital from the end of the first year to the end of the licence period.
The company has a cost of capital of 10 per cent.
Ignore taxation.
Required
(a) Prepare calculations that will help the company to evaluate further the profitability of the proposed project.
(b) State, with reasons, whether you would recommend that the project be undertaken.
(c) Explain how inflation can pose problems when appraising capital expenditure proposals, and how these problems may be dealt with.
(Certified Diploma) 8 You are the chief accountant of Deighton plc, which manufactures a wide range of building and plumbing fit- tings. It has recently taken over a smaller unquoted competitor, Linton Ltd. Deighton is currently checking through various documents at Linton’s head office, including a number of investment appraisals. One of these, a recently rejected application involving an outlay on equipment of £900,000, is reproduced below. It was rejected because it failed to offer Linton’s target return on investment of 25 per cent (average profit-to- initial investment outlay). Closer inspection reveals several errors in the appraisal.
Evaluation of profitability of proposed project NT17 (all values in current year prices)
Item (£000) 0 1 2 3 4
Sales 1,400 1,600 1,800 1,000
Materials (400) (450) (500) (250)
Direct labour (400) (450) (500) (250)
Overheads (100) (100) (100) (100)
Interest (120) (120) (120) (120)
Depreciation (225) (225) (225) (225)
Profit pre-tax 155 255 355 55
Tax at 33% (51) (84) (117) (18)
Post-tax profit 104 171 238 37
Outlay
Stock (100)
Equipment (900)
Market research (200) (1,200) Rate of returnAverage profit
Investment £138
£1,20011.5%
You discover the following further details:
1 Linton’s policy was to finance both working capital and fixed investment by a bank overdraft. A 12 per cent interest rate applied at the time of the evaluation.
2 A 25 per cent writing-down allowance (WDA) on a reducing balance basis is offered for new investment.
Linton’s profits are sufficient to utilise fully this allowance throughout the project.
3 Corporation Tax is paid a year in arrears.
4 Of the overhead charge, about half reflects absorption of existing overhead costs.
5 The market research was actually undertaken to investigate two proposals, the other project also having been rejected. The total bill for all this research has already been paid.
6 Deighton itself requires a nominal return on new projects of 20 per cent after taxes, is currently ungeared and has no plans to use any debt finance in the future.
Required
Write a report to the finance director in which you:
(a) Identify the mistakes made in Linton’s evaluation.
(b) Restate the investment appraisal in terms of the post-tax net present value to Deighton, recommending whether the project should be undertaken or not.
(ACCA)
9 (a) Explain how inflation affects the rate of return required on an investment project, and the distinction between a real and a nominal (or ‘money terms’) approach to the evaluation of an investment project under inflation.
(b) Howden plc is contemplating investment in an additional production line to produce its range of com- pact discs. A market research study, undertaken by a well-known firm of consultants, has revealed scope to sell an additional output of 400,000 units p.a. The study cost £0.1 million, but the account has not yet been settled.
The price and cost structure of a typical disc (net of royalties) is as follows:
£ £
Price per unit 12.00
Costs per unit of output
Material cost per unit 1.50 Direct labour cost per unit 0.50 Variable overhead cost per unit 0.50 Fixed overhead cost per unit 1.50
(4.00)
Profit 8.00
The fixed overhead represents an apportionment of central administrative and marketing costs. These are expected to rise in total by £500,000 p.a. as a result of undertaking this project. The production line is expected to operate for five years and require a total cash outlay of £11 million, including £0.5 million of materials stocks. The equipment will have a residual value of £2 million. Because the company is mov- ing towards a JIT stock management policy, it is expected that this project will involve steadily reducing working capital needs, expected to decline at about 3 per cent p.a. by volume. The production line will be accommodated in a presently empty building for which an offer of £2 million has recently been received from another company. If the building is retained, it is expected that property price inflation will increase its value to £3 million after five years.
While the precise rates of price and cost inflation are uncertain, economists in Howden’s corporate planning department make the following forecasts for the average annual rates of inflation relevant to the project:
Retail Price Index 6% p.a.
Disc prices 5% p.a.
Material prices 3% p.a.
Direct labour wage rates 7% p.a.
Variable overhead costs 7% p.a.
Other overhead costs 5% p.a.
Note: You may ignore taxes and capital allowances in this question.
Required
(a) Given that Howden’s shareholders require a real return of 8.5 per cent for projects of this degree of risk, assess the financial viability of this proposal.
(b) Briefly discuss how inflation may complicate the analysis of business financial decisions.
(ACCA)
The following case study brings together many of the issues raised in Part 2 of this book on the analysis of strategic investment decisions. In answering certain parts the student should also read Chapters 7 and 8.
Roger Davis, the newly appointed financial analyst of the Steel Tube division of Engineering Products plc, shut his office door and walked over to his desk. He had just 24 hours to re-examine the accountant’s profit projections and come up with a recommendation on the proposed new computer numerically controlled (CNC) milling machine.
At the meeting he had just left, the managing director made it quite clear: ‘If the project can’t pay for itself in the first three years, it’s not worth bothering with.’ Davis was unhappy with the accountant’s analysis which showed that the project was a loss maker. But as the MD said, ‘Unless you can convince me by this time tomorrow that spending £240,000 on this capital project makes economic sense, you can forget the whole idea.’
His first task was to re-examine the accountant’s profitability forecast (Table 6.11) in the light of the following facts that emerged from the meeting:
1 Given the rapid developments in the market, it was unrealistic to assume that the product had more than a four-year life. The machinery would have no other use and could not raise more than £20,000 in scrap metal at the end of the project.
2 The opening stock in Year 1 would be acquired at the same time as the machine. All other stock movement would occur at the year ends.
3 This type of machine was depreciated over six years on a straight-line basis.
4 Within the ‘other production expenses’ were apportioned fixed overheads equal to 20 per cent of labour costs.
As far as could be seen, none of these overheads were incurred as a result of the proposal.
5 The administration charge was an apportionment of central fixed overheads.
Practical assignment: Engineering Products case study
Table 6.11 Profit projection for CNC milling machine (£000)
Year
1 2 3 4
Sales 400 600 800 600
Less costs Materials
Opening stock 40 80 80 60
Purchases 260 300 360 240
Closing stock (80) (80) (60) –
Cost of sales 220 300 380 300
Labour 80 120 120 80
Other production expenses 80 90 92 100
Depreciation 40 40 40 40
Administrative overhead 54 76 74 74
Interest on loans to finance the project 22 22 22 22
Total cost 496 648 728 616
Profit (loss) (96) (48) 72 (16)
Later that day, Davis met the production manager, who explained that if the new machine was installed, it would have sufficient capacity to enable an existing machine to be sold immediately for £20,000 and to create annual cash benefits of £18,000. However, the accountant had told him that, with the machine currently standing in the books at £50,000, the company simply could not afford to write off the asset against this year’s slender profits. ‘We’d do better to keep it operating for another four years, when its scrap value will produce about
£8,000,’ he said.
Continued
Davis then raised the proposal with the marketing director. It was not long before two new pieces of information emerged:
(a) To stand a realistic chance of hitting the sales forecast for the proposal, marketing would require £40,000 for additional advertising and sales promotion at the start of the project and a further £8,000 a year for the remainder of the project’s life. The sales forecast and advertising effort had been devised in consultation with marketing consultants whose bill for £18,000 had just arrived that morning.
(b) The marketing director was very concerned about the impact on other products within the product range. If the investment went ahead, it would lead to a reduction in sales value of a competing product of around
£60,000 a year. ‘With net profit margins of around 10 per cent and gross margins (after direct costs) of 25 per cent on these sales, this is probably the “kiss of death” for the CNC proposal,’ Davis reflected.
The Steel Tube division was a profitable business operating within an attractive market. The investment, which employed new technology, had recently been identified as part of the group’s core activities. The chief engineer felt that once they had got to grips with the new technology it should deliver improved product quality, and greater flexibility, enabling shorter production runs and other benefits.
The latest accounts for the division showed a 16 per cent return on assets, but the MD talked about a three-year payback requirement. His phone call to the finance director at head office, to whom this proposal would eventual- ly be sent, was distinctly unhelpful: ‘We have, in the past, found that whenever we lay down a hurdle rate for divi- sional capital projects, it merely encourages unduly optimistic estimates from divisional executives eager to pro- mote their pet proposals. So now we give no guidelines on this matter.’
Davis decided to use 10 per cent as the required rate of return, made up of 6 per cent currently obtainable from risk-free government securities plus a small element to compensate for risk. Davis went home that evening with a very full briefcase and a number of unresolved questions.
1 How much of the information which he had gathered was really relevant to the decision?
2 What was the best approach to assessing the economic worth of the proposal? The company used payback and return on investment, but he felt that discounted cash flow techniques had some merit.
3 Cash was particularly limited this year and acceptance of this project could mean that other projects would have to be deferred. How should this be taken into consideration?
4 How should the strategic factors be assessed?
5 What about tax? Engineering Products plc pays Corporation Tax at 30 per cent and annual writing-down allowances of 25 per cent on the reducing balance may be claimed. The existing machine has a nil value for tax purposes and tax is payable in the same year as the cash flows to which it relates.
Required
Prepare the case, with recommendations, to be presented by Davis at tomorrow’s meeting. The report should address points 1–5 above.