Pike Robert, Neal Bill. Corporate finance and investment: decisions and strategy

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Chapter 6 Project appraisal – applications 165

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  £5,010  PVIF

110,32

 £5,010  0.7513  £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

PVIFA

110,62



£6,538

4.3553

 £1,501

EAA 

£5,010

2.4869

 £2,015

EAA 

NPV

PVIFA

110,32

£5,010  0.7513

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Questions with a

coloured number have 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.

profitability?

3 Your firm uses the IRR method and asks you to evaluate the following mutually exclusive projects:

QUESTIONS

166 Part II Investment decisions and strategies

Year

Cash flows (£) 0 1234

Proposal L 20,000 20,000 20,000 20,000

Proposal M 0 10,000 20,000 65,350

47,232

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.

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The required return is 15 per cent.

(i) You are required to calculate:

(a) payback period

(b) the net present value

(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.

Chapter 6 Project appraisal – applications 167

Projected Profit and Loss Accounts (£m)

Year

123 4

Sales 9.4 9.8 8.5 6.3

less Wages 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.

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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.

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.

168 Part II Investment decisions and strategies

Year

2345

£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.

6 The project will require an investment of £650,000 working capital from the end of the first year to the end

of the licence period.

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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.

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.

Chapter 6 Project appraisal – applications 169

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 return 

Average profit

Investment



£138

£1,200

 11.5%

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)

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(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:

170 Part II Investment decisions and strategies

££

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)

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Chapter 6 Project appraisal – applications 171

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

1234

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

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172 Part II Investment decisions and strategies

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.

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Investment strategy and process

Learning objectives

This chapter examines strategic issues in investment and the investment process:

■ How strategy shapes investment decisions.

■ Evaluating new technology and environmental projects.

■ The investment decision and control process.

■ Post-audit reviews.

A Mickey Mouse investment?

The Euro Disney theme park opened with all the

razzmatazz of a Disney spectacular. However, from an

investment perspective, it was a spectacular flop in its

first few years of operation. It planned to make a prof-

it in its opening year. Instead, Euro Disney produced

losses in each of its first three years, with the second

year producing a staggering loss of FFr 5.3 billion.

The park simply failed to attract sufficient visitors

to cover its initial costs. With only 12 million visitors

a year, the figure is still below the target of 13.3 mil-

lion set back in 1996. The northern French climate,

rising franc, economic recession, Gallic hostility to

American culture and high admission cost all con-

tributed to the lack of visitors.

After much huffing and puffing, Euro Disney

pulled off in September 2004 its second debt

restructuring in a decade, just in time to avoid

default by failing to meet the creditor deadline.

The latest financial rescue has resolved the imme-

diate crisis at Europe’s biggest tourist attraction,

but has yet to guarantee its future (Financial Times,

2004, p. 20).

This seemed a far cry from its initial public offer

for shares launched on many of the stock exchanges

throughout Europe. The offer document indicated an

internal rate of return of 13.3 per cent between

1992 and 2017 based on an inflation assumption of

5 per cent per annum. A fairytale start to Euro

Disney life, followed by a financially delinquent ado-

lescence – but would Euro Disney ever produce the

returns to make investors happy ever after? They are

still waiting.

CFAI_C07.QXD 10/28/05 4:18 PM Page 173

Where do positive NPV projects come from? By definition, a positive NPV means that

a project offers returns superior to those obtainable in the capital market on invest-

ments of comparable risk. In the short run, it is quite feasible to find capital projects that

do just this, but in a competitive market it will not be long before other firms make sim-

ilar investments, thereby ensuring that any superior returns are not perpetuated.

Selecting wealth-creating capital projects is no different from picking undervalued

shares on the stock market. Earlier discussion on market efficiency argued that this is

possible only if there are capital market imperfections that prevent asset prices reflect-

ing their equilibrium values.

Companies that consistently create projects with high NPVs have developed a sus-

tainable competitive advantage arising from imperfections in the product and factor

markets. These imperfections generally take the form of entry barriers that discourage

new entrants. Successful investments are therefore investments that help create, pre-

serve or enhance competitive advantage.

Porter (1985) argues that there are really only three coherent strategies for strategic

business units:

1 To be the lowest-cost producer.

2 To focus on a niche or segment within the market.

3 To differentiate the product range so that it does not compete directly with lower-

cost products.

Investment expenditure that helps achieve the appropriate strategy is likely to gen-

erate superior returns. For example, Coca-Cola invests enormous sums into its prod-

uct differentiation strategy through its brand support.

Capital projects should be viewed not simply in isolation, but within the context of

the business, its goals and strategic direction. This approach is often termed strategic

portfolio analysis.

The attractiveness of investment proposals coming from different sectors of the

firm’s business portfolio depends not only on the rate of return offered, but also on

the strategic importance of the sector. Business strategies are formulated that involve

the allocation of resources (capital, labour, plant, marketing support etc.) to these

business units. The allocation may be based on analysis of the market’s attractiveness

and the firm’s competitive strengths, such as the McKinsey–General Electric portfolio

matrix outlined in Figure 7.1.

The attractiveness of the market or industry is indicated by such factors as the size

and growth of the market, ease of entry, degree of competition and industry prof-

itability for each strategic business unit. Business strength is indicated by a firm’s mar-

ket share and its growth rate, brand loyalty, profitability, and technological and other

comparative advantages. Such analysis leads to three basic strategies:

1 Invest in and strengthen businesses operating in relatively attractive markets. This

may mean heavy expenditures on capital equipment, working capital, research and

development, brand development and training.

174 Part II Investment decisions and strategies

7.1 INTRODUCTION

A company’s ability to succeed in highly competitive markets depends to a great extent on

its ability to regenerate itself through wealth-creating capital investment decisions com-

patible with business strategy. In recent years, most of the combined internal and external

funds generated by UK firms have been committed to fixed capital investment. Applying

such resources to long-term capital projects in anticipation of an adequate return –

although a hazardous step – is essential for the vitality and well-being of the organisation.

7.2 STRATEGIC CONSIDERATIONS

strategic portfolio analysis

Assessing capital projects within

the strategic business context

and not simply in financial

terms

McKinsey–General Electric

portfolio matrix

An approach for assessing proj-

ects within the wider strategic

context which focuses on the

market attractiveness and busi-

ness strength of the product

and business unit relating to

the capital proposal

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