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Investment Appraisal (Case Study from C. Drury, Management and Cost Accounting / CH 14)

Investment Appraisal (Case Study from C. Drury, Management and Cost Accounting / CH 14)
Project description
Assignment: Case Study- Fosters Construction Ltd (full details will be attached in personalized order)
Requirements:
Please present your analysis in the form of a report answering all questions. Please elaborate on each question carefully and make your result clear. Back up your answer with appropriate data. please note that the explanation of the result is a as important as the accuracy of calculation.
Discussion questions:
1 Present the financial analyses required by FCLs CI procedures manual, as they have traditionally
been calculated. Explain any assumptions you make. According to FCLs usual decision criteria,
would the AL II be purchased now?
2 Explain to JD the difference between real and nominal RRRs, as mentioned by SC. What
adjustment to SCs suggested RRR would be needed in order to match the discount rate with the
cashflows used?
3 Re-calculate the NPV of the AL II purchase proposal, using what Sonya Carson would consider to
be an appropriate RRR. Do these revised NPV results suggest that the AL II should be purchased?
4 In the light of your calculations for the AL II purchase proposal, what would be your response to
FSs comment that the IRR of projects should be calculated?
5 What do you think might be the key variables in the AL II investment which will affect its
viability? How might you consider these uncertain variables in better assessing the proposal?
DISCUSSION QUESTIONS 5
6 What further information would be useful in analysing the AL II proposal?
FOSTERS
CONSTRUCTION LTD
Deryl Northcott, University of Manchester
Permission to reprint this case has been granted by Captus Press Inc. and the Accounting Education
Resource Centre of the University of Lethbridge.
FOSTER’S CONSTRUCTION LTD: ORGANIZATIONAL
BACKGROUND
Fosters Construction Ltd (FCL) is a privately owned company with revenue of £20 million per annum,
and 200 employees. The company has been operating for 24 years and is well established in the marketplace.
However, despite a national rate of 4 per cent per annum over the last few years (which is expected
to continue), a general economic downturn has seen FCL’s nominal revenue reduce at a rate of about 3
per cent per annum.
The company’s main activity is the construction of large industrial buildings. It also provides maintenance
services, mainly for those buildings which it has constructed. FCL has a large investment in
construction machinery, and has always kept up with the latest technology in the industry. The company
has concentrated on developing a corporate image as an innovative, technologically advanced construction
firm, and many of the managers of FCL consider that this corporate image has been a major factor in
securing large, competitive contracts in the past.
FCL is subject to corporation tax at 35 per cent, payable twelve months after year end, and a system of
25 per cent writing down allowance on capital assets.
FCL’S FORMAL CAPITAL INVESTMENT SYSTEM
An investment in construction equipment is central to the operations of FCL, the organization has, over
many years, developed a detailed system by which capital investment proposals are considered. The
summary sheet in Exhibit 1 is taken from the firm’s capital investment procedures manual, and outlines
the formal process for capital investment decision-making within FCL.
1
THE CURRENT CI DECISION: PURCHASE OF A
REPLACEMENT CRANE
The construction site manager (CSM) has recently submitted a CI/12 application for the purchase of a
new crane. The new asset would replace an existing crane which is ten years old, and which requires
major maintenance in order to meet required safety standards. The CSM has indicated in the January
budget-setting around that the firm would need to spend money maintaining the old crane, but had not at
that stage been aware of any replacement options. It had previously been expected that the existing crane
would see out its remaining useful life, to be replaced by a more modern crane (the Auto-Lift II, or
‘AL II’). The AL II is technologically more advanced than the firm’s existing crane, and is able to lift much
larger loads. The new crane would cost £345 000, which is considerably more than the original £195 000
cost of the existing crane.
The CSM consulted with the site accountants, and put forward the following information in the CI/12
application:
1 Description: purchase of an AL II crane to replace an existing crane which is in need of major
maintenance.
2 Cost projections: purchase price = £345 000; annual running cost = £60 000. It is expected that the
AL II crane would have a £30 000 scrap value at the end of its useful life in ten years’ time.
3 Projected time-scale; available for purchase from Allied Importers Ltd in one month’s time.
Purchase price payable on 31 March – the last day of FCL’s financial year for taxation purposes.
The site accountants and the CSM had agreed that no further information was necessary, as the CI
proposal qualified as a ‘replacement of existing asset’ Class I investment.
The CSM’s CI/12 application has now been considered by the director of CI, who feels uneasy about
recommending the AL II crane purchase for funding approval. The director of CI has called a meeting of
concerned parties to discuss the CI application.
EXHIBIT 1
Fosters Construction Ltd Capital Investment Procedures – Summary
Capital investment (CI) is defined as ‘any major expenditure on purchasing, construction or upgrading
capital assets, the benefits from which will accrue over several years.
1 In early January of each year the CI budget is determined. The total amount of available funds
for CI expenditure is determined by the directors, based on what they consider the company can
afford.
2 Later that month, divisional managers meet to discuss forthcoming CI requirements, and the
budget allocated across divisions. Managers must present their proposed CI requirements under the
following three headings:
(i) essential replacement of existing assets (Class 1);
(ii) strategic expansion (Class 2);
(iii) safety and regulatory expenditure (Class 3).
The final allocation across divisions is a decision taken jointly by the CEO and the director of CI.
3 Throughout the year, access to funds for investment requires the submission of a standard form CI/
12 – Capital Expenditure Application. The information normally required with such as submission
includes:
(i) a description of the proposed investment;
(ii) motivation for the investment, i.e. what will the investment achieve for the company;
2 FOSTERS CONSTRUCTION LTD
(iii) financial projections of the cost of the investment;
(iv) projected future financial benefits of the investment;
(v) key success indicators for the investment (used for assessing the riskiness of the project and for
subsequent post audit);
(vi) a projected time-scale for completion of the investment. However, proposed Class 3 projects may
dispense with items (iv) and (v), and those in Class 1 may dispense with items (ii), (iv) and (v).
4 The CI/12 form is assessed by the director of CI, who has the following options:
(i) accept the proposal and forward it to the CEO for financing approval;
(ii) refer the proposal back for further refinement;
(iii) reject the proposal.
CI proposals will be assessed with regard to the net present value (NPV) and payback period
(PP) of the proposed project, although Class I projects will be considered as ‘cost minimization
exercises’, since there is already an accepted need to continue with current operations and
assets, and Class 3 projects are not required to meet financial criteria.
5 All CI projects are assessed within a ten-year planning horizon, i.e. investment effects beyond this
ten-year horizon are considered uncertain, and are ignored.
6 If approved, a CI proposal is then allocated funds from the annual budget. A project supervisor is
then assigned, and this person is responsible for the implementation and reporting of the CI project.
7 In due course, some selected CI projects will be subject to post audit by the director of CI.
THE MEETING PARTICIPANTS
The following people are present at the meeting to discuss the AL II purchase proposal;
• Sonya Carson (SC) Director of CI. Sonya is new to this position, and is familiarizing herself with the
technical nature of the firm’s operations. She has an undergraduate economics degree and is
considered competent, if perhaps a little over-ambitions. However, many longer-serving
organizational members doubt Sonya’s ability to make good decisions regarding investment in an
industry about which she currently knows little. For this reason, her appointment to the position of
Director of CI was controversial.
• Julian Done (JD) Construction Site Manager (CSM). Julian has worked in the construction industry
for 15 years, progressing through the ranks to become CSM two years ago. He is considered to be
competent in his job, but is perceived as uncompromising and confrontational. Julian has no time
for ‘the head office bosses’, and his outspoken manner at meetings has often met with disapproval
from the CEO.
• Franc Silvero (FS) CEO of Foster’s Construction Ltd. Franc came to FCL seven years ago when the
construction industry was in a boom period. Received much accolade for record sales levels when
he first joined the firm as Contracts Director, and so has continued to implement the policies which
had met with success in the past. Franc is now perceived as conservative, and often resists
movement towards new areas of business operations. He has a construction background, and
sometimes feels uncomfortable with his new managerial role as CEO.
• Henry Morton (HM) Engineering Manager. Henry has an engineering degree and has worked in the
trade for eight years, joining FCL three years ago. Henry is often called to give advise on the
technical and operating implications of capital asset purchases, as well as their probable
maintenance costs. Henry keeps up-to-date on innovation and new technology in the construction
industry, and in his opinion is well respected. However, Henry has is the past been frustrated in
several attempts to introduce advanced technology into FCL’s construction equipment, and blames
this on the conservative approach of Franc Silvero.
THE MEETING PARTICIPANTS 3
THE MEETING
The meeting called by Sonya turned out to lengthy and lively. The was a considerable debate, and the
following excerpt reflects the main comments raised by the participants.
SC: Look Julian, there just isn’t enough information here. I have to be able to work out the new crane’s
NPV and payback period. In the past, if projects haven’t had a positive NPV at a required rate of return of
26 per cent, and paid back within five years, then they haven’t been approved. Do we know anything
about the financial benefits which the AL II might produce? What advantage is there in buying this thing
now? Couldn’t we just let our old crane run its course and consider our options once it reaches the end of
its useful life in a few years’ time?
FS: Yes, I think we need to look more closely at the details here. Julian, what do you think the outlook is if
we stay with the old crane?
JD: The old crane really needs some maintenance work done on it, to bring it up to safety standards. If we
spent about £40 000 on maintenance straight away it should be OK until it goes out of commission in five
years’ time.
FS: What does it cost to run the old crane?
JD: Running costs are around £40 000 per annum. Plus, the crane’s getting unreliable. I reckon there’s
about a 50 per cent chance that it will break down at some time during the year. If it does we lose three
days’ productivity on a job at a cost of around £15 000, not to mention the cost of fixing it, which was £10
000 last time. Even once it’s fixed there’s still a 50 per cent chance it could break down again within the
next twelve months.
FS: What if we go for the AL II?
JD: The running costs would be a bit higher, as it’s a finely tuned machine and needs regular maintenance.
I reckon we’re looking at about £60 000 a year, judging by the recommended service programme.
But, at least it’s not likely to break down. Also, I’m sure that the AL II would improve our chances of
winning contracts – it’s faster and it will help keep costs down. Take for example that Storex contract we
missed out on last month. The kind of cost savings we could get with the AL II could have won us that
bid, and jobs like that are worth around £40 000 pre-tax profit to FCL. We could pick up a couple more
like that one each year – maybe more.
FS: How would you rate the chance of picking up more work with the AL II?
JD: Well, probably about 60 per cent chance that we’d get another two like the Storex job each year, and
perhaps about 20 per cent chance of doubling that. It’s hard to say really, but the customers out there are
feeling the pinch – we’ve got to watch our cost competitiveness if we want to stay in the game.
HM: That’s a key point here, I think. We’ve got to take a long-term view. The way I read it, these AL II
cranes will take over the market in the next two years, and by the time we came to replace the old crane
five years from now, we’d be looking at buying an AL II anyway. The question is, do we get in on the new
technology now, or in five years’ time?
We really can’t assume that the status quo will continue if we don’t go for the AL II now. We’re
looking at a fall in price competitiveness, company image and profits if we don’t move with the times. If
we do go with the AL II now, we’ve got an edge over our competitors. Even then, we wouldn’t want to
hang on to the AL II for more than ten years – we need to keep upgrading to keep ahead of the game.
JD: I can’t see what the problem is with these numbers Sonya has to crunch. It’s only an asset
replacement, and I’ve given you all the information the manual says you need. Besides, I told everyone
in January that we’d need to spend some money on the crane, so we all knew this was coming.
FS: That’s true, Julian, but we’re talking £345 000 now, whereas we only expected to spend £40 000 on
maintenance. I’m not at all sure that we want to get into experimental technology anyway, it seems pretty
risky. What’s wrong with maintaining the old crane, as planned? It’s still got five years left in it, and
they’re pretty hard to sell second-hand. It’s in our books at £10 981 after accumulated WDAs. We’d
probably only get about £20 000 for it if we want to sell it, which isn’t much more than the £5000 scrap
value we’d get for it in five years’ time.
4 FOSTERS CONSTRUCTION LTD
SC: Julian, perhaps you, Henry and I can sit down and draw up the figures, including the cost and benefit
information you’ve mentioned today. Then I can run the numbers and see if it meets our investment
criteria.
There’s just a couple of things that bother me, though. It doesn’t seem right to use the same required
rate of return for every project. We should be using different rates for different types of projects. I’ve
been playing around with a few numbers, and it seems to me that 26 per cent is too high. It might be
OK for risky projects that are something new to us, but here we’re talking about a crane. That’s run-ofthe-
mill stuff for FCL, and it seems to me that a 21 per cent nominal required return would be more
appropriate.
Also, looking at past records of CI analyses, it looks like the 26 per cent rate has been used as a real
discount rate, when it is actually calculated to represent a nominal rate. We really need to do some
inflation adjustments to the rates we’re using.
JD: This is all gobbledegook to me. Perhaps that’s the problem here – we’re so tied up in the numbers that
we can’t see a good investment when it hits us in the face!
FS: We have to be sure that any investment is financially viable, Julian. Sonya, why don’t you run the
numbers both ways: the way we have in the past, and again using a rate you think is appropriate. I’d
be interested in seeing what difference it makes, although there’s never been a shortage of projects in
the past that have made the 26 per cent grade. I hope you wouldn’t be cutting it too fine using a rate
like 21 per cent. It doesn’t seem to leave much margin for error if our project estimates turn out to be
wrong.
SC: I’ll run the numbers, but the best way of dealing with margins for error is by getting things right in
the first place. There’s still a lot of uncertainty on this project. All we’ve got so far are ‘feelings’ and
estimates – do you think we can firm up those figures at all?
JD: No. There just isn’t any other information. Look, I’ve been in this industry since before you finished
school – I’ve learnt enough to know what’s what. I can tell you now that sooner or later we’ll need a new
crane to be able to do our jobs, and doing our jobs is what makes money for this company!
FS: OK, Julian, no one’s doubting your judgement. Sonya, how about doing what you suggested, and
sitting down with Henry and Julian. They should be able to give you the technical information, and you
can work through the numbers. I’d like to see the IRR too – I’ve never been able to understand why we
don’t calculate IRR. I know a lot of other firms that do.
HM: Maybe we could think about changing the CI procedures manual too. That way, the technical people
will know exactly what information the director of CI needs and things can be settled faster.
SC: Fine, that’s a good idea. Look, I know we haven’t resolved this, but thanks for coming to this meeting.
Perhaps we can all get together again in a week’s time to make a decision.
DISCUSSION QUESTIONS
1 Present the financial analyses required by FCL’s CI procedures manual, as they have traditionally
been calculated. Explain any assumptions you make. According to FCL’s usual decision criteria,
would the AL II be purchased now?
2 Explain to JD the difference between real and nominal RRRs, as mentioned by SC. What
adjustment to SC’s suggested RRR would be needed in order to match the discount rate with the
cashflows used?
3 Re-calculate the NPV of the AL II purchase proposal, using what Sonya Carson would consider to
be an appropriate RRR. Do these revised NPV results suggest that the AL II should be purchased?
4 In the light of your calculations for the AL II purchase proposal, what would be your response to
FS’s comment that the IRR of projects should be calculated?
5 What do you think might be the key variables in the AL II investment which will affect its
viability? How might you consider these uncertain variables in better assessing the proposal?
DISCUSSION QUESTIONS 5
6 What further information would be useful in analysing the AL II proposal?
7 Identify any problems that you see regarding the following:
(a) the current CI procedures manual (as outlined in the summary)
(b) communication and consultation between the people involved in, and affected by, the CI
decision.
8 Do you consider that it would be wise to conduct a post audit if this asset were purchased, to see if
it is achieving the expected benefits? It so, how might you use the findings of such a post audit?
9 Suggest changes to FCL’s CI procedures which might improve future CI decision-making.


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