You are the chief accountant of Deighton plc, which manufactures a wide range of building and plumbing
Question:
You are the chief accountant of Deighton plc, which manufactures a wide range of building and plumbing fittings.
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 Materials Direct labour Overheads Interest Depreciation Profit pre-tax Tax at 33%
Post-tax profit Outlay Stock Equipment Market research
(100)
(900)
(200)
(1,200)
1,400
(400)
(400)
(100)
(120)
(225)
155
(51)
104 1,600
(450)
(450)
(100)
(120)
(225)
255
(84)
171 1,800
(500)
(500)
(100)
(120)
(225)
355
(117)
238 1,000
(250)
(250)
(100)
(120)
(225)
55
(18)
37 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.
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