8 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-toinitial investment outlay). Closer inspection reveals several errors in the appraisal.

You discover the following further details:
1 Linton’s policy was to finance both working capital and fixed investment by a bank overdraft. A12 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.

Transcribed Image Text:

Evaluation of profitability of proposed project NT17 (all values in current year prices) Item (000) Sales Materials Direct labour 0 1 2 3 1,400 1,600 1,800 1,000 (400) (450) (500) (250) (400) (450) (500) (250) Overheads Interest Depreciation Profit pre-tax (100) (100) (100) (100) (120) (120) (120) (120) (225) (225) (225) (225) 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) Average profit 138 Rate of return 11.5% Investment 1,200