Case Study
You are the chief accountant of Everest Manufacturers. Everest manufactures a wide range of building and plumbing fittings. It has recently taken over a smaller unquoted competitor, Linton Limited. Everest 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-investment outlay). Closer inspection reveals several errors in the appraisal.
Evaluation of profitability of proposed project NT17
|
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0
|
I
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2
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3
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4
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|
Sales
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|
1,400
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1,600
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1,800
|
1,000
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|
Materials
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|
-400
|
-450
|
-500
|
-250
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|
Direct Labour
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|
-400
|
-450
|
-500
|
-250
|
|
Overheads
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|
-100
|
-100
|
-100
|
-100
|
|
Interest
|
|
-120
|
-120
|
-120
|
-120
|
|
Depreciation
|
|
-225
|
-225
|
-225
|
-225
|
|
Profit pre-tax
|
|
155
|
255
|
355
|
55
|
|
Tax at 33%
|
|
-52
|
-85
|
-118
|
-18
|
|
Post-tax profit
|
|
103
|
170
|
237
|
37
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|
Initial Investment
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|
|
|
|
|
|
working capital
|
-100
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|
|
|
|
|
Equipment
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-900
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|
|
|
|
|
Market research
|
-200
|
|
|
|
|
|
Investment
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-1200
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|
|
|
|
|
Average profit
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136.75
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|
|
|
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Rate of return = average profit/Investment
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11.4%
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|
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Required return
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25%
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You discover the following further details:
I. Linton's policy was to finance both working capital and fixed investment by a bank overdraft. A 12% interest rate is applied at the time of evaluation.
2. Of the overhead charge, about half reflects absorption of existing overhead costs.
3. The market research was actually undertaken to investigate two proposals, the other project also having been rejected. The total bill for this research has already been paid.
4. Everest has no debt in its capital structure and has no plans to use any debt finance in (inure.
5. Everest uses weighted average cost of capital to decide on project selection. The cost of equity is calculated by using capital asset pricing model. Beta of Everest is 1.25, risk-free rate is 3% and market risk premium is 8%.
Evaluate this proposal by:
(a) Identifying the errors made by Linton in their project appraisal.
(b) Calculating the weighted average cost of capital for Everest.
(c) Calculating the net present value of the project.