You are the chief accountant of Deighton Plc. which manufactures a wide range of building and plumbing fittings. It has recently taken over a small 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 of equipment of Sh.900,000, is produced below. It was rejected because it failed to offer Linton‟s target return on investment of 25% (average profit- to-initial investment outlay). Closer inspection reveals several errors in the appraisal.
1. Linton‟s policy was to finance both working capital and fixed investment a bank overdraft. A12% interest rate applied at the time of the evaluation.
2. A 25% writing down allowance (WDA) on a reducing balance basis is offered for new investments.
Linton‟s profits are sufficient to utilize fully this allowance throughout the project.
3. Corporate 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 also been paid.
6. Deighton itself requires a nominal return on new project of 20% after taxes, is currently ungeared and has no plans to use any debt finance in the future.
(a) Identify the mistakes made in Linton‟s evaluation.
(b) Restate the investment appraisal in terms of post-tax net present value and recommend whether or not Deighton should undertake the project.
(a) Mistakes made in evaluation
Market research – historical or sunk cost hence irrelevant Depreciation – non-cash item thus irrelevant Tax – not paid one year later
Interest charges – financing expenses and tax shield incorporated in after tax cost of debt capital 50% (half) of overheads is absorbed or allocated and thus not relevant to the project.
Tax shield on capital allowances has been ignored.
The interest on bank overdraft is the cost short term debt. Only overall cost of capital can be used for project appraisal.
Inflation has been ignored.
Since NPV is positive, accept the project.