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TABLE OF CONTENTS
Page
Abbreviations

iii

1.0

Introduction 1

2.0

Synopsis of Relevant and Irrelevant Cost Items 2


2.1

3.0

Key Assumptions

Theoretical Foundation for Analysis

3.1

Investment Appraisal methods

3.1.1

Simple payback (SPB)

3.1.2

Net Present Value (NPV)

3.1.3

Intern Rate of Return (IRR) 4

3.1.4

Adjusted Present Value (APV) 4

3.2

Required Minimum Rate of Return 4


3.2.1

Capital Asset Pricing Model (CAPM)

4.0

Results

5.0

Interpretation of the Results

6.0

Conclusion and Recommendations 8

6
7

References
Appendix

List of Abbreviations
CAPM

Capital Asset Pricing Model

IRR

Internal Rate of Return

NPV

Net Present Value

APV

Adjusted Present Value

SPB

Simple Payback

1.0

Introduction

Keavagh International is considering the viability of a project which involves provision of


modern distribution systems to a small European country. As of now, the companys financial
accountants have done some financial analysis of the project based upon accounting profits
and are advising to terminate the contract purely on the basis of payback period.
Being recently appointed as the Management Accountant, I am given the task of undertaking
the detailed assessment of the project via modern capital budgeting techniques. In the
process, I have investigated the figures and questioned the relevance of these variables. While
there are certain costs that are not incremental to the project, there are others that required
adjustments.
Below is the summarised description of these alterations, their impact on the investment
tools, the analysis of the results as well as an insightful conclusion of the dilemma.
All in all, on the basis of the information gathered this report will reappraise the investment
project in terms of analysing the previous information and investment decision; checking the
relevance of cost variables; computing the minimum return and level of risk attached to the
project; arriving at APV and subsequently the conclusion.

2.0

Synopsis of Relevant and Irrelevant Cost Items (see Appendix A)

2.1

Description

Given that the company accountants have purely relied on the traditional capital budgeting
techniques, there has been an immense focus on the profit figure so there are certainly some
cost items that needed review in our analysis. While there are some expenses that stand
irrelevant in modern cash flow techniques, there are a few that needed adjustment given their
relevance to the project. The irrelevant costs specifically include Depreciation, Interest on
loans to finance the project and Fixed Overheads. On the other hand, other items like
Materials; Labour and Hired in Plant; Site Clearing expense; relevant Administrative
Overheads; and Sales are updated according to the information gathered. Following is an
insight to the revised computation of these variables.
I.

Depreciation is a non-cash expense so it is completely irrelevant for the cash flow

II.

analysis techniques.
Interest on loan to finance the project is incorporated in the computation of cost of

III.

capital and thus NPV therefore it does not form part of the cash flow analysis.
Fixed overheads and a certain portion of Administrative overheads are not
incremental costs of the project so they are also taken as irrelevant. For the fixed
overheads which were included in other production expenses at the rate of 20% of old
labour cost, I have simply excluded this figure to arrive at the directly related expense.
As for the administrative overheads, I have found out that only a fixed annual amount

IV.

of 50,000 is relevant to the project.


Materials cost needed an adjustment since 30% is supplied by the client at cost. So, I
have excluded the 30% cost component and computed 20% mark-up on the remaining

V.

portion.
Given the effect of varying weather conditions on Labour and Hired in Plant, I have
applied prudent approach by taking into account the escalation in costs and the

VI.

probability of weather change.


Site clearing expenses are also adjusted in light of the cost sharing agreement with the
client; thus, Keavagh International will only incur current liability of 50,000 in 2019

VII.

in this regard.
As the name suggests, cash flow analysis is based purely upon the inflow and outflow
of cash so I have adjusted the previous Sales figure to reflect upon this principle and
get to the Cash Sales figure every year. The 5% held by client and one month arrears
are carefully adjusted in this regard.
2

2.2

Key Assumptions

Although the term of the project is four years, some cash flows like Sales and Site
Clearing expenses, are incurred even in the fifth year, i.e. 2020; therefore, the project

is assessed over the five years.


CAPM (14.92%) is used as the discount rate as this accounts for the risk involved.
Client will pay 5% of the Sales figure that is held every year at the termination of

project, i.e. 2019.


Exchange rate of 1.20/ is used throughout the four years for simplification and
understanding of the analysis.

3.0

Theoretical Foundation for the Analysis

3.1

Investment Appraisal Methods

The fundamental step in investment appraisal method is a to identify the nature of riskiness if
the business of the firm and the industry its employed in. The attractiveness of capital
budgeting is the apparent value of comparison that it allows investors in choosing between
projects. The projects can range from research and product development to company
expansion and restructure. Therefore it is crucial to employ the most apt capital budgeting
technique. The methodology is applicable for both long and short-term projects. With the
existence of a wide number of capital budgeting methods, it is bound to yield variable results.
Therefore it is necessary to identify the most accurate method of investment appraisal.
Various factors are taken into account while making this consideration, including the capital
structure of the firm i.e. the portion of debt and equity, which is a direct indicator of the level
of riskiness of the firm. Following are some of the appraisal methods utilised when analysing
Keavgh Internationals project analysis.
3.1.1

Payback Method

The simple payback method is the most rudimentary capital budgeting method, which
accounts for the time it will take for the project to return its initial amount. Already preferred
by the Managing Director of the company, it provides with a simple to understand and also to
apply measure. Importance is given to cash flows that meet the initial outflow required
therefore it has real limitations in the form of the timing of the cash flows and also ignores
the cash flows that occur after the initial outlay is recovered.

A modified payback method called the Discounted Payback addresses one of the issues of
the timing of cash flows, which takes into account the present value of cash flows when
calculating the payback period. This neutralizes the timing of the cash flow issue by
discounting future payments to their net present value.
3.1.2

Net Present Value (NPV)

This is the most commonly used and applied investment appraisal method, with certain
advantages that give it an edge. Essentially it is the change in the net cash inflows and
outflows taken at their present value at a certain discount rate or cost of capital. For accepting
a project, the NPV is slated to be positive otherwise a negative NPV project is rejected. The
obvious limitation with this method is its improbability of being used in comparison or
ranking of projects. Usually a company has a limited budget and there is a need to choose
between investments and with differing size and budgets of projects the NPV method is
lacking in application.
3.1.3

Internal Rate of Return (IRR)

The internal rate of return is the discount rate at which the NPV is zero. It is calculated by
equating the difference in the net cash outflows and inflows discounted with the IRR. This is
a trial and error method with a simple enough application. The IRR is compared with the cost
of capital taken out based on the riskiness of the company and the project. One issue with the
IRR is that it makes a major assumption about the nature of the cash flows as following a set
pattern. An irregular cash flow pattern can yield multiple internal rate of returns. Additionally
another supposition of this method is that all the cash flows are reinvested at the IRR which is
3.1.4

Adjusted Present Value (APV)

This is a modified version of the Net Present Value Method. One major crutch of the NPV is
the reliance of the method on the cost of capital or the discount rate. The cost of capital is
usually an approximate measure of the riskiness of the project extrapolated from factors such
as the cost of debt and the capital structure of the firm. It fails to account for other specific
factors that contribute to the level of riskiness of the project.
APV employs such factors in its measure of the appropriateness of the project. Similarly APV
also takes into account the financial benefits that may be accrued by undertaking the project
such as interest tax shield due to debt financing.

3.2

Minimum Rate of Return Required

3.2.1

Capital Asset Pricing Model (CAPM)

The most appropriate measure of calculating the minimum required rate is the Capital Asset
Pricing Model (CAPM). As compared to WACC, CAPM gives a more project specific rate of
return given the specific beta factor of the project is known. The application of this model is
straightforward with the following equation
Ri = Rf + {Rm Rf}Bi
The risk free rate is usually the appropriate yield on government securities with a comparable
debt term as the companies. Similarly the risk premium is the difference between the market
return and the risk free rate of return. The beta is usually taken to be the project specific beta
factor and in cases of differing capital structure, capital gearing is needed to convert the
companys beta to the projects beta. Despite based on a single period model the CAPM is
still appropriate as in a perfect market assumption; there is no theoretical objection to its
usage. The CAPM is used in the measurement of NPV and APV for investment appraisal
method.

4.0

Results

Present value calculation


Years

0
(000)

Capital Investment
Cash flows
Capital Allowances
Taxable Profit
Tax @ (25%)
Tax to be Paid (50% current year and
50% in arrears )
Net Cash Flows
Discount Factor @ 14.92%
Present Value
NPV
Gain on Loan (PV)
Tax Shield (PV)
Adjusted Present Value

SPB
Discounted Payback
IRR

1
(000)

3
(000)

5
(000)

1002.01
102.40
899.61
224.90

4
(000)
100
817.04
309.60
507.44
126.86

201.15
160.00
41.15
10.29

837.69
128.00
709.69
177.42

5.14
196.00
0.8702
170.56
1829.44

93.85
743.84
0.7572
563.23

201.16
800.85
0.6589
527.67

175.88
741.16
0.5733
424.94

124.25
362.31
0.4989
180.76

-1266.21

-738.54

-313.60

-132.84
128.98
53.74
49.88

1740.69

4.198517
53

(000)

-2,000

-2,000
1.0000
-2000.00
-2000.00

3.42 years
Beyond the life of
project
12%

486.56
0
486.56
121.64

5.0

Analysis of the Results (see Appendix B)

The results show contradictions on some level, with one variable going in support of the
project and another against it. However, it is important to analyse the worth of the project in
an overall perspective.
The project generates negative NPV of 132,840 since the initial cash outlay of 2,000,000 is
not recovered with the total cash inflow of 1,867,160 over the four-year term. While this
may put-off the project in the first sight, a relatively more modern and advanced criteria is
APV. APV takes into account the financing benefits, for example tax shields provided by the
deductible interest expense, hence this is regarded as stronger investment tool. This also has
relevance in our case since this project is entirely financed by debt and that too a subsidised
government loan. The project produces positive APV of 49,880 after adjusting for PV of
gain on loan (128,980) and PV of tax shield (53,740).
Other than this, the payback period of the project is 3.42 years while the discounted payback
goes beyond the life of the project. This fails the cut off of 3 years set by the managing
director. Also, the IRR of the project is 12% which is lower than the CAPM of 14.92% used
to discount the cash flows. IRR denotes the rate at which NPV of the project is zero and it is
generally recommended to be higher than the discount rate to rank the project as viable.
6.0

Conclusion and Recommendations

The thorough analysis comes to the point where the initial assessment of the financial
accountants should be for the most part disregarded in lieu of the revised computation of only
the relevant variables of the project. First of all, accounting profit does not give a correct
depiction of the viability of the project hence the cash flow techniques are more reliable
investment tool in the modern corporate world. Second of all, even in the case of accounting
profit, the companys accountants have made a few blunders by ignoring the make-up of
certain cost items, for instance, administrative overheads. Third of all, financial accountants
have failed to notice the relevance of the variables. Costs such as depreciation and fixed
overheads do not affect the desirability of the project and thus need not be accounted for in
the analysis.
As for the revised analysis, positive APV is what regards the project feasible for the company.
NPV, IRR and discounted payback stand in opposition of the project. Nevertheless, before
coming to any final conclusion, it is advised that the management should undertake
8

qualitative analysis of the project, and given the higher relevance of APV in our case,
Keavagh International may proceed with the investment.
There are a few concerns that need to be addressed in urgency:
I.

A project should be evaluated on a holistic approach by weighing up different

II.

investment tools rather just one such as Payback period.


Once the project is monetarily appraised, management should always go ahead for the
qualitative assessment since that is often what creates the competitive edge for the

III.

companies, for example customer loyalty.


The current financial accountants of the company are in need of heavy training to
equip them with modern days knowledge and practices.

Appendices

Appendix A

Point 1
(000)
Machinery Cost
Annual Depreciation

Beginning Balance/Net Book Value

800
20%
2016
(000)
800

2017
(000)

2018
(000)

2019
(000)

640

512

410

Cash on disposal

Capital Allowance (20%)

100

160

128

102

310

Point 2
10

LOAN
INTEREST RATE
HOME COUNTRY INTEREST
YEARS

2,400,000
5%
8%
FORWARD
INTEREST
RATE

PRINCIPAL
REPAYMENT

1.2

1.2

3
4

1.2
1.2

600,
000.00
600,
000.00
600,
000.00
600,
000.00

ANNUAL
INTEREST

120,00
0.00
90,00
0.00
60,00
0.00
30,00
0.00

ANNUAL
COST

600,00
0.00
575,00
0.00
550,00
0.00
525,00
0.00

2,400,000.00

PERSENT
VALUE

555,5
55.56
492,9
69.82
436,6
07.73
385,8
90.67
1,871,0
23.78
2,000,0
00.00
128,
976.22

Nominal Value of Loan


Gain on loan

Tax Shield
Interest

Tax shiled

Tax
shield

120,000

30,000

25,000

90,000

22,500

18,750

60,000

15,000

12,500

Years

PV of Tax
Shield
2
3,148
1
6,075
11

9,923
4

30,000

7,500

6,250

Total PV of Tax Shiled

4,594
53,740

Point 3
Markup

20%

Current Total Materials


Materials at Cost
Materials supplied by client at cost
Remaining Balance
20% Markup on Remaining
Revised Total Materials

2016
(000)
380
316.67
95
221.67
266
361

2017
(000)
600
500
150
350
420
570

2018
(000)
830
691.67
207.5
484.17
581
788.5

2019
(000)
540
450
135
315
378
513

Point 4
12

Annual Labour
Escalated Labour for 3 months
70% Escalated Labour
30% Not to be Escalated
Revised Annual Labour

2016
(000)
275
96.25
211.75
82.5
294.25

2017
(000)
370
129.5
284.90
111
395.90

2018
(000)
440
154
338.80
132
470.80

2019
(000)
290
101.5
223.30
87
310.30

Annual Hired in Plant


Escalated Hired in Plant for 3 months
70% Escalated Hired in Plant cost
30% Not to be Escalated
Revised Annual Hired in Plant

2016
(000)
50
17.5
38.50
15
53.50

2017
(000)
60
21
46.20
18
64.20

2018
(000)
70
24.5
53.90
21
74.90

2019
(000)
60
21
46.20
18
64.20

2016
(000)
160
55
105.00

2017
(000)
200
74
126.00

2018
(000)
200
88
112.00

2019
(000)
300
58
142.00

Point 5

Curret other production expenses


20% of old Labour cost
Revised Other Production Expenses

2020
(000)

Point 6
2019
13

Current Liability (Site Clearing Exp)

(000)
50

Point 7

Relevant Administrative Overheads

2016
(000)
50

2017
(000)
50

2018
(000)
50

2019
(000)
50

2016
(000)

2017
(000)

2018
(000)

2019
(000)

1,255
62.75
1,093

2,265
113.25
1,972
99
2,072

2,695
134.75
2,347
179
2,526

1,965
98.25
1,711
213
1,925

Point 8 workings

Sales
5% held by Client
Accounts Receivable 11Months
Accounts Receivable 1Month in Arrears
Total Receivables

1,093

2020

156
565

Point 9
Revenue lost from moving the
employees(000)

140
14

Profit Margin

20%

Net Revenue lost from moving the


employees

Year 0
(000)

2016
(000)

2017
(000)

2018
(000)

117

117

117

117

Appendix B

Minimun Return Required (CAPM)


CAPM

Risk-free rate
Beta
Market risk premium

4
1.30
8.4

Ke (%) =

Years
Sales (Payments Recieives)

Risk-free rate + Beta


(Market risk premium)

14.92

2016

2017

2018

2019

2020

(000)
1092.90

(000)
2071.79

(000)
2526.21

(000)
1924.54

(000)
564.56
15

Costs
Materials
Labour
Hired in Plant
Other Production Expenses
Administration Overhead
Site Clearance Expenses
Oppurtuninty Cost
Cash Flows

361.00
294.25
53.50
105
50.00

570.00
395.90
64.20
126
50.00

788.50
470.80
74.90
112
50.00

513.00
310.30
64.20
142
50.00

28.00
201.15

28.00
837.69

28.00
1002.0
1

28.00
817.04

50.00
28.00
486.56

16