Hathaway Co operates in the aviation industry, manufacturing safety equipment for commercial aircraft. The company has a policy of carefully appraising new investment opportunities, including the detailed analysis of all cost and revenue assumptions prior to their approval.
Project chi
Hathaway Co’s board is reviewing a potential investment, project chi. The company’s engineers have developed a new technology which can detect the potential for mechanical failure with a greater degree of accuracy than has previously been the case. Early test results have been extremely encouraging.
If the board accepts the engineers’ proposal, Hathaway Co would need to submit an application to the relevant regulatory authority. It is expected regulatory approval would be granted in one year’s time. Manufacturing and sales would commence immediately after being granted regulatory approval. Hathaway Co’s chief engineer presented an investment case for project chi to the board, including a summary of the following cost and revenue forecasts and assumptions.
Hathaway Co is expected to sell 3,000 units in the first year of production with demand increasing by 5% in each subsequent year of its four-year life. These sales forecasts are based on a contribution of $5,000 per unit in the first year of production and increasing at 2% per year in subsequent years. Annual fixed costs of $8·7m are expected in the first year of production, increasing at 3% per year throughout the life of the project.
An investment in plant and machinery of $12m will be required as soon as regulatory approval has been granted. Tax allowable depreciation is available on the plant and machinery at an annual rate of 20% on a straight-line basis. A balancing adjustment is expected at the end of the project when the plant and machinery will be scrapped.
Tax is payable at 20% in the year in which profits are made. The relevant cost of capital to be used in the appraisal is 12%.
Project chi extra information
The finance director, however, raised the following objections and consequences to the chief engineer’s presentation.
The chief engineer’s cost and revenue assumptions ignore the possibility of a recession, which has a 20% probability of occurring. In a recession, the total present values for the four years of production are likely to be 40% lower. The finance director also believes there is an alternative, mutually exclusive, development opportunity based on the new technology although this would still depend on it being granted regulatory approval. This alternative option would incur an identical investment cost of $12m but generate annual, inflation adjusted, post-tax cash flows of $3·43m over its seven-year life from year two onwards.
The investment case assumes regulatory approval is certain whereas historically only 70% of Hathaway Co’s applications have been approved. In one year’s time, if the regulatory application is not approved, it is assumed that the concept can be sold to Gepe Co for $1·0m at that time. If the board rejects the proposal now, assume the concept can be sold for $4·3m immediately.
Projects lambda and kappa
A recent board meeting discussed two recent investments, projects lambda and kappa, both involving the construction of new manufacturing plants for safety equipment. Both projects are now operational although project lambda experienced significant time delays and cost overruns while project kappa was under budget and within schedule.
On closer examination, the directors noticed that project lambda’s revenue far exceeded initial expectations, whereas project kappa’s revenue was much less than originally expected. On balance, Hathaway Co’s chief executive officer suggested that each project’s successes compensated for their respective failings and that this was to be expected when making predictions about the future in an investment plan. However, one of the directors suggested the company could benefit from the introduction of a capital investment monitoring system and post-completion audit. The directors agreed to discuss this in greater depth at the next board meeting.
Required:
(a) (i) Evaluate the financial acceptability of the project chi investment proposal based on the chief engineer’s forecasts, assuming regulatory approval is granted in one year’s time.
(ii) Calculate the expected net present value of the proposal based on the finance director’s assumptions about the likelihood of a recession and the potential impact on project chi’s cash flows.
(iii) Calculate the net present value of the finance director’s alternative option for the technology and advise the board whether this is worth pursuing.
(iv) Recommend whether the board should proceed with the application for regulatory approval after taking into consideration Hathaway Co’s 70% approval rate with its regulatory applications or to sell the concept now to Gepe Co. Include in your analysis any comments on your findings.
(i) Net present value (NPV): All figures are in $ms unless otherwise indicated
Workings
Working 1 (w1): Contribution
(ii) Incorporating finance director’s objections
Expected NPV of chief engineer’s proposal:
PV of years 2–5 = $17·74m
60% PV of years 2–5 = $10·64m
Expected PV of years 2–5 = (0·8 x $17·74m + 0·2 x $10·64m) = $16·32m
Expected NPV = $16·32m – $10·72m = $5·6m
(iii) Alternative option NPV
Annuity factor (12%, t2 – t8) = 4·968 – 0·893 = 4·075
PV of years 2–8 = 4·075 x $3·43m = $13·98m
NPV = $13·98m – $10·72m = $3·26m
Therefore, it is more beneficial to follow the chief engineer’s proposal.
(iv) Apply for regulatory approval or sell
Next, consider decision to sell to Gepe Co now or continue with application for regulatory approval.
NPV of sale to Gepe Co now = $4·3m
Expected NPV = 0·7 x $5·6m + 0·3 x (0·893 x $1·0m) = $4·19m
Therefore, more beneficial to sell immediately to Gepe Co.
Recommendation:
Immediate sale to Gepe Co for $4·3 million.
Comments
Based on the chief engineer’s assumptions, the project generates a positive NPV of $7·02 million and should therefore be accepted in preference to the option to sell the concept for $4·3 million. On the other hand, when the finance director’s objections are incorporated into the appraisal, the expected NPV is only $4·19 million and should therefore be rejected in favour of the option to sell.
It should be noted that the expected NPV of $4·19 million is an average. In other words, it is the average NPV if the project is carried out repeatedly which may not be useful in the case of a one-off development opportunity. Based on the calculations above, there is a 30% chance that the NPV will be only $893,000, which may pose a risk the directors are not prepared to take. The directors’ attitude to risk will be an important factor in the final decision.
Furthermore, the analysis largely depends upon the values of the probabilities prescribed, the range of possible outcomes and the accuracy of the revenue and cost assumptions. Sensitivity analysis may be useful in testing the impact of variations in each of these variables on the final outcome.
(b) Explain the rationale for implementing capital investment monitoring systems and post-completion audits. Suggest ways in which Hathaway Co may have benefited if these procedures had been applied to projects lambda and kappa.
Whilst Hathaway Co’s investment plans are based on a detailed analysis of all cost and revenue assumptions, projects lambda and kappa highlight failings in the appraisal and implementation phases.
Capital investment monitoring
Capital investment monitoring involves reviewing the implementation of an investment project to ensure it progresses according to the original investment plan, timescale and budget. This involves assessing the risks associated with the implementation phase and identifying deviations from the investment plan so that remedial action can be taken where necessary. Controls should be established to ensure effective delivery of the project.
Effective investment monitoring may have avoided the cost overruns and time delays experienced by Hathaway Co’s project lambda. The appointment of a project manager would have ensured ownership of the project and provided accountability for time delays and cost increases. The original investment plan, including cost estimates, provides a benchmark against which actual performance can be assessed. An effective monitoring system would ensure that any changes to the cost estimates would be justified and authorised. Where significant deviations are encountered, it may be necessary to terminate the project. A project steering committee would ensure greater scrutiny and accountability and oversee the implementation phase.
Post-completion audit
A post-completion audit is an objective, after the fact, appraisal of all phases of the capital investment process regarding a specific project. Each project is examined from conception until as much as a few years after it has become operational. It examines the rationale behind the initial investment decision, including the strategic fit, and the efficiency and effectiveness of the outcome. The key objective is to improve the appraisal and implementation of future capital investment projects by learning from past mistakes and successes.
An effective post-completion audit may have identified the reasons behind the failure of Hathaway Co’s project kappa to achieve its forecast revenues. By comparing the actual project outcome with the original projections, an audit will examine whether the benefits claimed prior to approval ever materialise. The audit is not an academic exercise; an effective audit would identify failings and help Hathaway Co learn from past mistakes as well replicate its successes. Project kappa’s principal failing seems to be the inaccuracy of the revenue assumptions. An audit would establish the reasons behind that failing and identify ways in which this can be addressed. For example, it is possible the initial assumptions failed to predict future competitor actions or the full range of potential economic scenarios. In this way, Hathaway Co’s managers benefit by learning how to appraise investment proposals more accurately and implement them more efficiently than before.