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Foster’s Construction Ltd: Organizational Background
Fosters Construction Ltd (FCL) is a privately owned company with revenue of £20 million per annum, and 200 employees. The company has been operating for 24 years and is well established in the market-place. However, despite a national rate of 4 per cent per annum over the last few years (which is expected to continue), a general economic downturn has seen FCL’s nominal revenue reduce at a rate of about 3 per cent per annum.
The company’s main activity is the construction of large industrial buildings. It also provides maintenance services, mainly for those buildings which it has constructed. FCL has a large investment in construction machinery, and has always kept up with the latest technology in the industry. The company has concentrated on developing a corporate image as an innovative, technologically advanced construction firm, and many of the managers of FCL consider that this corporate image has been a major factor in securing large, competitive contracts in the past.
FCL is subject to corporation tax at 35 per cent, payable twelve months after year end, and a system of 25 per cent writing down allowance on capital assets.
FCL’s Formal Capital Investment System
An investment in construction equipment is central to the operations of FCL, the organization has, over many years, developed a detailed system by which capital investment proposals are considered. The summary sheet in Exhibit 1 is taken from the firm’s capital investment procedures manual, and outlines the formal process for capital investment decision-making within FCL.
The Current CI Decision: Purchase of a Replacement Crane
The construction site manager (CSM) has recently submitted a CI/12 application for the purchase of a new crane. The new asset would replace an existing crane which is ten years old, and which requires major maintenance in order to meet required safety standards. The CSM has indicated in the January budget-setting around that the firm would need to spend money maintaining the old crane, but had not at that stage been aware of any replacement options. It had previously been expected that the existing crane would see out its remaining useful life, to be replaced by a more modern crane (the Auto-Lift II, or ‘AL II’). The AL II is technologically more advanced than the firm’s existing crane, and is able to lift much larger loads. The new crane would cost £345 000, which is considerably more than the original
£195 000 cost of the existing crane.
The CSM consulted with the site accountants, and put forward the following information in the CI/12 application:
1. Description: purchase of an AL II crane to replace an existing crane which is in need of major maintenance.
2. Cost projections: purchase price = £345 000; annual running cost = £60 000. It is expected that the AL II crane would have a £30 000 scrap value at the end of its useful life in ten years’ time.
3. Projected time-scale; available for purchase from Allied Importers Ltd in one month’s time. Purchase price payable on 31 March – the last day of FCL’s financial year for taxation purposes.
The site accountants and the CSM had agreed that no further information was necessary, as the CI proposal qualified as a ‘replacement of existing asset’ Class I investment.
The CSM’s CI/12 application has now been considered by the director of CI, who feels uneasy about recommending the AL II crane purchase for funding approval. The director of CI has called a meeting of concerned parties to discuss the CI application.
EXHIBIT 1
Fosters Construction Ltd Capital Investment Procedures – Summary
Capital investment (CI) is defined as ‘any major expenditure on purchasing, construction or upgrading capital assets, the benefits from which will accrue over several years.
1. In early January of each year the CI budget is determined. The total amount of available funds for CI expenditure is determined by the directors, based on what they consider the company can afford.
2. Later that month, divisional managers meet to discuss forthcoming CI requirements, and the budget allocated across divisions. Managers must present their proposed CI requirements under the following three headings:
(i). essential replacement of existing assets (Class 1);
(ii). strategic expansion (Class 2);
(iii). safety and regulatory expenditure (Class 3).
The final allocation across divisions is a decision taken jointly by the CEO and the director of CI.
3. Throughout the year, access to funds for investment requires the submission of a standard form CI/12 – Capital Expenditure Application. The information normally required with such as submission includes:
(i). a description of the proposed investment;
(ii). motivation for the investment, i.e. what will the investment achieve for the company;
(iii). financial projections of the cost of the investment;
(iv). projected future financial benefits of the investment;
(v). key success indicators for the investment (used for assessing the riskiness of the project and for subsequent post audit);
(vi). a projected time-scale for completion of the investment. However, proposed Class
3 projects may dispense with items (iv) and (v), and those in Class 1 may dispense with items (ii), (iv) and (v).
4. The CI/12 form is assessed by the director of CI, who has the following options:
(i). accept the proposal and forward it to the CEO for financing approval;
(ii). refer the proposal back for further refinement;
(iii). reject the proposal.
CI proposals will be assessed with regard to the net present value (NPV) and payback period (PP) of the proposed project, although Class I projects will be considered as ‘cost minimization exercises’, since there is already an accepted need to continue with current operations and assets, and Class 3 projects are not required to meet financial criteria.
5. All CI projects are assessed within a ten-year planning horizon, i.e. investment effects beyond this ten-year horizon are considered uncertain, and are ignored.
6. If approved, a CI proposal is then allocated funds from the annual budget. A project supervisor is then assigned, and this person is responsible for the implementation and reporting of the CI project.
7. In due course, some selected CI projects will be subject to post audit by the director of CI.
The Meeting Participants
The following people are present at the meeting to discuss the AL II purchase proposal;
• Sonya Carson (SC) Director of CI. Sonya is new to this position, and is familiarizing herself with the technical nature of the firm’s operations. She has an undergraduate economics degree and is considered competent, if perhaps a little over-ambition. However, many longer-serving organizational members doubt Sonya’s ability to make good decisions regarding investment in an industry about which she currently knows little. For this reason, her appointment to the position of Director of CI was controversial.
• Julian Done (JD) Construction Site Manager (CSM). Julian has worked in the construction industry for 15 years, progressing through the ranks to become CSM two years ago.
He is considered to be competent in his job, but is perceived as uncompromising and confrontational. Julian has no time for ‘the head office bosses’, and his outspoken manner at meetings has often met with disapproval from the CEO.
• Franc Silvero (FS) CEO of Foster’s Construction Ltd. Franc came to FCL seven years ago when the construction industry was in a boom period. Received much accolade for record sales levels when he first joined the firm as Contracts Director, and so has continued to implement the policies which had met with success in the past. Franc is now perceived as conservative, and often
resists movement towards new areas of business operations. He has a construction background, and sometimes feels uncomfortable with his new managerial role as CEO.
• Henry Morton (HM) Engineering Manager. Henry has an engineering degree and has worked in the trade for eight years, joining FCL three years ago. Henry is often called to give advice on the technical and operating implications of capital asset purchases, as well as their probable maintenance costs. Henry keeps up-to-date on innovation and new technology in the construction industry, and in his opinion is well respected. However, Henry has is the past been frustrated in several attempts to introduce advanced technology into FCL’s construction equipment, and blames this on the conservative approach of Franc Silvero.
The Meeting
The meeting called by Sonya turned out to lengthy and lively. The was a considerable debate, and the following excerpt reflects the main comments raised by the participants.
SC: Look Julian, there just isn’t enough information here. I have to be able to work out the new crane’s NPV and payback period. In the past, if projects haven’t had a positive
NPV at a required rate of return of 26 per cent, and paid back within five years, then they haven’t been approved. Do we know anything about the financial benefits which the AL II might produce? What advantage is there in buying this thing now? Couldn’t we just let our old crane run its course and consider our options once it reaches the end of its useful life in a few years' time?
FS: Yes, I think we need to look more closely at the details here. Julian, what do you think the outlook is if we stay with the old crane?
JD: The old crane really needs some maintenance work done on it, to bring it up to safety standards. If we spent about £40 000 on maintenance straight away it should be OK until it goes out of commission in five years’ time.
FS: What does it cost to run the old crane?
JD: Running costs are around £40 000 per annum. Plus, the crane’s getting unreliable. I reckon there’s about a 50 per cent chance that it will break down at some time during the year. If it does we lose three days' productivity on a job at a cost of around £15 000, not to mention the cost of fixing it, which was £10 000 last time. Even once it’s fixed there’s still a 50 per cent chance it could break down again within the next twelve months.
FS: What if we go for the AL II?
JD: The running costs would be a bit higher, as it’s a finely tuned machine and needs regular maintenance. I reckon we’re looking at about £60 000 a year, judging by the recommended service programme. But, at least it’s not likely to break down. Also, I’m sure that the AL II would improve our chances of winning contracts – it’s faster and it will help keep costs down. Take for example that Storex contract we missed out on last month. The kind of cost savings we could get with the AL II could have won us that bid, and jobs like that are worth around £40 000 pre-tax profit to FCL. We could pick up a couple more like that one each year – maybe more.
FS: How would you rate the chance of picking up more work with the AL II?
JD: Well, probably about 60 per cent chance that we’d get another two like the Storex job each year, and perhaps about 20 per cent chance of doubling that. It’s hard to say really, but the customers out there are feeling the pinch – we’ve got to watch our cost competitiveness if we want to stay in the game.
HM: That’s a key point here, I think. We’ve got to take a long-term view. The way I read it, these AL II cranes will take over the market in the next two years, and by the time we came to replace the old crane five years from now, we’d be looking at buying an AL II anyway. The question is, do we get in on the new technology now, or in five years' time?
We really can’t assume that the status quo will continue if we don’t go for the AL II now. We’re looking at a fall in price competitiveness, company image and profits if we don’t move with the times. If we do go with the AL II now, we’ve got an edge over our competitors. Even then, we wouldn’t want to hang on to the AL II for more than ten years – we need to keep upgrading to keep ahead of the game.
JD: I can’t see what the problem is with these numbers Sonya has to crunch. It’s only an asset replacement, and I’ve given you all the information the manual says you need. Besides, I told everyone in January that we’d need to spend some money on the crane, so we all knew this was coming.
FS: That’s true, Julian, but we’re talking £345 000 now, whereas we only expected to spend £40 000 on maintenance. I’m not at all sure that we want to get into experimental technology anyway, it seems pretty risky. What’s wrong with maintaining the old crane, as planned? It’s still got five years left in it, and they’re pretty hard to sell second-hand. It’s in our books at £10 981 after accumulated WDAs.
We’d probably only get about £20 000 for it if we want to sell it, which isn’t much more than the £5000 scrap value we’d get for it in five years’ time.
SC: Julian, perhaps you, Henry and I can sit down and draw up the figures, including the cost and benefit information you’ve mentioned today. Then I can run the numbers and see if it meets our investment criteria.
There’s just a couple of things that bother me, though. It doesn’t seem right to use the same required rate of return for every project. We should be using different rates for different types of projects. I’ve been playing around with a few numbers, and it seems to me that 26 per cent is too high. It might be OK for risky projects that are something new to us, but here we’re talking about a crane.
That’s run-of-the-mill stuff for FCL, and it seems to me that a 21 per cent nominal required return would be more appropriate.
Also, looking at past records of CI analyses, it looks like the 26 per cent rate has been used as a real discount rate, when it is actually calculated to represent a nominal rate. We really need to do some inflation adjustments to the rates we’re using.
JD: This is all gobbledegook to me. Perhaps that’s the problem here – we’re so tied up in the numbers that we can’t see a good investment when it hits us in the face!
FS: We have to be sure that any investment is financially viable, Julian. Sonya, why don’t you run the numbers both ways: the way we have in the past, and again using a rate you think is appropriate. I’d be interested in seeing what difference it makes, although there’s never been a shortage of projects in the past that have made the 26 per cent grade. I hope you wouldn’t be cutting it too fine using a rate like 21 per cent. It doesn’t seem to leave much margin for error if our project estimates turn out to be wrong.
SC: I’ll run the numbers, but the best way of dealing with margins for error is by getting things right in the first place. There’s still a lot of uncertainty on this project. All we’ve got so far are ‘feelings’ and estimates – do you think we can firm up those figures at all?
JD: No. There just isn’t any other information. Look, I’ve been in this industry since before you finished school – I’ve learnt enough to know what’s what. I can tell you now that sooner or later we’ll need a new crane to be able to do our jobs, and doing our jobs is what makes money for this company!
FS: OK, Julian, no one’s doubting your judgement. Sonya, how about doing what you suggested, and sitting down with Henry and Julian. They should be able to give you the technical information, and you can work through the numbers. I’d like to see the IRR too – I’ve never been able to understand why we don’t calculate IRR. I know a lot of other firms that do.
HM: Maybe we could think about changing the CI procedures manual too. That way, the technical people will know exactly what information the director of CI needs and things can be settled faster.
SC: Fine, that’s a good idea. Look, I know we haven’t resolved this, but thanks for coming to this meeting. Perhaps we can all get together again in a week’s time to make a decision.

Discussion Questions:

1. Present the financial analyses required by FCL’s CI procedures manual, as they have traditionally been calculated. Explain any assumptions you make. According to FCL’s usual decision criteria, would the AL II be purchased now?
2. Explain to JD the difference between real and nominal RRRs, as mentioned by SC. What adjustment to SC’s suggested RRR would be needed in order to match the discount rate with the cashflows used?
3. Re-calculate the NPV of the AL II purchase proposal, using what Sonya Carson would consider to be an appropriate RRR. Do these revised NPV results suggest that the AL II should be purchased?
4. In the light of your calculations for the AL II purchase proposal, what would be your response to FS’s comment that the IRR of projects should be calculated?
5. What do you think might be the key variables in the AL II investment which will affect its viability? How might you consider these uncertain variables in better assessing the proposal?
6. What further information would be useful in analysing the AL II proposal?
7. Identify any problems that you see regarding the following:
(a). the current CI procedures manual (as outlined in the summary)
(b). communication and consultation between the people involved in, and affected by, the CI decision.
8. Do you consider that it would be wise to conduct a post audit if this asset were purchased, to see if it is achieving the expected benefits? It so, how might you use the findings of such a post audit?
9. Suggest changes to FCL’s CI procedures which might improve future CI decision-making.

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