Coursework – Capital Budgeting Appraisal of a Plant Expansion Project

Introduction

Capital expenditure decisions are the least reversible commitments an Australian manufacturer makes. The sector generated value added of approximately A$130 billion in 2022-23 and continues to invest in plant to offset high energy and labour costs (ABS 2024). Because such assets are specialised and illiquid, an appraisal error cannot usually be corrected by resale.

This coursework appraises a proposed A$4.5 million expansion of the Wingfield plant operated by Torrens Extrusions Ltd (Torrens), a hypothetical ASX-listed producer of aluminium extrusions supplying South Australian and Victorian rail and construction markets. A second extrusion press would be commissioned on 1 July 2025 and appraised over six years, matching the contracted supply period. The analysis sets out the assumptions, estimates the weighted average cost of capital (WACC), builds the discounted cash flow (DCF) schedule, applies the standard criteria and stress-tests the result. Figures are in Australian dollars and, unless stated, in thousands.

Task 1: Relevant Cash Flows and Assumptions

The appraisal uses incremental after-tax operating cash flows, the only basis consistent with the net present value rule (Peirson et al. 2015). Three exclusions follow. The A$85,000 feasibility study is sunk. The A$95,000 per annum of allocated corporate overhead is not incremental, so only the A$380,000 of genuinely additional fixed cash costs is recognised. Interest and principal are excluded because the cost of debt is already embedded in the discount rate (Brealey, Myers & Allen 2020). No opportunity cost is recognised for the bay the press occupies, vacant since 2021 with no tenancy achievable under the zoning.

Table 1: Project assumptions, Torrens Extrusions Ltd plant expansion

Two simplifications warrant note. Torrens depreciates plant on a straight-line basis under AASB 116 Property, Plant and Equipment (AASB 2015), whereas the deduction claimed is a Division 40 capital allowance under the Income Tax Assessment Act 1997 (ATO 2024); the appraisal assumes the two coincide. The nil residual value is likewise conservative, given an active secondary market for presses.

Task 2: Estimating the Weighted Average Cost of Capital

The expansion carries business risk similar to the existing operation and is financed in the target proportions, so the firm’s WACC is an acceptable discount rate. The cost of equity uses the capital asset pricing model, with the risk-free rate from 10-year Commonwealth Government bond yields (RBA 2025):

K_e = R_f + β_e (E(R_m) – R_f) = 4.2% + 1.20 × 6.0% = 4.2% + 7.2% = 11.4%

Interest is deductible, so the relevant debt cost is the after-tax rate:

K_{d(after tax)} = K_d (1 – t_c) = 6.5% × (1 – 0.30) = 4.55%

Weights use market values. Equity is 26 million shares at A$1.75, or A$45.5 million, and debt A$24.5 million, so total capital is A$70.0 million and the weights are 45.5 ÷ 70.0 = 65 per cent and 24.5 ÷ 70.0 = 35 per cent:

WACC = (E ÷ V) K_e + (D ÷ V) K_d (1 – t_c) = (0.65 × 11.4%) + (0.35 × 4.55%) = 7.410% + 1.593% = 9.003%, rounded to 9.0%

Two qualifications attach. Dividend imputation makes part of the company tax paid recoverable by resident shareholders, so a strict Officer-style WACC would adjust the effective tax rate; Australian survey evidence indicates the capital asset pricing model is near-universal in practice while imputation adjustments are applied inconsistently (Truong, Partington & Peat 2008). Second, a firm-wide rate assumes average project risk and overvalues riskier projects (Brealey, Myers & Allen 2020), though here the expansion replicates an existing process.

Task 3: Discounted Cash Flow Schedule

Revenue is price multiplied by volume, so Year 3 revenue is 800 × A$4,000 = A$3,200,000, while operating costs combine both elements: (800 × A$1,850) + A$380,000 = A$1,860,000. Depreciation is deducted to reach earnings before interest and tax (EBIT), taxed at 30 per cent, then added back because it is not a cash flow. Working capital moves with forward-year revenue and is released at Year 6.

Table 2: Discounted cash flow schedule for the plant expansion, Years 0-6 (A$’000; outflows in brackets)

The Year 0 outflow of A$4,692,000 comprises the A$4,500,000 capital outlay and A$192,000 of opening working capital. Two checks confirm consistency: total EBIT of A$3,110,000 equals 18,400.0 less 10,790.0 less 4,500.0, and tax of A$933,000 is exactly 30 per cent of it; working capital also sums to nil, as it must once released. Figure 1 shows the same flows as a timeline.

Task 4: Application of the Investment Criteria

Net present value

Net present value is the sum of discounted free cash flows less the initial outlay. Year 3, for example, discounts to 1,150.2 ÷ (1.09)³ = 1,150.2 ÷ 1.29503 = A$888,200. Across the horizon:

NPV = A$5,015,700 – A$4,692,000 = A$323,700

The expansion should therefore add roughly A$0.32 million to shareholder wealth after compensating both debt and equity providers for time and risk. The profitability index states the same result per dollar committed: PI = 5,015,700 ÷ 4,692,000 = 1.069. Because it is measured in dollars and is additive across projects, net present value is given primary weight (Peirson et al. 2015).

Internal rate of return

The internal rate of return is the discount rate at which net present value equals zero. At 12 per cent the inflows are worth A$4,562,400 and net present value is negative A$129,600, so the true rate lies between 9 and 12 per cent. Linear interpolation gives:

IRR ≈ r_L + [NPV_L ÷ (NPV_L – NPV_H)] × (r_H – r_L) = 9% + [323,700 ÷ (323,700 + 129,600)] × 3% = 9% + (0.7141 × 3%) = 11.14%

Interpolation across a wide bracket is imprecise because the net present value profile is convex, so the estimate is refined using a narrower one. At 11 per cent net present value is a positive A$14,300 and at 12 per cent negative A$129,600, giving IRR ≈ 11% + [14,300 ÷ 143,900] × 1% = 11.10%, which clears the hurdle by 2.1 percentage points. Agreement with net present value is expected, because the flows are conventional with a single sign change and the decision is stand-alone rather than a choice between mutually exclusive alternatives (Peirson et al. 2015).

Payback period and discounted payback

Cumulative free cash flow reaches A$4,214,000 by the end of Year 4, leaving A$478,000 outstanding. Assuming cash accrues evenly within the year:

Payback period = 4 + (478,000 ÷ 1,236,000) = 4 + 0.39 = 4.39 years, or about 4 years and 5 months

Discounted payback repeats the calculation on present values, so it does not ignore the cost of capital during recovery. Cumulative present value reaches A$4,169,600 by Year 5, leaving A$522,400:

Discounted payback = 5 + (522,400 ÷ 846,100) = 5 + 0.62 = 5.62 years, or about 5 years and 7 months

The fifteen-month gap between the two measures is the clearest warning in the appraisal. The project recovers its discounted outlay barely five months before the horizon closes, so the whole surplus is earned in the final months of Year 6 and any commissioning slippage would consume it. Payback ignores everything beyond the cut-off, yet remains widely applied because it proxies for liquidity risk (Graham & Harvey 2001).

Task 5: Sensitivity Analysis

A single-point result conveys false precision, so each revenue driver has been flexed by 10 per cent in isolation. A price movement alters revenue but not operating costs; a volume movement alters both.

Table 3: Sensitivity of net present value to selling price and sales volume (A$’000; negative values in brackets)

Price dominates. A 10 per cent movement swings net present value by A$1,880,200, more than five times the base case result and an elasticity of roughly 29 to 1, against A$1,001,600 and about 15 to 1 for volume. The asymmetry is intuitive: a price change flows straight to margin, whereas a volume change is partly absorbed by the A$1,850 per tonne of variable cost moving with it.

The switching values matter more than the swings. Because the relationship is close to linear across the tested range, net present value falls by about A$94,000 for each 1 per cent reduction in price and about A$50,100 for each 1 per cent reduction in volume. Price can therefore fall only 3.4 per cent, to A$3,862 per tonne, or volume only 6.5 per cent, to 561 tonnes in Year 1, before the expansion destroys value. A capital overrun is better tolerated, since a larger asset base generates a larger depreciation tax shield: delivered cost can reach A$4,917,300, an overrun of 9.3 per cent. A simultaneous 10 per cent fall in both drivers produces a net present value of negative A$1,023,100.

That figure exposes a limitation. Varying one factor at a time ignores correlation, and in a construction-linked market weakening demand depresses volume and price together, so the combined scenario is the more realistic stress case.

Task 6: Qualitative and Strategic Considerations

Four qualitative factors bear on a finely balanced decision.

Energy exposure. Aluminium extrusion is electricity-intensive, and the A$1,850 per tonne variable cost assumes a stable delivered price. Wholesale prices in the National Electricity Market have been volatile, with South Australian quarterly averages moving sharply with thermal plant availability (AEMO 2025). Since price is the most sensitive variable, a multi-year hedge or a corporate power purchase agreement is close to a precondition.

Cost escalation. Unit costs are held constant in nominal terms because the supply agreements are indexed, an assumption only as strong as those clauses. Award wages have risen at rates reflecting recent inflation outcomes (Fair Work Commission 2024) and the South Australian market for skilled press operators is tight, so if wage growth outpaces indexation the 3.4 per cent price switching value is consumed without any fall in the headline price.

Regulatory exposure. Wingfield sits below the 100,000 tonne carbon dioxide equivalent threshold at which the Safeguard Mechanism applies, so carries no direct baseline obligation. Its billet supplier is a covered facility, however, and declining baselines create a real prospect of input cost pass-through (Clean Energy Regulator 2024).

Strategic option value. A static DCF model treats the project as a fixed commitment, understating it twice over. The press is specified above contracted volume, creating a growth option at low marginal capital cost, and the equipment has an active secondary market, creating an abandonment option. Flexibility of this kind carries value conventional analysis omits, particularly where uncertainty is high and commitments can be staged (Trigeorgis & Reuer 2017). Working against it is customer concentration: two rail contracts underwrite much of the forecast volume, and losing either would breach the 6.5 per cent volume switching value.

Recommendation

The expansion should be approved, subject to conditions. Every criterion supports acceptance: net present value is positive at A$323,700, the internal rate of return of 11.1 per cent exceeds the cost of capital by 2.1 percentage points, and the profitability index is 1.069. The case is nonetheless marginal, since a 3.4 per cent shortfall in realised price eliminates the surplus and discounted payback of 5.6 years leaves almost no buffer.

Four conditions would make that case defensible. Indexed take-or-pay agreements should cover at least 70 per cent of Years 1-3 volume before capital is committed. Electricity should be hedged for a minimum of three years. The authorisation should be staged, with a review at the end of Year 2 and discretion to defer the second tranche of tooling. Finally, the appraisal should be re-run if delivered capital cost exceeds A$4.7 million or the pre-tax cost of debt rises above 7.5 per cent.

Conclusion

This coursework has appraised a A$4.5 million plant expansion using incremental after-tax cash flows discounted at a WACC of 9.0 per cent. Table 2 yields a net present value of A$323,700, an internal rate of return of 11.1 per cent by interpolation, a payback period of 4.39 years, a discounted payback of 5.62 years and a profitability index of 1.069. Sensitivity testing establishes selling price as the critical driver, with a switching value of only 3.4 per cent against 6.5 per cent for volume and 9.3 per cent for capital cost. The wider lesson is that the decision rests less on the point estimate than on the conditions attached to it: a surplus of A$323,700 on an outlay of A$4,692,000 is a margin under 7 per cent, well inside the error bounds of a six-year forecast.

References

Australian Accounting Standards Board (AASB) 2015, AASB 116 Property, Plant and Equipment, Australian Accounting Standards Board, Melbourne.

Australian Bureau of Statistics (ABS) 2024, Australian industry, 2022-23, cat. no. 8155.0, Australian Bureau of Statistics, Canberra.

Australian Energy Market Operator (AEMO) 2025, Quarterly energy dynamics: Q4 2024, Australian Energy Market Operator, Melbourne.

Australian Taxation Office (ATO) 2024, Guide to depreciating assets 2024, Australian Taxation Office, Canberra.

Brealey, RA, Myers, SC & Allen, F 2020, Principles of corporate finance, 13th edn, McGraw-Hill Education, New York.

Clean Energy Regulator 2024, Safeguard mechanism: guidance for responsible emitters, Clean Energy Regulator, Canberra.

Fair Work Commission 2024, Annual wage review 2023-24 decision, Fair Work Commission, Melbourne.

Graham, JR & Harvey, CR 2001, ‘The theory and practice of corporate finance: evidence from the field’, Journal of Financial Economics, vol. 60, no. 2-3, pp. 187-243.

Peirson, G, Brown, R, Easton, S, Howard, P & Pinder, S 2015, Business finance, 12th edn, McGraw-Hill Education Australia, Sydney.

Reserve Bank of Australia (RBA) 2025, Statement on monetary policy, February 2025, Reserve Bank of Australia, Sydney.

Trigeorgis, L & Reuer, JJ 2017, ‘Real options theory in strategic management’, Strategic Management Journal, vol. 38, no. 1, pp. 42-63.

Truong, G, Partington, G & Peat, M 2008, ‘Cost-of-capital estimation and capital-budgeting practice in Australia’, Australian Journal of Management, vol. 33, no. 1, pp. 95-121.