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TYNESIDE GRAVEL CO LTD:

A Case Study on fnvestment Appraisal.

TIis case v,as x'riilan by fVneside Gravel Co. is an old esrablished farnily firm
Clfi stap h cr I'. M c livoj,, I operating frorn 3 sites at Rytoll about l0 miles west of
Deparntent of M nu genrcnl
u Newcastle upon Tyne. The present chief executive is John
Stud i e s, Lough bo ro ug lt Heppfe and his two sons Michael aged 26, and George a1ed 24,
U niv e r s i I ), of Tec h no kt 91,,
UK. Tltis cese \ves
are also on the board of directors. Because of the rapid
prepared as a bu.ris for expansion in building and civil engineering pl.ojects in rhe Tyne
class discus.sion rather Ilmn. and Wear arca in the past 15 years, there liave been plenry of
to illustrate either e.ffectitc opportunitie.s tbr expansion; but John Hepple, being hwarL of
or ineffective handling of a the lirnits of his management ability, has irot been kEen to aim
,runoge nrcnt si lual.io rt.
at rapid expansion and has been particularly anxious to avoid
glpanding beyond the point where he might lose control.
However, in order to allow scope fbr the growing managerial
.skills of the two Hepple sons, if has now been deciOed to-look
for growth opportunities and there are ample financial
resources available to suppolt the kind of expansion
contemplated. At the moment the only limiting factor on
expansion is tlre scarcity of new sand and gravellites in the
arca, but they do- not wish to move out of the area nor do they
want to operate ll'orn sub-sites which are situated morc than 20
milcs tj'om tlie home base at Rytol'r.

Flank Wardlaw, tlie director with responsibility for

development, ha.s t'ound two sites which offer good prospects at
Clcadon near Sunderland where the new fyne Tunnel-to-
Teeside motorway is undcr construction. The local council has
putchased the land on which tliese sites are placed but it is
willing to granl a mineral lease on one of the siies since it does
not have irnrnediate buildirrg plans for both sites. In fact it is
willing to lea.se eitlrer one but not bottr of the sites for a
maximum period ol' 12 years and ir is indifferenr as to which
.site is developcd.

@ 1980 Chlistophcl P Mcl.)voy. l-oughlrolough llrrive:r-sity of 'lbchnology, UK

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Tyneside Gravel Co. Ltd 280-001-1

One of the sites, Bardon Farm, will provide enjoying a l'eeling of satisfaction in the
sand and although the firrn d'oes not at belief that his leadership has been
present have a lot ol customers in the area it successful.
is felt that there is good market potential for
sand because of the increase in the nuurber of Hepple's managelnent style has been
housing starts in South Shields and also the somewhat autocratic but his character,
gleat potential in the Washingtor"r New Town which includes a degree of charisma and a
development. generous nature, has made his style easily
acceptable and earned him the genuine
The other site is called Cleirdon Hill and will respect of the workforce. Now 57 years
produce gravel for which thele is a ready old, one of Hepple's main ambitions is to
market to the motol'wty contractols. A larye perpetuate the family involvement with
contract can be secured tbr fbur years from the firm and to this end he is keen to
this contractor who at present is drawing on involve his sons more in the management.
supplies fi'om lurLher alield. However, at the He still retains 55Vo of the shareholding
end of this fbur years the market lbr gravel in however; of the rest of the shares his wife
the area will depend to a large extent on holds 107o, Frank Wardlaw has l2%o and
further development programmes which, of tlre remaining 23%, is spread between the
coulse, carlnot'be gualanteed. A tneeting ol other dilectors.
the Board of Directors of Tyncside Gravel is
called to consider these two altelnative Hepple is tinnly convinced that very rapid
projects and it is decided to appoirrt the growth at this stage would be highly
Finance Dilector, Jirn Thompson, [o lead a dangelous tor the firm and prefers instead
committee whictr will olganise a I'easibility a policy of controlled glowth with
study; the Marketing Director, John Machin intervals of consolidation. His knowledge
and also Frank Wardlaw are to be included o[ finance is not very deep but he is
on this committee. sl'rlewd enough to be aware that rapid
growth will inevitably lead to a need for
THE MANAGEMENT TEAM. external funds, a consequent dilution of
his ownership and eventually his control
John Hepple. of the company. Since he has no desire to
relinquish that control for many yeals yet,
Chairman and Managing DirectoL, he he has used his shareholding power to
ioined the firm (establi.shed by his lather veto any growth projects except those
in 1912) at rhe age of 28. He was which could be financed internally. In the
irnmediately given a lot of management prst, his insistence on this point has
responsibility and in tact succeeded to full caused him little concern despite the
control six years later on tctirement of his obvious l'r'ustration among certain other
father through ill hcalth. In the 23 yeals boald membeLs, but recently he has begun
which have elapsed since then the titm's to t'eel that his attitude may alienate his
annual sales turnover has increased from sons. The frustration of his elder son
f250,000 to over f,12 million and Michael is particularly obvious.
although some of this sales growth is
simply the result of tnonetaly inllation, Michael Hepple.
physical output has inct'eased more than
l0 times during the period of John Joined the lirm at the age of 20 following
Hepple's leadership. Crowth in the pa.st two years as a naval cadet officer. A quick
l0 years has been greatly assisted by thc learner, though occasionally impetuous,
lapid expansion in the local market; he l'ras successfully held several positions
nevertheless it is rrotable that Tyneside of responsibility in the firrn and is at
Gravel has lared considerably better than present Transport Manager. He is keen,
most of its local cornpetitors. John Hepple energetic and arnbitious, and he believes
therefore has some iustification l'or that because of his thther's obstinacy the

2
Tyneside Gravel Co. Ltd. 280-001-1

company is rnissing many oppoltlnlitles Frank War-dle.

which are l'alling instead to le.ss capable
competitors. Patience und tolertance are The longest serving member of the
not among Michacl's many virtues and he managelnent team aPart from John
continually tries to impless on his father Heppte. After some experience in
the need to take evsry opportullity to roadway construction and a short period
incrcase the f inn's share of their rnarket. with a competitor of Tyneside Gravel, he
was employed by John Hepple 25-years
George Hepple. ago to be foreman of the Ryton QuqrY
and is now Director with responsibility
The other son, began work with the for production and developmext. A
company some eighteen months ago al'ter steady, reliable and loyal manager, he has
completing a Business Studies degree. earned the respect and fiiendship of John
Under the guidance of the finance Hepple over the years of their association.
director, Jim Thornpsorl, he has been However, Wardlaw now feels somewhat
given a wide-ranging role designed to uueasy in his present role and has
involve him in managemcnt; his iob title experienced a growing feelil_g of
is 'Pers'oual Assistrrlt to the Finance insecurity since the alrival of the Hepple
Director', but his role includes not only sorls ol1 the Board of Directors. It is no
finlncial anrlysis, but ulso rnonitoring sccrct either that Michael Hepple believes
economic folecasts and liaising with that Wardlaw's managership is a brake on
govefnmerlt dcpanrnet'lts. George accepts the finn's development and that Michael
the logic of his brother's argument would very muclt like to take on
concerning their lather's cautions policy, Wardlaw's job as the next step in his
but he has an unwavcling loyalty to his development wilh thc comPanY-
father and rvould not considcr joirring any
serious opposition to his policies. Jirn Thornpson.

The major management posts in Marketing, A qualified management accountant, he

Production, and Finance are filled by had experience in various industries
managers who have had a good rccord with before joining Tyneside Gravel as
the company: Accountant six Years o$o - he was
appointed Finance Director two years ago.
John Machin. He is aged 38, is verY ambitious and
wants to be associated with a successful
Aged 44, he has a thorough knowledge of firm and is, theritbre, keen to promote an
the building and corlstruction industry. Hc expansionist policy. There has been a
joined Tyneside Gravel as Sulcs Director' noliceable tendency, particularly in -tecent
8 years ago after many years experience months, for ThomPson to join the
with civil engirteering lirrns in thc Nolth Machin/Michael Hepple alliance in
East and elsewhere. At the tirne of joining boardroom arglrments.
Tyneside Gravel he had iust completed 5
years as North East Area Sales Managcr There follows a suinmary of the preliminary
for the Wirnpey Group aud lte has indings of the Comrnittee concerning
f
invaluable experience in dealing with markei estimates, costs and relative
local authorities. pr:ol'itability of the two projects.

He is ambitious, a dynamic salesmln arrd CLEADON HILL.

feels he can justil'iahly clairn cledit lor
much ol'the firrn's growth in rccent ysars. l. The Market.
He is a clo.se lliend o1'Michacl Hepple.
It is estimated
that output l'rom this site
would be about 240, 000 tons a year and

3
Tyneside Gravel Co. Ltd 280-001-r

all ol'this would be t:rken up by the (iii) Land Reclarnation.

inotorway contl'acLol's, Mowlern, at f2"60
per ton. John Machin has already securcd The lease will contain a clause which
a plomise of a lour year contl'act with requires the company to restore the land
Mowlem's fol the whole of the output if to its original s[ate before it is retumed to
Cleadon Hill is developed. Thelefore the council. The cost of this work will be
there seems littlc reason to doubt the f40,000 and must be done sometime
estimates for tlie first tbur year period. before expily of the lease.

Beyond this 4-year prnduction period the (iv) Operating Costs.

extent of sales will depend on whether
Mowlem's secure another ma jor Operating costs based on similar
construction contract in the area (about experience at other sites are estimated to
which they are optimistic) and they would be:
hope to continue a gravel contract with
Tyneside Cravel on an annual ba.sis. Increased adrninistration costs and other
However, failing a contract with Mowlem, expenses...f28,000 per year.
it is unlikely, that the qualry would he
viable, so it would have to be closed. Production costs...f, l. l0/ton at the
Sales Department's market estimltes are 240, 000 ton output level or f 1.30/ton at
as follows: the 200,000 ton level.

lst 4 yeal period: 240,000 .tons p.a. @ (v)WoLkingCapital.

f2.60/ton ex/quarry.
It will be necessary to build up stocks
Beyond 4 years: before sales begin and it is expected that
an extra f50,000 of working capital will
Possible range of sales... I 60,000- be needed for this purpose during the last
280,000 tons p.a. 2 months of the year of development. The
customer will not require a long period of
Possible range ol'prices...f2.30 - f2.70 credit; nevertheless it is expected that it
per lon. will take about 4 weeks to receive
payment tbl sales. A further f,100,000 of
Period of continucd contl'act...2-5 years. working capital will be tied up in giving
credit beginning during the first 3 months
Best estimate ol' outcome...200,000 tons of sales.
p.a. tbr 3 yeafs @\ L2.40 pcr tolr.
3. Finance
2. Costs.
(i) Internal Finance.
(i) Lease.
Apart tiom some sholt/medium term bank
f500,000 payable on signing the lease. tjnance the company has a policy of self
finilncing. Therefore it is intended that the
(ii) Development. rnaiority of the funds required for this
project will be covered from internal
The cost o1' developing the site and sources. The film's minimum required
installing machinery is expected to be late of return on this type of project is
f95,000; this expenditure will be incuncd l4%o.
during tlre llrst year ol'the project.
(ii) Bon'owing.
Arnple security is available to provide

4
Tyneside Cravel Co. Ltd 280-001-1

cover tbr an increase in the present level sul'veys have shown the site to be capable
of borrowing and the bank has indicatcd of producing 300,000 tons of sand a year
that it wor,rld bc prcpar"ed to advancc lbr lcn ycars and John Machin believes
f85, 000 over a peiiod'of llve years. Tliis there is a malket potential which provides
loan would bc taken up immcdiately and an opportunity to build up to sales of
repaid at the end o[ five yeurs. 300,000 tons p.a. altliough this would take
afcw yeal's to achieve.
4. Taxation
Many of the labour-controlled local
The rate ol corporation tax is 507o. Tax is councils in the area are embarking on a
paid over to the Inland Revenue during policy of direct building for council
the year lollowing that in which profits housing and clearly this could be an
are made. Installation of plant costing opportunity to break into the market. The
950,000 during tlre year of development average price level for sand at present is
will qualify for a capital allowance. f3.20 per ton dclivered and although there
Although there are no protits expected is kcen compet.itiorr for Iocal authority
from the Cleadon Hill prclject during that tenders, Lhe tendered prices tend to fall
year it is reasonahlc to assulne that prolits within a nrn'ow range and would certainly
will be rnadc el.sewhere in the cornpany, not be expected to fall below f,3.05 per
against which this allowance rnay he ton. Machin is convinced that the
ott'set. company can win a good share of local
council tenders at this price. He also
Similarly it i.s expected that f30,000 of believes that an overall average price of
the investment in Land Reclarnation f3.10 a lon is likely to be achieved and on
during Lhe tenth year will also quality lor this basis the sales department offer the
capital allowance. Therelore there will be tbrecast shown in Exhibit 1 as the most
tax savings ol'f25,()00 and f 15,000 in the likely outcome of the proiect.
second and elcventh ycars rcspectively.
Once the f900,000 sales level is reached
5. Prot'itability. in the I'ifth year o1'sales, it is likely to
continue at that level for the remaining
It is expected that a lull year will be lit'e of the project. Therefore, allowing for
required to develop the site following two years to develop the site, it is
purchase ol'lhe lease, so thxt sales will not expected that a total of9 1/2 years of sales
begin until ttre second year ol'the project. will be possible, with the last 6 months of
A forecast prol'it and loss statement the lease period being taken up by
showing the estirnated lnost likely leinstating the land before handing the
outcome of the proiect is attached; these site back to the council.
tigures arc based on the best estirnates ol'
the department.s cor"tcerned, narnely Mindful of the high level of risk in this
tinance, marketing and development. market, the sales department have also
prepared lllther figures and it is felt that
BARDON FARM. sales could lall anywhere within the range
showrr in Exhibit 2.
1. The Malket.
2. Costs.
Tyneside Glavel aheady hus a nunrber ol'
customers wlro operute in the area of lhe (i) Lease.
new site; but the viability ol this project
will depend on thc lirm's ability to sccule The a.sking price is f700,000 payable at
new customers in South Shields. the time the lease is granted.
Sunderland and Washington Ncw Town.
Frank Wardlaw us.surcs thc cornmittee that

5
Tyneside Glavel (--o. Lttl. 280-001-l

(ii) Development such a large proportion of the funds,

particularly over this relatively long
This is a l'.rrge site and scltnewltat remote. period. However, the bank manager has
Theretbre, development alld building the put Jirn Thornpson in touch with the
access roads are expected to take almost Industrial and Commercial Finance
two years to cornplete befole sales sun Corporation (I.C.F.C.) who sometimes
begin to flow. The cosl of this provide this type of ploject tjnance.
development work is
estimated at
f400,000 of which f300.000 will be spent With the bank's help Thompson has been
in the first year. negotiating with I.C.F.C. and so far the
negotiatiolls seem to have been quite
(iii) Land Reclamation. successful. For: this type of financing
operation I.C.F.C. would normally expect
This work will be carried out in year 12 to take some equity in the company but in
after sales end and the cost is expected to this case because of the strong objections
be f70,000. of management and the influence of the
bank, it has been agreed to made all the
(iv) Working Capital. llnance available on a loan basis.

During the t'ilst l'ive yeals o[ salcs thcrc The interest on this loan will be higher
will be an increasing nced for I'urther than the bank's interest rate and it will be
injections ol'working capital. Based on valiable. The average rate is estimated to
the best estimates of sales levels, the be I47o.If it is needed, this loan will be
required increases in wolking capital will taken up irnmediately and it has been
be as shown in Exhibit 3. agreed that the interest for the first two
years could be capitalised and therefore
It is expected that the whole of this no interest payments will be made until
working capital will be recovered when year 3 of the project.
sales end.
The lernainder of the finance needed for
(v) Operating Costs. the project would be provided from
internal sources.
Costs per ton related to output are shown
in Exhibit 4. Despite the heavy loan funding on the
project and at the high interest rate, the
General adrninistration expenses are committee has been persuaded that, to be
expected to irrcrease by f30,000 a year. consistent, it should continue to use 147o
a.s its cut-off rate for return on capital.
3. Finance.
4. Taxation
Because of the lalge outlay on the lease,
this project could not he tlnanced l'rom the f,320,fin invcsted in plant and equipment
company's own financial resources and during the t'irst two yeans of development
the council is n<lt prepared to tccepl. will quality tor capital allowance and is to
staggered pxyment over several yeats. be set olT against prot'its elsewhere in the
fir'm during year 3. Tlle rernainder of the
The tlrrn would therelnre need f500,000 investment expenses are to be written off
exteilral funds and in lhe cilcumstances, as depreciation and amortisation of the
the form of linance most acceptable to lease over 5 years on the stlaight-line
management is a loan which would be basis.
requiled tol about sevell years because of
the expected slow build-up in sales. The f50,000 of the investment in reinstating
bank is opposed to the idea ol'providing the land in year 12 will also qualify. These

6
Tyneside Gravel Co. t,td. 280-001-r

benefits will be taken as providing tax (c) The Net Pleserrt Value (N.P.V.),
savings in years 3 and l2 respectivcly.
Any losses which rnay be sustained (d) The Internll rate of return (I.R"R.).
during the elrly yeals of trading are also
assumed to be set ol'f against profits Compale your results in (a) to (d) above
eamed elsewlrere. and comment on them.

Taxes will be paid over to the Inland (iii) Use the results obtained in (ii) to advise
Revenue in the yeat following that in the management with regard to the sales
which they ate assessed on prolits. between the two projects. If there are
cont'licts between the results obtained
through the various appraisal
5. Profitabiliry. techniques, explain how these conflicts
arise and how they may be resolved.
Trading will not begin until year' 3
because of the time nceded to dcvelop the (iv) What other tactors should be taken into
site. accouut in the choice between
CLEADON HILL and BARDON
The fotscilst ptol'it and loss statement FARM?
which is attached shows thc comrnittee's
estimate of the rnost likely prol'it outcome. (v) Brielly outline some approaches to the
problerns of handling risk in investment
STUDENT ASSTGNMENTS appraisal and show how the methods
you have explained might be applied to
(i) Prepare cash l'low statements lor the ihe analysis of the risk involved in
two projects. CLEADON HILL and BARDON
FARM.
(ii) For both CLEADON HILL and
BARDON FARM calculate: (vi) When the question of choice between the
projects is discussed at board level, how
(a) The payback peliod, do you think the debate may develop ..
and what lines of argument are likely to
(b) Accounting late of return, be pursued'l

7
Tyneside Gravel Co. Ltd. 280-001-1
Exhibits 1,2,3, & 4
Exhibit I

Sales Years I 2 3 4 5

Sales Tonnage 68 r90 240 26A 290

Sales Revenue
(f000's) 2TT 589 744 806 900

Exhibit 2

Sales Years I 2 3 4 5

Sales Volurne (Tons)

Max. 90 220 270 300 340
Min. s0 100 160 200 250

Exhibit 3

Sales Yeam I 2 3 4 5

Working Capital
Inputs (€000's) 30 70 60 50 50

Exhihit 4

Below 100,000 tons p.a. output f 1.40 per ton delivered

100,000 - 180,000 tons p.a. output f,l.30 per ton delivered
180,000 - 250,000 tons p.a. output f 1.15 per ton delivered
Above 250,000 tons p.a. output f 1.10 per ton delivered

8
 d
(D
o
a
ta

(D

o
0 I 2 3 4 5 6 7 8 9 10 1 I -
Year
Lease (s00)
Development (e5)
(150) 150
WCapital
85 (8s)
BankLoan
237 237 237 237 to7 t07 r07
Profit Before Tax
85 8s 85 85 85 85 85
Add Depreciation
(40)
Land Reclamation
(r le) (l le) (1 re) (l 19) (54) (s4) (s4)
\0 Tax Payment
I5
Tax Saving 25

N
'oo
Fto
Pi
(DH
>J-
 F.l

o
rt
q
(D

Bardon Farm
Fstimated Annual Net Cash Flows (f,000's) (D

o
9 10 ll t2 l3 i-
I 2 J 4 5 6 7 8
Year 0

Lease (700)
Development (300) (100)
(70)
Land Reclamation
(70) (60) (50) (50) 26A
Working Capital (30)
(650)
I.C.F.C. Loan 500
(e2) 163 260 3t2 373 464 464 464 4& 228
Profits Before Tax
87 87 87 87 87 87 87
Depreciation 87 87
(81) (130) (rs6) (186) (232) Q32) Q32) (232) (114)
Tax Payment
25
Tax Saving 160 46

t\)
F
-'l I
!tA
d-
(D
ul
Tyneside Gravel Co. Ltd. 280-001-1
Table C

Cleadon Hill Forecast Prol'it and Loss Aeeou:tJ

Years I 2 3 4 5 6 7 8

€'000

Sales 624 624 624 624 480 480 480

Cost of Sales 264 264 264 264 260 260 260

Gross Profit 360 360 360 360 220 220 220

kss:
General Expenses 28 28 28 28 28 28 28
Depreciation 85 85 85 85 85 85 8s
Bank Interest 10 l0 10 r0

Netprofit 237 237 237 237 r07 107 107

Tax Provision 119 119 119 119 54 54 54

Profit After Tax 118 118 118 118 53 53 53

11
 Fl
o
a
o
o
t
F'
C0

o
i-
e
Project Years J 4 5 6 7 8 9 1 0 1 I I2

f'000

Sales 2tl s89 744 806 900 900 900 900 900 400
Cost of Sales 9s 218 276 286 3t9 319 319 3t9 3r9 142

a 258
Gross Profit 1 16 J 7t 468 520 581 581 s8l s81 581
General Expenses 30 30 30 30 30 30 30 30 30 30
N
Depreciation 87 87 87 87 87 8: 87 87 87
Loan Interest 91 9l 9t 91 91

Net Piofit Before (e2) 163 260 312 373 464 464 464 464 228
Tax
Tax Provision 81 130 156 186 232 232 232 232 114

(e2) 82 130 156 186 ,1) 232 232 232 tt4

N)
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*lO
&&
6'H