Case 094Budgeting, variance and reportingCore

A new mill budgeted at Rs 400 crore cost Rs 520 crore: steel escalation, scope additions and interest during a nine-month delay. Decompose the overrun and restate the project's IRR.

The situation

Nalikara Steel Tubes, an invented pipe maker, approved a new mill at Rs 400 crore on the basis of post-tax cash flow of Rs 90 crore a year for ten years. The mill has just been commissioned at a cost of Rs 520 crore, nine months late. The project team's reconciliation shows Rs 40 crore of steel price escalation on the structure, Rs 50 crore of scope additions, mainly an extra finishing line the plant head asked for during construction, and Rs 30 crore of interest capitalised during the delay.

Expected cash flow is unchanged at Rs 90 crore a year. The board, which approved the project at a 12% hurdle, wants to know what happened to the return and who is responsible for each piece.

Your task

Decompose the Rs 120 crore overrun by cause and owner, restate the IRR at each stage, and say what the board should change in its approval process.

Quick check

At Rs 520 crore for the same Rs 90 crore a year, does the mill still clear the 12% hurdle?

Worked solution

Try it on paper, then open one step at a time.

30-second answerThe answer to give first

The IRR falls from 18.3% at budget to 11.5% as built, below the 12% hurdle, and the Rs 120 crore overrun has three owners. Steel escalation of Rs 40 crore is a market risk carried unhedged. The Rs 50 crore of scope is a management choice never separately approved, which must earn its own return. The Rs 30 crore of interest is the cost of delay. NPV at 12% moves from plus Rs 109 crore to minus Rs 11 crore. The board should require separate approval for scope changes and test returns on all-in cost.

Step 1Why does a capex overrun cost return for ten years?

If you pay Rs 52 lakh for a flat you had budgeted at Rs 40 lakh and the rent is the same, you have not lost 12 lakh once; you have lowered the yield on every rupee for as long as you own it. An overrun is permanent because the cash flows it was supposed to earn do not grow with it. Rs 90 crore a year for ten years earns 18.3% on Rs 400 crore and only 11.5% on Rs 520 crore. To hold the original return at the higher cost, the mill would need about Rs 117 crore a year, Rs 27 crore more than planned, every year. Just to reach the 12% hurdle it needs Rs 92 crore.

Nalikara's mill went from a Rs 400 crore budget to Rs 520 crore through Rs 40 crore of steel price escalation, Rs 50 crore of scope additions and Rs 30 crore of interest during the nine-month delay, a 30% overrun with three different owners.

Step 2Who owns each piece of the overrun?

Split the Rs 120 crore by cause, because each cause has a different fix. Steel escalation is a market risk: the project could have fixed its steel price with the fabricator or a forward contract, and the board should ask why it did not. Scope additions are a management decision: the extra finishing line was approved by nobody but the plant head, and it should have come to the board as its own Rs 50 crore project with its own cash flows; if it adds nothing to the Rs 90 crore, it has to be judged as Rs 50 crore spent for no return. Interest during construction is the cost of the delay: nine months of 9% on the drawn debt, plus nine months of the Rs 90 crore of cash flow that did not arrive, roughly Rs 68 crore, which the reconciliation does not even show. The variance analysisBreaking the gap between a budget and the actual outcome into named causes, each with an amount and an owner. is only useful once each line has a name against it.

Cause	Rs crore	Type of risk	Owner	What should have happened
Steel price escalation	40	Market	Project finance team	Fix the price in the fabrication contract
Scope additions	50	Decision	Plant head, board	A separate approval with its own cash flows
Interest during delay	30	Execution	Project manager	A schedule with liquidated damages on contractors
Total	120			30% over budget

Each of the three causes of Nalikara's Rs 120 crore overrun is a different kind of risk with a different owner and a different remedy, which is why the board needs the split and not just the total.

Step 3How does the IRR move at each stage?

Restate the return as each cause lands. At Rs 400 crore the IRR is 18.3%; steel takes it to 15.7%, scope to 12.9%, and the delay interest to 11.5%, so the last Rs 30 crore is what pushes the mill below the hurdle. Each Rs 40 crore costs roughly two points of return. At the board's 12% hurdle, the NPV is plus Rs 109 crore on budget and minus Rs 11 crore as built. The mill is not a disaster: it earns 11.5% on money already spent and should obviously be run. But as an investment decision it would not have been approved at Rs 520 crore, and that is the fact the board must record.

The relationship

400 = 90 \times a_{10, r} \Rightarrow r = 18.3\% \qquad 520 = 90 \times a_{10, r} \Rightarrow r = 11.5\% \qquad \text{NPV}_{12\%} = 90 \times 5.650 - 520 = -11.5

a(10, r)	the ten-year annuity factor at rate r
90	post-tax cash flow a year, unchanged by the overrun
5.650	the ten-year annuity factor at the 12% hurdle
520	the mill's all-in cost

What it says in wordsThe same Rs 90 crore a year returns 18.3% on Rs 400 crore and 11.5% on Rs 520 crore, and at the 12% hurdle the mill now has a negative NPV of about Rs 11 crore.

Nalikara's project IRR falls from 18.3% on the Rs 400 crore budget to 15.7% after steel escalation, 12.9% after the scope additions and 11.5% after the delay interest, so the last cause is the one that takes it below the 12% hurdle.

Step 4What should the board change?

Three rules. Any scope change above a threshold comes back for approval as its own project, with its own cash flows, so a Rs 50 crore line has to show it can earn Rs 11 crore a year to hold the project's return. Market risks in a budget are either hedged or carried as a named contingency with an owner, not discovered at commissioning. And the post-completion review tests the return on the all-in cost, including capitalised interest and the cash flow lost to delay, against the hurdle the board approved, so that the next budget is built by people who know the last one will be checked. The limit of the analysis is that the extra finishing line may genuinely add cash flow; if it does, the plant head should be asked to show it, and the restated IRR will improve.

Where candidates lose it

The common loss is treating the overrun as a one-time cost and saying the mill still earns Rs 90 crore a year, so nothing has changed. The return on capital is what changed, from 18.3% to 11.5%, and it stays changed for the life of the mill.

The second loss is reporting one Rs 120 crore number. A board cannot act on a total; it can act on an unhedged steel price, an unapproved scope change and a schedule with no penalties, each of which has a different fix and a different person to answer for it.

What the interviewer asks next

The extra finishing line adds Rs 8 crore a year of cash flow. Was it a good decision on its own, and does it rescue the project?
How would you treat the nine months of lost cash flow in the variance report?
Should capitalised interest count as part of the project cost when judging management, given that the company chose to borrow?
What contingency would you have built into the Rs 400 crore budget, and how would you stop it being spent by default?

Company names and figures are illustrative.