This is a modified version of the report for Understanding Finance (Part 1: Investment Appraisal – Eastern plc Assessment Standard) in Bath Full Time MBA Class of 2020.

Investment Appraisal – Eastern plc Assessment Standard

Introduction

This report will answer the requirements of this coursework. These issues are to prepare the NPV calculation for Eastern plc, to explain what the cost of capital of 8% represents and to comment on whether and how this investment may contribute to shareholder wealth.

Preparing the NPV calculation for Eastern plc

As a result of the calculation, the NPV of this investment is approximately £9.2 millions or more precisely £91,931,456. This NPV is calculated to sum up the discounted cash flows in the life of project including the end of year 5 which the plant and equipment, which the company is going to invest, will be disposed. Each discounted cash flow is computed to multiply the net cash flow by discount rate which is equal to the cost of capital (8%). The net cash flow or free cash flow if the company financed by only equity is the cash flow which subtracts of all obligatory payments from gross profit adding the depreciation. The gross profit will be estimated to 35% of the sales which is going to earn selling 4 million units per year with the current price of £2.50, however, the price is expected to inflate by 4% per year. The depreciation is emulated using the Straight Line Basis method which means the investment subtracting from disposal value (£0.15 millions) is divided by life of project (5 years). The obligatory payments are the investment, fixed cost, tax payable and working capital change in this case. £2 millions of investment in new plant and machinery will be paid immediately and the remains (£6 millions) will do so at the end of the first year. The fixed cost is estimated be £2 million per year, however, this includes the depreciation (£1.57 millions), and therefore the actual fixed cost will be £0.43 millions per year. The tax payable is reckoned to multiply tax rate (20%) by taxable income which is to subtract gross profit from depreciation and fixed cost. The working capital change of a year is determined to subtract the working capital of 1 year later as of the year from the working capital of the year which will be maintained at 10% of the following year’s sales. The detail of calculation is in the MS Excel sheet which is also uploaded with this report.

Explaining what the cost of capital of 8% represents

What the cost of capital of 8% represents can be the minimum rate of return on the prospective investment projects as for the investors, who are supplying funds for Eastern plc. In addition, it can be also the degree of risk to invest this investment. Therefore, if Capital Asset Pricing Model (CAPM) theory hold and this cost of capital is financed by only equity, the investors require almost 7.2% premium for the risk of this investment owing to the fact that 10 years British government bond rate is 0.79%, which used as a risk free rate. Moreover, if the theory hold, this additional risk premium might depend on the company’s beta. According to Statista, the average market risk premium in the United Kingdom, 2019 is 6.2% and therefore, the market implied the company’s beta can be approximately 1.12. This means the company might be more sensitive than the whole market return. In comparison with other London stock exchange listed plastic companies such as Daios Plastics SA having beta 0.0133 and Lordos United Plastics Public Ltd with beta 0.0237, the risk can be significantly higher than competitors and therefore the investors require higher return for the company. This can be because the structure of asset might be weighted to debt which the lenders own less business risk than stockholders if the assumption that the cost pf capital is financed by only equity relax.

Comment on whether and how this investment may contribute to shareholder wealth

This investment may contribute to shareholder wealth. This is mainly because the NPV is a positive with a large cash flow owing to relatively highly competitive advantage of the company only if the sales figure is feasible. Therefore, this investment will earn a large amount of free cash flows which they are expecting and then those cash flow will be back to the investors as a dividend. The depreciation using the Straight-Line Basis method can be affected the NPV positively because if they adopted the other method, they would have to pay more cash flow as depreciation and then the NPV will reduce more than using Straight Line Basis.