Evaluation Report of Alternative Investment

Projects for Barking Plc

Table of Contents

1  Introduction. 3

2 Calculation of Net Cash Flows. 3

3 Calculation of the Cost of Capital 4

4 Evaluation of Different Alternatives Using Payback Period, NPV and IRR. 5

4.1 Payback Period. 5

4.2 Net Present Value. 6

4.3 Internal Rate of Return. 7

5  Conclusions and Recommendations. 7

References. 8

1  Introduction

Barking Plc is a U.K based public limited company that provides a wide range of products and services for sale in to UK based consumers. The company’s main objectives include:

–        Increasing operating cash flow and dividends per share year-on-year by at least 5%; and

–        Increasing the wealth of shareholders while at the same time satisfying the interests of other major stakeholders such as employees, customers, government agencies, regulatory bodies, as well as maintaining the highest standards of ethics when conducting business.

In meeting with the above objectives, Barking Plc is considering two mutually exclusive investments and needs to select one of them. The objective of this report is to provide an evaluation and analysis of the two investment alternatives and decide based on the evaluation and analysis which of the two investments Barking Plc should undertake. In meeting with this objective, this paper will employ a number of investment appraisal techniques including the Payback Period, the Net Present Value (NPV) and the Internal Rate of Return (IRR).

2 Calculation of Net Cash Flows

Appendix 1 shows the net cash flows calculated based on the available information for alternative 1. In addition to the information provided, the following assumptions were made:

–        Revenues from years 3 will grow at a constant rate of 5%. This is consistent with the company’s objective to increase operating cash flows and dividends per share year-on-year by at least 5%.

–        The explicit forecast horizon is 8 years. This is because the machinery used for the project has a useful life of 8 years.

–        Depreciation is calculated using the straight line method. The cost of machinery is £8.22million and is expected to have a useful life of 8 years.

–        The equipment is expected to have a residual or salvage value of zero after 8 years.

–        The company pays no tax during the first four years considering the tax relief available right up to year 4. Tax is paid from year 5 onwards at a rate of 30% applied to net profit.

Appendix 2 shows the net cash flows for alternative 2. The calculations are based on the information provided and the following assumptions:

–        Revenues from years 3 onwards will grow at a constant rate of 5% again consistent with the company’s objective to increase operating cash flows and dividends per share year-on-year by at least 5%.

–        Explicit forecast horizon is 6 years because the factory equipment will have to be replaced in 6 years.

–        Depreciation is also calculated based on the straight line method. The cost of equipment is £2.5million and the useful life is 6 years.

–        The equipment is expected to have residual or salvage value of zero at the end of year 6.

–        The company pays no tax during the first four years considering the tax relief available right up to year 4. Tax is paid from year 5 onwards at a rate of 30% applied to net profit.

3 Calculation of the Cost of Capital

To calculate the cost of capital we use the constant growth dividend model. As stated in the question the company has the following capital structure:

Ordinary shares of 50p each                                                               £5,200

Reserves                                                                                               4,850

9% Preference shares of £1 each                                                          4,500

14% bank loan                                                                                                  5,000

Total long-term funds                                                                       £19,550

In addition, the current ordinary share price is 80p and next year’s dividend is estimated at 4p per share and is expected to grow at a constant rate of 12% forever. Finally, the preference share is quoted at 72p per share and the tax rate is 33%.

The above information can be used to determine the component costs of capital and later on the overall or weighted average cost of capital for the company.

To determine the equity cost of capital we use the constant growth dividend discount model. According to this model, the price of a stock at time zero is given by (Myers and Brealey, 2002; Ross et al., 1999; Bodie et al., 2005; Penman, 2007):

(1)

Where

represents the current stock price;

r_e is the cost of equity capital

D₁ represents next year’s dividend per share; and

g represents the constant growth rate in dividends.

Therefore,

Dividing both sides by P₀  and rearranging, the cost of equity capital becomes:

(2)

The above formula indicates that the

Based on the above formula the cost of equity capital is given by:

= 17%

Cost of debt is 14% and the cost of preferred stock is 9%.

Because interest on debt is tax-deductible, we assume that the after-tax cost of debt is tax-deductible; the cost of debt has to be estimated on an after-tax basis. The tax rate is 33% indicating the after-tax cost of debt is given by:

14% (1-.33) = 9%.

Based on the above information, we can now calculate an overall cost of capital for the company using the weighted average cost of capital (WACC). WACC is given by (Myers and Brealey, 2002; Ross et al., 1999):

(3)

Where w_e, w_p and w_d represent the weights of equity, preferred stock and debt respectively, in the capital structure; r_e, r_p, and r_d represent the costs of equity, preferred capital, and debt respectively; and t_c represents the corporate tax rate. Using the above equation (2) and the information provided the weighted cost of capital for the company is calculated to be 13%. Details of the calculation are found in the attached excel spreadsheet.

4 Evaluation of Different Alternatives Using Payback Period, NPV and IRR.

Having determined the cash flows and the component costs of capital, we now evaluate the two alternative investments using payback period, IRR and NPV.

4.1 Payback Period

The payback period for an investment is the time required for the project, is the time required for the project to recoup its initial cost.

The initial costs required for alternative 1 include the conversion cost of £1.3million, the cost of equipment of £8.22 million, and the redundancy costs of £1.2million. This give a total cost outlay of £10.52million.

In year 1 the company had a negative cash flow, indicating nothing was recovered in year 1. In year 2 the company had net cash inflows of £5,429,300.00; and in year 3 cash inflows were £7,039,300.00. Therefore, the total initial cash outlay was recovered in year 3. We need to determine the exact time that the initial cash was recovered. To do this we use the following formula:

Payback period = 2  +   Unrecovered cost at start of year of recovery

Cash flow during year

= 2+ [(10,520,000-5,429,300)/7,039,300] = 2.72 years.

The initial outlay of alternative 2 is given by conversion costs of £1.3million, redundancy costs of £0.24million and equipment cost of £2.5million. This gives a total outlay of £4.04million. the company recovered £2,625,000.00 in year 1 and £4,155,000.00 in year 2 from its operations with respect to alternative 2. Therefore, the payback period is given by:

Payback period = 1 +  [(4,040,000-2,625,000)/4,155,000] = 1.3 years.

Based on the payback period, the second alternative is worthwhile. This is because it takes a shorter time to recoup the initial investment. However, the payback period has a number of drawbacks. For example, it ignores the time value of money, as well as any cash flows after the payback period, so it is necessary to use techniques that take into consideration the time value of money and all cash flows. These are the NPV and IRR approaches.

4.2 Net Present Value

The NPV of a project is calculated using the following formula (Ross et al., 1999; Myers and Brealey, 2002; Arnold, 2005):

(4)

Where:

C₀represents initial investment;

C₁, …, C_n represents the net cash flows at time t = 1, …, t = n; and

r is the discount rate or cost of capital.

Applying the above formula to the cash flows using a discount rate of 13%, the net present value of the first alternative is £14,697,856.87 and the NPV for the second alternative is £17,230,610.82. (details of the calculation are found in the attached excel spreadsheets). Comparison was also made to the forgone alternative. This alternative is the long-established subsidiary Stratford, which yielded net-after tax cash flows of £1.5million on an annual basis. Discounting these cash flows on an annual basis, using the WACC and considering a forecast horizon of 8 years we get a net present value of £8,646,769.40. This means that both alternatives 1 and 2 yield a higher NPV as compared to the forgone alternative. Since the NPVs for both projects are positive, it means that both can be accepted. However, because only one project has to be selected, we select project 2 because it has a higher NPV.

4.3 Internal Rate of Return

The IRR is the discount rate that makes the NPV equal to zero. (Arnold, 2005). That is, the IRR is calculated by making IRR the subject of the formula (Arnold, 2005):

(5)

The above equation is often difficult to evaluate and thus IRR is usually calculating a trial and error approach. However, this is not a problem because computer applications such as excel can do it without too much stress. The IRR using excel is calculated by using the following formula “=IRR(Values, [guess])”. Using this approach the IRRs for alternatives 1 and 2 are 46% and 247% respectively. Since the IRRs are above the cost of capital this means that both projects are equally worthwhile. However, project 2 is more preferred because of its higher IRR.

5  Conclusions and Recommendations

Based on the analysis above using Payback period, NPV and IRR approaches, one can conclude that the second alternative is preferred over the first under all three approaches. In addition, the second alternative employs less expensive equipment which is readily available in the United Kingdom. This will greatly reduce delivery time and transport cost for the company. Finally, the second alternative can process waste at a lower cost and provides a much larger market. From the foregoing, the company should consider the second alternative and discard the first.

References

Arnold, G. (2005). Corporate Financial Management. 3rd Edition. Prentice Hall, Financial Times.

Myers, S. C. Brealey, R. A. (2002). Principles of Corporate Finance. 7th Edition McGraw-Hill.

Penman S. (2007) Financial Statement Analysis and Securities Valuation. 3^rd Edition, McGraw-Hill.

Ross, S.A., Westerfield, R.W., Jaffe, J.  (1999). Corporate Finance. 5th  Edition. McGraw-Hill International Edition Finance Series.

Appendix

Appendix 1: Calculation of Cash Flows for Alternative 1.

Appendix 2: Calculation of Cash Flows for Alternative 2.