Due to the availability of all the required information, NPV analysis was used as the discounted cash flow method. Moreover, the FCFE cash flow method was used as the company will obtain no debt to finance the new contract as doing so would result in a breach of covenants (Black 2008, 221). For the discount rate, the capital asset model was used to come to an equity discount rate which was 20%. The use of an equity discount rate was appropriate since the project is being financed with equity. Nevertheless this does seem to raise a point given that the company will be cash strapped in the future and so raising 12 million seems difficult from internal sources (John 2007). Nevertheless, this point was ignored for the analysis due to absence of any concrete numbers.
It seems that the company is better off investing in the project. As a summary measure, the NPV of the project is positive and stands at ~19mn pounds. This despite the fact that the company will be facing increased distribution costs due to the far away location of the market, that is, East Asia. Distribution and administration costs were previously 25% of the company’s sales since it catered to European markets, which are nearer to Britain. However, the more distant East Asian markets now demand that the company’s distribution costs as a percentage of sales increase to 33% of sales (Collins 2003, 55).
The company is invariably following a contraction strategy. It feels that the demand of its products is going to fall in the foreseeable future due to the forecasted European recession driven by the austerity measures of the various European governments (Reilly 2007, 76). Moreover, it has also been having trouble renewing its contracts for the same reasons. So looking forward, it has decided to rid itself of the excess capacity it had built as part of its organic growth. Nevertheless, the new contract that it has been presented with recently seems to merit otherwise. The new contract as already mentioned is profitable as it enjoys a positive NPV (Smith 2005, 81). Hence there is every reason that the company should follow it. It is true that this will make the company deviate from its stated strategy but the financials always speak the truth. Moreover, the financial forecasts created for the analysis are not really forecasts but are actually contracted numbers at least in the case of revenue figures (Fall 2006).