Question NPV (Jun-2023)

Gini Co is a listed company that manufactures innovative products for the telecommunications
industry. Gini Co has just developed a new product called the LP500, which is expected to have a
project life of four years.

Gini Co's management has decided that the sales price for the LP500 will be $90 per unit, as
anything higher than this will dramatically reduce the expected annual sales volume which is
currently forecast to be 20,000 units per year.

The variable cost of the LP500 includes the cost of a bought-in component, the X22. The price of the
X22 has been volatile due to supply problems with the manufacturers and consequently, the
variable cost per unit is at present uncertain. The management of Gini Co has made the following
estimates of the variable cost per unit, along with its associated probability:

Variable cost per unit Probability

$ %

40 20

50 40

60 20

70 20

Incremental fixed costs will be $300,000 per year.

All of the above figures are expressed in current price terms. Sales price inflation is expected to be
5% per year. Variable cost per unit inflation and fixed cost inflation are both expected to be 3% per
year.

New plant and equipment costing $1.5m will need to be purchased at the start of the first year of
operation and is expected to have a residual value of $125,000, in nominal terms, at the end of year
four. Gini Co pays corporation tax at a rate of 20% and tax is payable at the end of the year following
the year to which it relates. The company can claim tax-allowable depreciation at a rate of 25% per
year on a reducing balance basis with a balancing adjustment in the year of disposal.

Additional working capital totalling $100,000 will also be required at the start of the project.
Working capital inflation is expected to be 3% per year.

Gini Co's nominal after-tax weighted average cost of capital for projects of this nature is 12%.

Required:

(a) Calculate the expected net present value of the LP500 project and comment on its financial
acceptability. (12Marks)

(b)(i) Briefly discuss how your decision in part (a) will help Gini Co achieve their primary
objective. (2 marks)
(ii) Discuss THREE limitations of using probability analysis in deciding whether or not to
proceed with the LP500. (6 marks)
Question NPV (Dec-2023)

Pulorough Co produces household electrical goods for its home country market and for markets in
neighbouring countries. Pulorough Co is planning to make a major investment in new production
facilities in order to produce an upgraded model of its cooker. Pulorough Co’s finance director has
assigned probabilities to a number of possible sales volumes of this new model, based on
Pulorough Co’s previous experience of launching product upgrades. He has calculated annual
expected values for sales for the four-year time period over which the investment will be assessed.

However, after a number of years of strong economic growth, Pulorough Co’s home country and its
neighbours appear likely to enter a period of recession, meaning that consumers may be less
willing to spend money on new kitchen goods.

The initial investment cost will be $39m. The finance director has assumed that there will be zero
realisable value at the end of the four years. Working capital can be ignored.

The expected volumes of sales are:

Year 1 2 3 4

60,000 150,000 140,000 80,000

from the upgraded cooker throughout the four years is $200 per cooker. This will not be a ected by
the rate of inflation

Incremental fixed costs, excluding depreciation, are expected to be $2.5m in year 1. They will
increase by the rate of inflation in each of years 2 to 4, which are predicted to be as follows:

Year 2 3 4

Inflation rate per year 6% 4% 3%

Pulorough Co pays corporation tax of 25% per year one year in arrears. No tax-allowable
depreciation is available on the investment expenditure.

Pulorough Co currently uses 11% as the after-tax discount rate to appraise investments like this.

One of the other directors has commented that he thinks the level of contribution that the finance
director has assumed is too high. He also wondered that, with the economic uncertainty, the cost
of capital should be higher. The finance director has said that he will prepare sensitivity
calculations, showing in relative terms the level of change in contribution and discount rate that
would produce a nil net present value. He will assume that the contribution will be lower by the
same percentage each year.

Another director has stated that she has heard that probability analysis can be helpful in decision-
making, and wonders if this will be the same as the sensitivity analysis that the finance director is
going to prepare.

Required:
(a) Discuss the di erence between risk and uncertainty in the context of investment
decisions. (3 marks)

(b)(i) Calculate the nominal net present value of the investment project and comment on its
financial acceptability; (5 marks)

(ii) Calculate the sensitivity of the project's net present value to a change in the level of
contribution per unit; and (3 marks)

(iii) Calculate the sensitivity of the project's net present value to a change in the discount rate.
(3 marks)

(c) Compare and contrast sensitivity analysis and probability analysis as methods of assisting
investment decisions when there is more than one possible outcome. (6 marks)