Problems
6.1 What are the limitations of the results of a sensitivity analysis such as the one carried
out in Example 6.1 (Greene plc)?
6.2 When deducing the expected NPV of a project, you can:
(a) identify all possible outcomes (and their individual NPVs) and deduce the expected
NPV from them; or
(b) deduce the expected value of each of the inputs and use these to deduce the
expected NPV directly.
What are the advantages and disadvantages of each of these two approaches?
6.3 What is the difference between the ‘specific’ and ‘systematic’ risk of a project? Why
might it be helpful to distinguish between these two?
6.4 What does the word ‘utility’ mean in the context of utility theory?
6.5 What is a risk-averse person? Are most of us risk-averse?
6.6 It is possible to wager on the spin of a fair coin. This will pay out £100 if the coin lands
head up and nothing if it lands tail up. What can you say about how much a risk-loving
individual would be prepared to pay to enter the wager?
REVIEW QUESTIONS
Suggested answers to
review questions appear
in Appendix 3.
(Problems 6.1 to 6.3 are basic-level problems, whereas problems 6.4 to 6.7 are more
advanced and may contain some practical complications.)
6.1*Easton Ltd needs to purchase a machine to manufacture a new product. The choice
lies between two machines (A and B). Each machine has an estimated life of three years
with no expected scrap value.
Machine A will cost £15,000 and Machine B will cost £20,000, payable immediately
in each case. The total variable costs of manufacture of each unit are £1 if made on
Machine A, but only £0.50 if made on Machine B. This is because Machine B is more
sophisticated and requires less labour to operate it.
The product will sell for £4 per unit. The demand for the product is uncertain but
is estimated at 2,000 units for each year, 3,000 units for each year or 5,000 units for
each year. (Note that whatever sales volume level actually occurs, that level will apply
to each year.)
The sales manager has placed probabilities on the level of demand as follows:
Annual demand Probability of occurrence
2,000 0.2
3,000 0.6
5,000 0.2
Presume that both taxation and fixed costs will be unaffected by any decision made.
PROBLEMS
Sample answers to
problems marked with
as asterisk appear in
Appendix 4.
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