Chapter 6 • Risk in investment appraisal
Easton Ltd’s cost of capital is 6 per cent p.a.
(a) Calculate the NPV for each of the three activity levels for each machine, A and B,
and state your conclusion.
(b) Calculate the expected NPV for each machine and state your conclusion.6.2*In problem 6.1, assume that the 2,000 level is the ‘best estimate’ of annual demand for
Easton Ltd, and that only Machine A is available.
(a) Should the business acquire Machine A on the basis of its NPV?
(b) Carry out a sensitivity analysis on the decision recommended in (a).6.3 Plaything plc has just developed a new mechanical toy, the Nipper. The development
costs totalled £300,000. To assess the commercial viability of the Nipper a market
survey has been undertaken at a cost of £35,000. The survey suggests that the Nipper
will have a market life of four years and can be sold by Plaything plc for £20 per Nipper.
Demand for the Nipper for each of the four years has been estimated as follows:Number of Nippers Probability of occurrence
11,000 0.3
14,000 0.6
16,000 0.1If the decision is made to go ahead with the Nipper, production and sales will begin
immediately. Production will require the use of machinery that the business already
owns, having bought it for £200,000 three years ago. If Nipper production does not go
ahead the machinery will be sold for £85,000, there being no other use for it. If it is used
in Nipper production, the machinery will be sold for an estimated £35,000 at the end
of the fourth year. Each Nipper will take one hour’s labour of employees who will be
taken on specifically for the work at a rate of £8.00 per hour. The business will incur an
estimated £10,000 in redundancy costs relating to these employees at the end of the
four years.
Materials will cost an estimated £6.00 per Nipper. Nipper production will give rise to
an additional fixed cost of £15,000 p.a.
It is believed that if Plaything plc decides not to go ahead with producing the Nipper,
the rights to the product could be sold to another business for £125,000, receivable
immediately.
Plaything plc has a cost of capital of 12 per cent p.a.
(a) On the basis of the expected net present value, should the business go ahead with
production and sales of the Nipper? (Ignore taxation and inflation.)
(b) Assess the expected net present value approach to investment decision making.6.4 Block plc has £6 million of cash available for investment. Four possible projects have
been identified. Each involves an immediate outflow of cash and is seen as having two
possible outcomes as regards the NPV. The required initial investment, possible NPVs
and probabilities of each project are as follows: