ProblemsProject Initial outlay NPV Probability
£ million £ million
A 6.0 3.0 (positive) 0.5
1.5 (negative) 0.5
B 2.0 1.0 (positive) 0.5
0.5 (negative) 0.5
C 2.0 1.0 (positive) 0.5
0.5 (negative) 0.5
D 2.0 1.0 (positive) 0.5
0.5 (negative) 0.5The outcomes of the projects are completely independent of one another.
The business has decided to adopt one of two strategies.
l Strategy 1: Invest all of the cash in Project A.
l Strategy 2: Invest one-third of the cash in each of Projects B, C and D.
Deduce as much information as you can about the effective outcome of following each
strategy.
Which of the two investment strategies would you recommend to the directors? Why?
What assumptions have you made about the directors and the shareholders in making
your recommendation?
Would your recommendation have been different had more or less finance been
involved in the decision?6.5*Hi Fido plc manufactures high fidelity sound reproduction equipment for the household
market. It has recently spent £500,000 developing a new loudspeaker, called the Tracker.
A decision now needs to be taken as to whether to go ahead with producing and
marketing Trackers. This is to be based on the expected net present value of the relev-
ant cash flows, discounted at the business’s estimate of the 20X0 weighted average
cost of capital of 8 per cent (after tax). Management believes that a three-year planning
horizon is appropriate for this decision, so it will be assumed that sales will not continue
beyond 20X3.
Manufacture of Trackers would require acquisition of some plant costing £1 million,
payable on installation, on 31 December 20X0. This cost would attract the normal cap-
ital allowances for plant and machinery. If the company makes the investment, for tax
purposes, the plant will be depreciated on a reducing balance basis at 25 per cent p.a.,
starting in the year of acquisition irrespective of the exact date of acquisition during the
year. In the year of disposal, no tax depreciation is charged, but the difference between
the written down value and the disposal proceeds is either given as an additional tax
allowance or charged to tax depending whether the written down value exceeds the
disposal proceeds or vice versa. For the purposes of assessing the viability of the
Tracker, it will be assumed that the plant would not have any disposal value on 31
December 20X3.
The first sales of Trackers would be expected to be made during the year ending 31
December 20X1. There is uncertainty as to the level of sales that could be expected, so
a market survey has been undertaken at a cost of £100,000. The survey suggests that,
at the target price of £200 per pair of Trackers, there would be a 60 per cent chance of
selling 10,000 pairs and a 40 per cent chance of selling 12,000 pairs during 20X1. If the
20X1 volume of sales were to be at the lower level, 20X2 sales would be either 8,000
pairs of Trackers (30 per cent chance) or 10,000 pairs (70 per cent chance). If the 20X1 ‘