Chapter 6 • Risk in investment appraisal
volume of sales were to be at the higher level, 20X2 sales would be estimated at 12,000
pairs of Trackers (50 per cent chance) or 15,000 pairs (50 per cent chance). In 20X3 the
volume of sales would be expected to be 50 per cent of whatever level of sales actu-
ally occur in 20X2.
Sales of Trackers would be expected to have an adverse effect on sales of Repros,
a less sophisticated loudspeaker, also produced by the business, to the extent that for
each two pairs of Trackers sold, one less pair of Repros would be sold. This effect
would be expected to continue throughout the three years.
Materials and components would be bought in at a cost of £70 per pair of Trackers.
Manufacture of each pair of Trackers would require three hours of labour. This labour
would come from staff released by the lost Repro production. To the extent that this
would provide insufficient hours, staff would work overtime, paid at a premium of
50 per cent over the basic pay of £6 an hour.
The Repro has the following cost structure:Per pair
£
Selling price 100
Materials 20
Labour (4 hours) 24
Fixed overheads (on a labour-hour basis) 33The management team currently employed would be able to manage the Tracker
project, except that, should the project go ahead, four managers, who had accepted
voluntary redundancy from the company, would be asked to stay on until the end of
20X3. These managers were due to leave the business on 31 December 20X0 and to
receive lump sums of £30,000 each at that time. They were also due to receive an
annual fee of £8,000 each for consultancy work which the business would require of
them from time to time. If they were to agree to stay on, they would receive an annual
salary of £20,000 each, to include the consultancy fee. They would also receive lump
sums of £35,000 each on 31 December 20X3. It is envisaged that the managers would
be able to fit any consultancy requirements around their work managing the Tracker
project. These payments would all be borne by the business and would qualify for full
tax relief.
Tracker production and sales would not be expected to give rise to any additional
operating costs beyond those mentioned above.
Working capital to support both Tracker and Repro production and sales would be
expected to run at a rate of 15 per cent of the sales value. The working capital would
need to be in place by the beginning of each year concerned. There would be no tax
effects of changes in the level of working capital.
Sales should be assumed to occur on the last day of the relevant calendar year. The
corporation tax rate is expected to be 33 per cent throughout the planning period.
On the basis of expected NPV, should Hi Fido plc go ahead with the Tracker project?6.6 Focus plc has several wholly owned subsidiaries engaged in activities that are outside
the business’s core business. A decision has recently been taken to concentrate exclus-
ively on the core business and to divest its other activities.
One of the non-core subsidiaries is Kane Ltd, which operates in an activity that the
board of Focus believes to be fast declining. It seems likely that it will be difficult to find
a buyer for Kane as a going concern, and its break-up value is considered to be small.
In view of these points it has been decided to retain Kane, allowing it to run down gradu-
ally over the next three years as its product demand wanes.