R plc plans to invest £1 million in new machinery to produce Product GF. Advertising costs in the first two years of production would be £70 000 per year and quality control costs would be 3 per cent of sales revenue.

Sales revenue from Product GF would be £975 000 per year and production costs would be £500 000 per year. Both sales revenue and production costs are at current prices and annual inflation is expected to be as follows.

Initial investment in working capital of £80 000 will be made and this investment will rise in line with general inflation. At the end of four years, production of Product GF will cease.
Capital allowances on the initial investment in machinery are available on a 25 per cent reducing balance basis. The equipment used to make Product GF is expected to have a scrap value of £50 000. R plc pays profit tax at a rate of 30 per cent per year and has a real weighted average after tax cost of capital of 8.7 per cent.

(a) Calculate the net present value of investing in the production of Product GF.
Show all your workings and explain clearly any assumptions you make.

(b) Calculate the sensitivity of the net present value of investing in the production of Product GF to a change in selling price.

Initial investment in working capital of £80 000 will be made and this investment will rise in line with general inflation. At the end of four years, production of Product GF will cease.
Capital allowances on the initial investment in machinery are available on a 25 per cent reducing balance basis. The equipment used to make Product GF is expected to have a scrap value of £50 000. R plc pays profit tax at a rate of 30 per cent per year and has a real weighted average after tax cost of capital of 8.7 per cent.

(a) Calculate the net present value of investing in the production of Product GF.
Show all your workings and explain clearly any assumptions you make.

(b) Calculate the sensitivity of the net present value of investing in the production of Product GF to a change in selling price.

(c) Explain the difference between risk and uncertainty in relation to investment appraisal, and discuss the usefulness of sensitivity analysis as a way of assessing the risk of investment projects.

Transcribed Image Text:

Sales revenue inflation Production cost inflation General inflation 4 per cent per year 5 per cent per year 3 per cent per year