The general manager of the nationalised postal service of a small country, Zedland, wishes to introduce a new service. This service would offer same-day delivery of letters and parcels posted before 10 a.m. within a distance of 150 km. The service would require 100 new vans costing $8,000 each and 20 trucks costing $18,000 each. One hundred and eighty new workers would be employed at an average annual wage of $13,000, and five managers on average annual salaries of $20,000 would be moved from their existing duties, where they would not be replaced.

Two postal rates are proposed. In the first year of operation, letters will cost $0.525 and parcels $5.25. Market research undertaken at a cost of $50,000 forecasts that demand will average 15,000 letters and 500 parcels per working day during the first year, and 20,000 letters and 750 parcels per working day thereafter. There is a five-day working week. Annual running and maintenance costs on similar new vans and trucks are estimated to be $2,000 per van and $4,000 per truck, respectively, in the first year of operation. These costs will increase by 20 per cent p.a. (excluding the effects of inflation). Vehicles are depreciated over a five-year period on a straight-line basis. Depreciation is tax-allowable, and the vehicles will have negligible scrap value at the end of five years. Advertising in Year 1 will cost $500,000, and in Year 2 $250,000. There will be no advertising after Year 2.

Existing premises will be used for the new service, but additional costs of $150,000 per year will be incurred.

All the above cost data are current estimates and exclude any inflation effects. Wage and salary costs and all other costs are expected to rise because of inflation by approximately 5 per cent p.a. during the five-year planning horizon of the postal service. The government of Zedland will not permit annual price increases within nationalised industries to exceed the level of inflation.

Nationalised industries are normally required by the government to earn at least an annual after-tax return of 5 per cent on average investment and to achieve, on average, at least zero net present value on their investments.

The new service would be financed half by internally generated funds and half by borrowing on the capital market at an interest rate of 12 per cent p.a. The opportunity cost of capital for the postal service is estimated to be 14 per cent p.a. Corporate taxes in Zedland, to which the postal service is subject, are at the rate of 30 per cent for annual profits of up to $500,000 and 40 per cent for the balance in excess of $500,000. Tax is payable one year in arrears. All transactions may be assumed to be on a cash basis and to occur at the end of the year, with the exception of the initial investment, which would be required almost immediately Required

(a) Acting as an independent consultant, prepare a report advising whether the new postal service should be introduced. Include a discussion of other factors that might need to be taken into account before a final decision was made. State clearly any assumptions that you make.

(b) Monte Carlo simulation has been suggested as a possible method of estimating the net present value of a project. Briefly assess the advantages and disadvantages of using this technique in investment appraisal.