Advanced: NPV calculation, choice of discount rate and sensitivity analysis The managing director of Tigwood Ltd believes that a market exists for ‘microbooks’. He has proposed that the company should market 100 best-selling books on microfiche which can be read using a special microfiche reader that is connected to a television screen. A microfiche containing an entire book can be purchased from a photographic company at 40% of the average production cost of best-selling paperback books.

It is estimated that the average cost of producing paperback books is £1.50, and the average selling price of paperbacks is £3.95 each. Copyright fees of 20% of the average selling price of the paper¬ back books would be payable to the publishers of the paperbacks plus an initial lump sum which is still being negotiated, but is expected to be £1.5 million. No tax allowances are available on this lump sum payment. An agreement with the publishers would be signed for a period of six years. Additional variable costs of staffing, hand¬ ling and marketing are 20 pence per microfiche, and fixed costs are negligible.

Tigwood Ltd has spent £100000 on market research, and expects sales to be 1 500 000 units per year at an initial unit price of £2.

The microfiche reader would be produced and marketed by another company.

Tigwood would finance the venture with a bank loan at an interest rate of 16% per year. The company’s money (nominal) cost of equity and real cost of equity are estimated to be 23% per year and 12.6% per year respectively. Tigwood’s money weighted average cost of capital and real weighted average cost of capital are 18% per year and 8% per year respectively. The risk free rate of interest is 11% per year and the market return is 17% per year.

Corporate tax is at the rate of 35%, payable in the year the profit occurs. All cash flows may be assumed to be at the year end, unless otherwise stated.

Required

(a) Calculate the expected net present value of the microbooks project. (5 marks)

(b) Explain the reasons for your choice of discount rate in your answer to part (a). Discuss whether this rate is likely to be the most appropriate rate to use in the analysis of the proposed project. (5 marks)

(c) (i) Using sensitivity analysis, estimate by what percentage each of the following would have to change before the project was no longer expected to be viable:
- initial outlay - annual contribution - the life of the agreement - the discount rate.
(ii) What are the limitations of this sensitiv¬ ity analysis? (10 marks)

(d) What further information would be useful to help the company decide whether to under¬ take the microbook project? (5 marks)
(Total 25 marks) ACCA Level 3 Financial Management