Charm Co is a software company which developed a new game, "Fingo" which it plans to launch in the near future. Sales of the new game are expected to be very strong following a favorable review by a popular PC magazine. Charm Co has been informed that the review will give the game a "best buy" recommendation. Sales and production volume, as well as selling price for "Fingo" over its 4-year life are expected as follows:

Year	1	2	3	4
Sales and production units	150,000	70,000	60,000	60,000
Selling price	$25	$24	$23	$22

Financial information for "Fingo" for the first year of production is as follows:

Direct material cost $5.40

Other variable production cost $6.00

Fixed costs $4.00

Advertising costs to stimulate demand are expected to be $650,000 in the first year of production and $100,000 in the second year of production. No advertising costs are expected in the third and fourth years of production. Fixed costs represent incremental cash fixed production overheads. "Fingo" will be produced on a new production machine costing $800,000. Although this production machine is expected to have a useful life of up to ten years, government legislation allows Charm Co to claim the capital cost of the machine against the manufacture of a single product. Capital allowances will therefore be claimed on a straight line basis over four years. Charm Co pays tax on profit at a rate of 30% per year and tax liabilities are settled in the year in which they arise. Charm Co uses an after tax discount rate of 10% when appraising new capital investments. Ignore inflation.

Required: a. Calculate the net present value of the proposed investment and comment on your findings.

b. Calculate the internal rate of return of the proposed investment and comment on your findings.

c. Discuss the reasons why the net present value investment appraisal method is preferred to other appraisal methods such as payback, return on capital employed and internal rate of return.

Question 2

Umunat is considering investing $50,000 in a new machine with an expected life of 5 years.

The machine will have no scrap value at the end of 5 years. It is expected that 20,000 units

will be sold each year at a selling price of $3.00 per unit. Variable production costs are

expected to be $10,000 per year. Umunat uses a discount rate of 12% for investment

appraisal purposes and expects investment projects to recover their initial investment within

2 years.

Required:

a. Explain why risk and uncertainty should be considered in the investment appraisal

process.

b. Calculate and comment on the payback period of the project.

c. Evaluate the sensitivity of the project's net present value to a change in the

following project variables:

1. Sales volume
2. Sales price
3. Variable cost

and discuss he use of sensitivity analysis as a way of evaluating project risk.

d. Upon further investigation it is found that there is a significant chance that the

expected sales volume of $20,000 units per year will not be achieved. The sales

manager of Umunat suggests tgat sales volumes could depend on expected

economic situations that could be assigned the following probabilities:

Economic situation Poor Normal Good

Probability 0.3 0.6 0.1

Annual sales in units 17,500 20,000 22,500

calculate and comment on the expected net present value of the project.