innovation Technology Co is considering an opportunity to produce an innovative component which, when fitted into motor vehicle engines, will enable them to utilise fuel more efficiently. The component can be manufactured using either process Process Alpha or process Beta. Although this is an entirely new line of business for Innovation Technology Co, it is of the opinion that developing either process over a period of four years and then selling the production rights at the end of four years to another company may prove lucrative.

The annual after-tax cash flows for each process are as follows:

Process Alpha

Year	0	1	2	3	4
After-tax cash flow (000)	(3,800)	1,200	2,153	1,386	2,829
Process Beta
Year	0	1	2	3	4
After-tax cash flow (000)	(3,800)	643	546	1,055	5,990

Innovation Technology Co has 10 million 50c shares trading at 180c each. Its loans have a current value of $3.6 million and an average after-tax cost of debt of 4.50%. Innovation Technology Co's capital structure is unlikely to change significantly following the investment in either process.

Recycle Co manufactures electronic parts for cars including the production of a component similar to the one being considered by Innovation Technology Co. Recycle Co's equity beta is 1.40, and it is estimated that the equivalent equity beta for its other activities, excluding the component production, is 1.25. Recycle Co has 400 million 25c shares in issue trading at 120c each. Its debt finance consists of variable rate loans redeemable in seven years. The loans paying interest at base rate plus 120 basis have a current value of $96 million. It can be assumed that 80% of Recycle Co debt finance and 75% of Recycle Co equity finance can be attributed to other activities excluding the component production.

Both companies pay annual corporation tax at a rate of 25%. The current base rate is 3.5% and the market risk premium is estimated at 5.8%.

Required

Prepare the report for the board of directors of Innovation Technology Co which:

1. Evaluate the financial acceptability of the investment according to the above results.
2. Recycle Co has estimated an annual standard deviation of $800,000 on one of its other projects, based on a normal distribution of returns. The average annual return on this project is $2,200,000. (i) Estimate the project's value at risk (VaR) at a 99% confidence level for 1 year and over the Project's life of 5 years. Explain what is meant by the answers obtained.

(ii) Apart from the use of VaR, briefly explain methods that Recycle Co can use to deal with risk and uncertainty in investment appraisal and their drawbacks.