PQR Limited is appraising an investment project which has an expected life of four years and which will not be repeated. The initial investment payable at the start of the first year is 5m. A scrap value of 0.5m is expected to arise at the end of four years. There is some uncertainty about what price to charge for the units produced by the investing project, as this is expected to depend on the future state of the economy. The following forecast of selling prices and their probabilities are prepared: Future Economic state Weak Medium Strong Probabilities of future economic state 35% 50% 15% Selling price in current price terms 25/unit 30/unit 35/unit These selling prices are expected to be subject to annual inflation of 4% regardless of the economic state prevailing in the future. Sales, production volumes, and total nominal variable cost have already been forecasted as follows: Year 1 2 3 4 Sales and Production (units) 150,000 250,000 400,000 300,000 Nominal variable cost (000) 2,385 4,200 7,080 5,730 Incremental overhead of 400,000 per year in current price terms will arise as a result of undertaking the project. A large proportion of these overheads relate to energy cost which are expected to increase sharply in the future because of energy supplies shortages, so overhead inflation of 10% per year is expected. These selling prices are expected to be subject to annual inflation of 4% regardless of the economic state prevailing in the future. Sales, production volumes, and total nominal variable cost have already been forecasted as follows: Year 1 2 3 4 Sales and Production (units) 150,000 250,000 400,000 300,000 Nominal variable cost (000) 2,385 4,200 7,080 5,730 Incremental overhead of 400,000 per year in current price terms will arise as a result of undertaking the project. A large proportion of these overheads relate to energy cost which are expected to increase sharply in the future because of energy supplies shortages, so overhead inflation of 10% per year is expected. The initial investment will attract a tax-allowable depreciation on a straight-line basis over the four years project life. The rate of corporation tax is 30% and taxes are paid in the year in which they arise. POR Limited traditionally used an after-tax discount rate of 11% to appraise its projects. Required 2. Distinguish between risk and uncertainty and explain why they should be considered in the investment appraisal process. Critically assess if sensitivity analysis will help PQR in assessing the risk of the investment project. PQR Limited is appraising an investment project which has an expected life of four years and which will not be repeated. The initial investment payable at the start of the first year is 5m. A scrap value of 0.5m is expected to arise at the end of four years. There is some uncertainty about what price to charge for the units produced by the investing project, as this is expected to depend on the future state of the economy. The following forecast of selling prices and their probabilities are prepared: Future Economic state Weak Medium Strong Probabilities of future economic state 35% 50% 15% Selling price in current price terms 25/unit 30/unit 35/unit These selling prices are expected to be subject to annual inflation of 4% regardless of the economic state prevailing in the future. Sales, production volumes, and total nominal variable cost have already been forecasted as follows: Year 1 2 3 4 Sales and Production (units) 150,000 250,000 400,000 300,000 Nominal variable cost (000) 2,385 4,200 7,080 5,730 Incremental overhead of 400,000 per year in current price terms will arise as a result of undertaking the project. A large proportion of these overheads relate to energy cost which are expected to increase sharply in the future because of energy supplies shortages, so overhead inflation of 10% per year is expected. These selling prices are expected to be subject to annual inflation of 4% regardless of the economic state prevailing in the future. Sales, production volumes, and total nominal variable cost have already been forecasted as follows: Year 1 2 3 4 Sales and Production (units) 150,000 250,000 400,000 300,000 Nominal variable cost (000) 2,385 4,200 7,080 5,730 Incremental overhead of 400,000 per year in current price terms will arise as a result of undertaking the project. A large proportion of these overheads relate to energy cost which are expected to increase sharply in the future because of energy supplies shortages, so overhead inflation of 10% per year is expected. The initial investment will attract a tax-allowable depreciation on a straight-line basis over the four years project life. The rate of corporation tax is 30% and taxes are paid in the year in which they arise. POR Limited traditionally used an after-tax discount rate of 11% to appraise its projects. Required 2. Distinguish between risk and uncertainty and explain why they should be considered in the investment appraisal process. Critically assess if sensitivity analysis will help PQR in assessing the risk of the investment project
