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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

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.

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.

PQR Limited traditionally used an after-tax discount rate of 11% to appraise its projects.

Required

  1. Calculate the expected net present value (ENPV) and comment on its acceptability.

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