Question 2

Umunat plc is considering investing $50,000 in a new machine with an expected life of five years. The machine will have no scrap value at the end of five years. It is expected that 20,000 units will be sold each year at a selling price of $300 per unit. Variable production costs are expected to be $165 per unit, while incremental fixed costs, mainly the wages of a maintenance engineer, are expected to be $10,000 per year. Umunat plc uses a discount rate of 12% for investment appraisal purposes and expects investment projects to recover their initial investment within two years.

Required:

(a)Explain why risk and uncertainty should be considered in the investment appraisal process.(5 marks)

(b)Calculate and comment on the payback period of the project.(4 marks)

(c)Evaluate the sensitivity of the project's net present value to a change in the following project variables:

(i)sales volume;

(ii)sales price;

(iii)variable cost;

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

(10 marks)

(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 plc suggests that sales volumes could depend on expected economic states that could be assigned the following probabilities:

Economic state

Poor

Normal

Good

Probability

0.3

0.6

0.1

Annual sales volume (units)

17,500

20,000

22,500

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