QUESTION THREE [40] [20] PART A The management of Lota Ltd used discounted cash-flow techniques to evaluate capital expenditure projects. They recognise that budgeting several years ahead is subject to estimating probabilities. They therefore estimate not only the likely cash-flows but also the probabilities of different cash-flows. They are contemplating the acquisition of a machine at a cost of R234 000. The probabilities of its life expectancy are as follows: 10 years 0.2 11 years 0.5 12 years 0.3 For a premium which will be payable in addition to the purchase price, the supplier of the machine is prepared to guarantee that the machine will last at least 11 years. The machine produces a single product with a selling price of R12 per unit and variable cost of production of R7 per unit. 0.6 The probabilities of the following production volumes are: 5 000 units per annum 0.1 6 000 units per annum 0.3 7 000 units per annum The present value of R1 per annum at the company's screening rate for capital projects is as follows: 10 years R6.71 11 years R7.13 12 years R7.52 Required: a) Advise the management of Lota Ltd on whether they should acquire the machine. (14) b) Calculate how much Lota Ltd can afford to pay by way of a premium in the first year for a guarantee that the machine will last 11 years. (6) PART B [20] Sparkling Ltd is contemplating the manufacture of pool equipment and must decide whether to build a large or a small plant. There is a 0.6 probability that the demand for the equipment will be strong and a 0.4 probability that the demand will be weak. If demand is strong and a large plant is built a profit of R10 million will result. However if demand is weak but the plant is large, profits will amount to R1 million. If Sparkling Ltd builds a small plant and demand is weak, profits of R4million will be made. If demand is strong and Sparkling Ltd has a small plant, the likelihood of competition is greater. It is estimated that there is a 75% chance that the company will come up against competition under these circumstances. In such a case, Sparkling Ltd could either build another separate small plant in a different area, or expand the existing plant. If Sparkling Ltd decides not to invest in further plant, profits of R6 million are expected, regardless of whether there is any competition. If there is competition, however, either form of expansion is expected to yield a 0.7 probability of a profit of R8 million and a 0.3 probability of a profit of no change in the status quo. If there is no competition, building the separate plant would yield a profit of R9 million with a 0.8 probability and a profit of R7 million with a 0.2 probability. Expanding the existing plant is expected to result in a profit of R7.5 million. Required: a) Draw a decision tree for Sparkling Ltd. b) Determine the optimal strategy by means of backward induction
