Sweet Homes Co is a small manufacturing company. As a Finance Manager of the company, you have been tasked to evaluate the two investment options which are not mutually exclusive.

Option A

Sweet Homes Co is looking to replacing one of the machines used in its production process.

Sweet Homes Co is a small manufacturing company. As a Finance Manager of the company, you have been tasked to evaluate the two investment options which are not mutually exclusive.

Option A

Sweet Homes Co is looking to replacing one of the machines used in its production process.

	Old Machine	New Machine
Estimated life	4 years	4 years
Current book value	K4million	Nil
Current selling price	K5million	Nil
Net realizable value at end of year 4	NIL	K3million
Current purchase price	NIL	K20million
Capital Allowance	K1million	K4million

Currently the level of revenue is K30million per year. However since the new machine improves the quality of the product, sales are expected to increase by K1.2million. The old machines production costs average K15million per year but the new machine is expected to save K700, 000 per year. The current and expected tax rate over the next four years is 30% with the return required by the firm set at 12% per year.

Required:

Evaluate whether the firm should replace the old machine with the new machine.

Option B

Sweet Homes Co is considering investing K220, 000 in a new specialized machine with an expected life of five (5) years. The machine will have no scrap value at the end of five years. It is expected that 25,000 units will be sold each year at a selling price of K6.00 per unit. Variable production costs are expected to be K2.10 per unit, while incremental fixed costs are expected to be K20, 000 per year. The company gearing level is 30% which is almost equivalent to the industry average. The asset beta for Sweet Homes Co. is 0.81 and equity premium is 8%. The interest on government treasury bills is 5%. The pretax cost of debt is 9% and tax is payable at the rate of 25% per year. The selling price and variable production cost are expected to increase by 10% per annum and 8% per annum respectively from year two (2) on wards.

Required:

1. Explain the reasons why risk and uncertainty should be considered in the investment appraisal process.
2. Measure the sensitivity of the project's net present value to a change in the following project variables:

1. sales volume;
2. sales price;
3. variable cost; and
4. Cost of capital

C) Discuss the use of sensitivity analysis as a way of evaluating project risk.

Currently the level of revenue is K30million per year. However since the new machine improves the quality of the product, sales are expected to increase by K1.2million. The old machines production costs average K15million per year but the new machine is expected to save K700, 000 per year. The current and expected tax rate over the next four years is 30% with the return required by the firm set at 12% per year.

Required:

Evaluate whether the firm should replace the old machine with the new machine