The Board of Quest plc is due to meet to consider investing in a new project which will allow the company to diversify its existing product range. Before the meeting the Finance Director, has asked you, to evaluate the project using the following information.

Market research has been undertaken at a cost of HK$500,000 which shows that the project will result in the following cash flows:

	Year 1	Year 2	Year 3	Year 4
Sales volume (units)	100,000	130,000	130,000	90,000
Selling price (HK$/unit)	472	523	551	660
Variable cost (HK$/unit)	275	315	351	403
Fixed costs (HK$)	8,760,000	9,030,000	9,320,000	9,610,000

These forecasts are after taking account of selling price inflation of 30% per year, variable cost inflation of 60% per year and fixed cost inflation of 35% per year.

In addition included in the fixed costs is a figure of HK$1,000,000 which represents an apportionment of general overheads. The balance of the fixed costs are incremental fixed costs which are associated with the new project.

The total machinery costs of the project in year 0 are estimated to be HK$40,000,000 and the machinery from the project will be sold for scrap with a value of HK$4,000,000 at the end of year 4.The company will also have to spend HK$ 3,000,000 refurbishing the building before the new machinery can be installed.

Quest plc pays corporation tax of 25% per year. This is paid in the following year (i.e. one year in arrears) Capital allowances on an 18% reducing balance basis are available on the machinery only. A balancing charge or allowance is available at the end of the fourth year of operation.

Quest plc has a real cost of capital of 9% and the general rate of inflation is 3.7%

Required:

1. Recommend to the Board whether the project should be undertaken by:
   1. Calculating the nominal after-tax Net Present Value of the new project using the money cost of capital.(Round to the nearest whole number)

(21 marks)

2. Calculating the Internal Rate of Return of the new project.

(5 marks)

After the Board meeting, you were asked to consider the risk of the project and you have reported back to the board that the Expected Net Present Value and the Standard Deviation of the project are HK$1,290,000 and HK$1,640,000 respectively.

Required:

2. Calculate the percentage probability that the project will be value destroying (you can assume a normal distribution of outcomes.) and briefly discuss the difficulties of using probability analysis in incorporating risk into investment appraisal.

(8 marks)

One of the directors thinks that incorporating inflation into the calculation in the way outlined above is too time consuming and just adds more costs to the business without giving a significant benefit.

Required:

3. Explain one other way that inflation can be incorporated in the NPV calculation and discuss which method you think the company should adopt.(use the figures above to support your answer)

(6 marks)