The UK manufacturer of footwear, Willow plc, is considering a major investment in a new product area, novelty umbrellas. It hopes that these products will become fashion icons.

The following information has been collected:

– The project will have a limited life of 11 years.

– The initial investment in plant and machinery will be £1m and a marketing budget of £200,000 will be allocated to the first year.

– The net cash flows before the depreciation of the plant and machinery and before the marketing expenditure for each umbrella will be £1.

– The products will be introduced both in the UK and in France.

– The marketing costs in Years 2 to 11 will be £50,000 per annum.

– If the product catches the imagination of the consumer in both countries then sales in the first year are anticipated at 1m umbrellas.

– If the fashion press ignore the new products in one country but become enthusiastic in the other the sales will be 700,000 umbrellas in Year 1.

– If the marketing launch is unsuccessful in both countries, first year sales will be 200,000 umbrellas. The probability of each of these events occurring is:

– 1m sales: 0.3

– 0.7m sales: 0.4

– 0.2m sales: 0.3

If the first year is a success in both countries then two possibilities are envisaged:

a. Sales levels are maintained at 1m units per annum for the next 10 years – probability 0.3.

b. The product is seen as a temporary fad and sales fall to 100,000 units for the remaining 10 years – probability 0.7.

If success is achieved in only one country in the first year then for the remaining 10 years there is:

a. a 0.4 probability of maintaining the annual sales at 700,000 units; and

b. a 0.6 probability of sales immediately falling to 50,000 units per year.

If the marketing launch is unsuccessful in both countries then production will cease after the first year.

The plant and machinery will have no alternative use once installed and will have no scrap value.

The annual cash flows and marketing costs will be payable at each year-end.

Assume

– Cost of capital: 10 percent.

– No inflation or taxation.

– No exchange rate changes.

Required

a Calculate the expected net present value for the project.

b Calculate the standard deviation for the project.

c If the project produces a net present value less than minus £1m the directors fear that the company will be vulnerable to bankruptcy. Calculate the probability of the firm avoiding bankruptcy. Assume a normal distribution.