ACCA FM Syllabus D. Investment Appraisal - Risk & Uncertainty basics - Past Papers ^{1 / 5}

Vyxyn Co is evaluating a planned investment in a new product costing $20m, payable at the start of the first year of operation. The product will be produced for four years, at the end of which production will cease. The investment project will have a terminal value of zero. Financial information relating to the investment project is as follows:

These selling prices have not yet been adjusted for selling price inflation, which is expected to be 3·5% per year. The annual fixed costs are given above in nominal terms.

Variable cost per unit depends on whether competition is maintained between suppliers of key components. The purchasing department has made the following forecast:

The variable costs in this forecast are before taking account of variable cost inflation of 4·0% per year.

Vyxyn Co can claim tax-allowable depreciation on a 25% per year reducing balance basis on the full investment cost of $20m and pays corporation tax of 28% per year one year in arrears.

It is planned to finance the investment project with an issue of 8% loan notes, redeemable in ten years’ time. Vyxyn Co has a nominal after-tax weighted average cost of capital of 10%, a real after-tax weighted average cost of capital of 7% and a cost of equity of 11%.

Required:
(a) Discuss the difference between risk and uncertainty in relation to investment appraisal. (3 marks)

Vyxyn Co is evaluating a planned investment in a new product costing $20m, payable at the start of the first year of operation. The product will be produced for four years, at the end of which production will cease. The investment project will have a terminal value of zero. Financial information relating to the investment project is as follows:

These selling prices have not yet been adjusted for selling price inflation, which is expected to be 3·5% per year. The annual fixed costs are given above in nominal terms.

Variable cost per unit depends on whether competition is maintained between suppliers of key components. The purchasing department has made the following forecast:

The variable costs in this forecast are before taking account of variable cost inflation of 4·0% per year.

Vyxyn Co can claim tax-allowable depreciation on a 25% per year reducing balance basis on the full investment cost of $20m and pays corporation tax of 28% per year one year in arrears.

It is planned to finance the investment project with an issue of 8% loan notes, redeemable in ten years’ time. Vyxyn Co has a nominal after-tax weighted average cost of capital of 10%, a real after-tax weighted average cost of capital of 7% and a cost of equity of 11%.

Required:
(c) Critically discuss how risk can be considered in the investment appraisal process. (8 marks)

Ridag Co operates in an industry which has recently been deregulated as the government seeks to increase competition in the industry.

Ridag Co plans to replace an existing machine and must choose between two machines. Machine 1 has an initial cost of $200,000 and will have a scrap value of $25,000 after four years. Machine 2 has an initial cost of $225,000 and will have a scrap value of $50,000 after three years. Annual maintenance costs of the two machines are as follows:

Where relevant, all information relating to this project has already been adjusted to include expected future inflation.

Taxation and tax allowable depreciation must be ignored in relation to Machine 1 and Machine 2.
Ridag Co has a nominal before-tax weighted average cost of capital of 12% and a nominal after-tax weighted average cost of capital of 7%.

Ridag Co is appraising a different project, with a positive NPV. It is concerned about the risk and uncertainty associated with this other project.

Which of the following statements about risk, uncertainty and the project is true?

A. Sensitivity analysis takes into account the interrelationship between project variables
B. Probability analysis can be used to assess the uncertainty associated with the project
C. Uncertainty can be said to increase with project life, while risk increases with the variability of returns
D. A discount rate of 5% could be used to lessen the effect of later cash flows on the decision