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Class Example - Capital Budgeting Risk Analysis Updated

Pinnacle Products Ltd is evaluating the manufacturing of a new consumer product with a selling price of R9 and variable cost of R4, requiring an initial investment of R700,000. The expected NPV analysis indicates a positive expected NPV of approximately R205,673, suggesting that the company should invest in the new product despite a 25% chance of incurring a loss of over R63.432 million. The decision tree outlines various sales scenarios and their probabilities, leading to the conclusion that investment is advisable based on expected returns.

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28 views3 pages

Class Example - Capital Budgeting Risk Analysis Updated

Pinnacle Products Ltd is evaluating the manufacturing of a new consumer product with a selling price of R9 and variable cost of R4, requiring an initial investment of R700,000. The expected NPV analysis indicates a positive expected NPV of approximately R205,673, suggesting that the company should invest in the new product despite a 25% chance of incurring a loss of over R63.432 million. The decision tree outlines various sales scenarios and their probabilities, leading to the conclusion that investment is advisable based on expected returns.

Uploaded by

4035889
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd

CLASS EXAMPLE

Pinnacle Products Ltd is considering manufacturing a new consumer


product which is expected to have a selling price of R9 per unit. The
variable cost is R4 per unit. The cost of new plant and equipment is
R700 000. Incremental fixed costs are expected to be R100 000 per
year. Demand for the product is dependent on what happens in the first
year. The three possible outcomes in Year 1 and their associated
probabilities are depicted in the following table:

Probability No. of Contribution


Units to per unit
be sold in
Yr 1
Year 1 A 50% 160, 000 5.00
B 25% 80, 000 5.00
C 25% 40, 000 5.00

If the company achieves sales of 160 000 units in the first year, then
there is a 60% chance that demand will be 140 000 units per year for the
following 4 years, and a 40% chance that the sales will amount to 70
000 units per year for the following 4 years. If the company sells 80 000
units in the first year, then sales will be maintained at this level for the
following four years. The company will close the plant at the end of Year
1, if demand is for 40 000 units in the first year. The residual value of the
plant is expected to be zero at any time after purchase due to its
specialised nature.

The tax rate is 28% and the company’s required rate of return is 11%.
The company is not able to claim a depreciation deduction.
Required:
Draw a decision tree and determine whether the company should invest
on the basis of expected NPV. (20 Marks)
Solution
QUESTION 1
Cost R 700 000 Tax rate 28%
Selling Price R9 Required return 11%
Variable Cost R4

(SP-VC) Contribution R 5

Fixed Cost R 100 000


Prob No of Units Contribution Total Fixed Net CF Tax Net CF
to be sold in per unit Contribution Costs
yr. 1
YR A 50% 160 000 R5 800 000 (100 000) 700 000 (196 000) 504 000
1
B 25% 80 000 R5 400 000 (100 000) 300 000 (84 000) 216 000
C 25% 40 000 R5 200 000 (100 000) 100 000 (28 000) 72 000
YR AA 60% 140 000 R5 700 000 (100 000) 600 000 (168 000) 432 000
2
AB 40% 70 000 R5 350 000 (100 000) 250 000 (70 000) 180 000
60%
432 000
50% 504 000 40%
180 000

Cost 25%

-R700 000
216 000 100 % 216 000

25%
Stop 100%

72 000
Estimates NPV Initial CF1 CF2 CF3 CF4 CF5
Cost
AA 961 492,3765 (700 000) 504 000 432 000 432 000 432 000 432 000
AB 257 153,3551 (700 000) 504 000 180 000 180 000 180 000 180 000
B 98 313,7558 (700 000) 216 000 216 000 216 000 216 000 216 000
C (635135,1351) (700 000) 72 000

Probability Joint Probability Estimated NPV Expected NPV


AA 50% 30% (50 % x 60%) 961 492,3767 288 447,713
AB 50% 20% (50% x 40%) 257 153,3551 51 430,6710
B 25% 25% (25% x 100%) 98 313,7558 24 578,4395
C 25% 25% (25% x 100%) (635135,1351) (158 783,7838)
Expected NPV 205 673, 0397

The expected NPV of the new product is positive and therefore on the basis of
expected NPV, the company should invest in the new product. At the same time, the
company should be prepared that there is 25% probability that the firm could lose
just over R63.432m.

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