Advanced financial management revision question and answer

The Lakeside Company Limited is considering investing in a project requiring an initial outlay of Sh.100 million. The project life is two years after which there would be no expected salvage value. The possible incremental after-tax cash flows and associated probabilities of occurrence as as follows:

The company‟s required rate of return for this investment is 12%.

Required:
a) i) The expected net present value of the project.

ii) Suppose that the possibility of abandonment exists and that the abandonment value of the project at the end of the first is Sh.50 million after taxes is abandonment the right choice?

iii) Calculate the new expected net present value assuming that the company would abandon the project if it is advantageous to do so. What are the implications of this calculation to you as a Finance
Manager?
b) Identify the case for and against Sensitivity Analysis as a method of handling risk in capital budgeting.
ANSWER
(a) I) Note that PVIF12%, 1 = 0.893 and PVIF12%, 2 = 0.797 The expected NPV could thus be established as follows:

ii) The option to abandon will depend on the PV of abandonment value at end of year 1 and PV of cash flows at end of year 2.

PV of Sh.50M abandonment value = 50M x 0.893 =44.65M

The expected cash flows at end of year 2 would be as follows:


Decisions = don‟t abandon.

iii) If abandonment was a viable option, then NPV would be as follows:

Year 1 expected cash flows = (50 x 0.4) + (85 x 0.4) + (90 x 0.2) = 20 + 34 + 18 = 72M


b) Advantages of sensitivity analysis:
• It indicates the critical variables for which additional information is required.
• It helps in exposing inappropriate forecasts
• The decision maker can identify variables affecting the cash flow forecasts thus leads to a better understanding of the whole project
• It is usually simple to compute.
Weaknesses
• It assumes independence of variables and ignores any interrelationship which may exist
e.g between selling price and variable costs.
• It does not provide clear – cut results.
• It ignores uncertainty of cash flows forecasts.

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