Question 32c
Vyxyn Co is evaluating a planned investment in a new product costing $20m, payable at the start of the first year of operation. The product will be produced for four years, at the end of which production will cease. The investment project will have a terminal value of zero. Financial information relating to the investment project is as follows:
| Year | 1 | 2 | 3 | 4 |
|---|---|---|---|---|
| Sales volume (units/year) | 440,000 | 550,000 | 720,000 | 400,000 |
| Selling price ($/unit) | 26·50 | 28·50 | 30·00 | 26·00 |
| Fixed cost ($/year) | 1,100,000 | 1,121,000 | 1,155,000 | 1,200,000 |
These selling prices have not yet been adjusted for selling price inflation, which is expected to be 3·5% per year. The annual fixed costs are given above in nominal terms.
Variable cost per unit depends on whether competition is maintained between suppliers of key components. The purchasing department has made the following forecast:
| Competition | Strong | Moderate | Weak |
|---|---|---|---|
| Probability | 45% | 35% | 20% |
| Variable cost ($/unit) | 10·80 | 12·00 | 14·70 |
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)