MC Question 30
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 $50,000 after three years. Annual maintenance costs of the two machines are as follows:
| Year | 1 | 2 | 3 | 4 |
|---|---|---|---|---|
| Machine 1 ($ per year) | 25,000 | 29,000 | 32,000 | 35,000 |
| Machine 2 ($ per year) | 15,000 | 20,000 | 25,000 |
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