ACCA FM Syllabus D. Investment Appraisal - Probability analysis - Past Papers ^{3 / 5}

September 2016 ^Specimen

1615 others answered this question

MC Question 29

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%.

Doubt has been cast over the accuracy of the year 2 and year 3 maintenance costs for Machine 2. On further investigation it was found that the following potential cash flows are now predicted:

Year	Cash ($)	flow Probability
2	18,000	0·3
2	25,000	0·7
3	23,000	0·2
3	24,000	0·35
3	30,000	0·45

What is the expected present value of the maintenance costs for year 3?

A. $26,500
B. $18,868
C. $21,624
D. $35,173

Reveal answer

June 2016 ^Sample

2133 others answered this question

Question 5c

Degnis Co is a company which installs kitchens and bathrooms to customer specifications. It is planning to invest $4,000,000 in a new facility to convert vans and trucks into motorhomes. Each motorhome will be designed and built according to customer requirements. Degnis Co expects motorhome production and sales in the first four years of operation to be as follows.

Year	1	2	3	4
Motorhomes produced and sold	250	300	450	450

The selling price for a motorhome depends on the van or truck which is converted, the quality of the units installed and the extent of conversion work required. Degnis Co has undertaken research into likely sales and costs of different kinds of motorhomes which could be selected by customers, as follows:

Motorhome type	Basic	Standard	Deluxe
Probability of selection	20%	45%	35%
Selling price ($/unit)	30,000	42,000	72,000
Conversion cost ($/unit)	23,000	29,000	40,000

Fixed costs of the production facility are expected to depend on the volume of motorhome production as follows:

Production volume (units/year)	200–299	300–399	400–499
Fixed costs ($000/year)	4,000	5,000	5,500

Degnis Co pays corporation tax of 28% per year, with the tax liability being settled in the year in which it arises. The company can claim tax allowable depreciation on the cost of the investment on a straight-line basis over ten years. Degnis Co evaluates investment projects using an after-tax discount rate of 11%.

Required:
(c) Critically discuss the use of probability analysis in incorporating risk into investment appraisal. (5 marks)

Reveal answer