ACCA FM Syllabus D. Investment Appraisal - Sensitivity Analysis - Past Papers ^{2 / 5}

The following financial information relates to an investment project:

What is the sensitivity of the net present value of the investment project to a change in sales volume?

A. 7·1%
B. 2·6%
C. 5·1%
D. 5·3%

Hraxin Co is appraising an investment project which has an expected life of four years and which will not be repeated. The initial investment, payable at the start of the first year of operation, is $5 million. Scrap value of $500,000 is expected to arise at the end of four years.

There is some uncertainty about what price can be charged for the units produced by the investment project, as this is expected to depend on the future state of the economy. The following forecast of selling prices and their probabilities has been prepared:

These selling prices are expected to be subject to annual inflation of 4% per year, regardless of which economic state prevails in the future.

Forecast sales and production volumes, and total nominal variable costs, have already been forecast, as follows:

Incremental overheads of $400,000 per year in current price terms will arise as a result of undertaking the investment project. A large proportion of these overheads relate to energy costs which are expected to increase sharply in the future because of energy supply shortages, so overhead inflation of 10% per year is expected.

The initial investment will attract tax-allowable depreciation on a straight-line basis over the four-year project life. The rate of corporation tax is 30% and tax liabilities are paid in the year in which they arise. Hraxin Co has traditionally used a nominal after-tax discount rate of 11% per year for investment appraisal.

Required:
(b) Critically discuss if sensitivity analysis will assist Hraxin Co in assessing the risk of the investment project. (6 marks)

What is the sensitivity of the net present value of the investment project to a change in sales volume?

A. 7·1%
B. 2·6%
C. 5·1%
D. 5·3%

Critically discuss the use of sensitivity analysis and probability analysis as ways of including risk in the investment appraisal process, referring in your answer to the relative effectiveness of each method.

Warden Co plans to buy a new machine. The cost of the machine, payable immediately, is $800,000 and the machine has an expected life of five years. Additional investment in working capital of $90,000 will be required at the start of the first year of operation. At the end of five years, the machine will be sold for scrap, with the scrap value expected to be 5% of the initial purchase cost of the machine. The machine will not be replaced.

Production and sales from the new machine are expected to be 100,000 units per year. Each unit can be sold for $16 per unit and will incur variable costs of $11 per unit. Incremental fixed costs arising from the operation of the machine will be $160,000 per year.

Warden Co has an after-tax cost of capital of 11% which it uses as a discount rate in investment appraisal. The company pays profit tax one year in arrears at an annual rate of 30% per year. Capital allowances and inflation should be ignored.

Required:

(i) Explain briefly the meaning of the term ‘sensitivity analysis’ in the context of investment appraisal;

(ii) Calculate the sensitivity of the investment in the new machine to a change in selling price and to a change in discount rate, and comment on your findings.