(a) The discussion of the appraisal of projects in Block 4 notes that they and their associated cash flows involve risk. Five types of risk are described, as shown below: Operating or organisational risk Market risk Foreign exchange rate risk Interest rate risk Environmental risk, Select any three of these five types of risk and give a brief explanation of each one chosen. (6 marks)
Foreign exchange rate risk – The risk associated with the change of value of currency in such a way that the payment value of the buy/seller becomes less than the other buyer/seller agreed price. e.g. (when purchased 2€ = 1 pound but at transaction the value is 3€ = 1 pound )
Interest rate risk - The risk associated with a change in the rate of return (e.g base rate) is such a way that it becomes less or non competitive with inflation reducing the future value of money. e.g (Interest rate becomes less than bank base rate)
Environmental risk – The risk associated with Sociological, Technological ,Economical ,Environmental Political changes. e.g. (Flood reduces value of property)
(b)A company is considering investing in a new machine to increase sales. They can buy the machine now at a cost of E100,000 and sell it after 5 years for E15,000. The marketing department has forecast additional product sales of 5,000 units if the price of E25.00 per unit is held constant. Variable costs are E14.00 per unit and the fixed costs of maintaining and running the machine E20,000 per annum. The company uses a discount rate of 10% to assess such capital expenditure. Ignore tax and inflation. Year 0 1 2 3 4 5 Discount factor at 10% 1 0.909 0.826 0.751 0.683 0.621 Calculate Net Present Value and draw conclusions from your calculations. (12 marks)
(c) Describe briefly the two most important factors that an organisation should consider when setting a discount rate to be used for assessing a project. (7 marks)
Answer B
DCF(Discount cash flow) for purchase of new machine
Year 0 | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | Year 6 | |
Initial investment | (€100000) | 0 | 0 | 0 | 0 | 0 | €15000 |
Return from Sales | 0 | €125000 | €125000 | €125000 | €125000 | €125000 | 0 |
Variable costs | 0 | (€70000) | (€70000) | (€70000) | (€70000) | (€70000) | 0 |
Fixed Costs | 0 | (€20000) | (€20000) | (€20000) | (€20000) | (€20000) | 0 |
Net cash flow | (€100000) | €35000 | €35000 | €35000 | €35000 | €35000 | €15000 |
Discount Rate(10%) | 1.00 | 0.909 | 0.826 | 0.751 | 0.683 | 0.621 | 0.564 |
Present Value | (€100000) | €31815 | €28910 | €26285 | €23905 | €21735 | €8460 |
Slow Growth in sales-Would make payback longer than 2 years and 10 months over 5 years. I.e (Already at more than 50% of timespan)
Fast growth in sales-Would make payback faster than 2 years and 10 months over 5 years.I.e (Already at more than 50% of timespan - Still long)
This project requires a large capital investment to be tied up for more than half the life of the project. Working capital will also be effected as there would be both an increase in current assets and current liabilities. To account for this the machine would have to be more productive. The NPV is still positive and with an overall gain of 41% more than the original E100 000 invested.
Answer C
The discount should account for the “The time value of money”. The current value of money and the future value using the discount rate is only an estimate which is effected by two factors:
Rate of return – Price of money is expected to increase when there is inflation.
Inflations rate - Prices are likely to change so managers have to estimate the future rate of inflation.
The “time exchange rate” of consumption is reflected in the interest rate where future consumption is expected to be greater. There are 2 ways that interest rates try to take into account the above 2 factors:
Nominal interest rate- Unadjusted rate that doesn't include inflation.
Real interest rate- Adjusted/deflated market interest rate that accounts for inflation.
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