Explain the difference between risk and uncertainty

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Reference no: EM133338955

Assignment:

Gabane (Pty) Ltd is evaluating a significant investment in equipment and the development of a website.

Due to the fast-changing nature of the equipment and the Internet software, Gabane (Pty) Ltd 's management has set a project lifetime of three years.

The new equipment will cost P50,000 payable at the start of the first year of operation. It is not expected to have any scrap value.

Gabane (Pty) Ltd has estimated that sales revenue will increase as a result of the investment by the following amounts in real terms.

Year 1 Year 2 Year 3

P P P

Increase in sales revenue at Year 0 prices 48,000 60,000 72,000

Gabane (Pty) Ltd estimated final sales for the current year are P1,200,000. The company's costs behave in such a way that its contribution to sales ratio for the current year is expected to be 40% and its net margin 10%. A considerable proportion of Gabane 's total fixed costs are marketing expenses. The proposed project will lead to savings in this area. So, in year 1, fixed costs (at Year 0 prices) will total P316,800.

From 1 January Year 1, inflation will have the following effects on Gabane (Pty) Ltd operations.

(i) Sales prices will increase by 5% per annum.

(ii) All costs (ie variable and fixed) will increase by 10% per annum.

Initial investment of P20,000 in working capital would also be required, followed by incremental annual investment to maintain the purchasing power of working capital (assume 5% inflation).

The website would be designed and installed during the first four months of Year 1. It will cost P100,000 (at Year 0 prices) payable at the end of Year 1. The suppliers will be paid a retaining/advisory fee of P10,000 in both Year 2 and Year 3. These are Year 0 prices and it is anticipated that, due to inflation, they will increase at the same rate as all other costs.

Gabane (Pty) Ltd has a nominal cost of capital of 10% and pays tax at an annual rate of 30% in the year profits are earned. It can claim tax allowable depreciation on a 25% reducing balance basis.

Question:

(a) Calculate the net present value of the proposed investment.

(b) Explain the difference between risk and uncertainty in the context of investment appraisal and describe how probability analysis can be used to incorporate risk into the investment appraisal process, discussing the weaknesses of probability analysis.

Reference no: EM133338955

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