Chapter 10: Investment appraisal under uncertainty

Wanjiru plc is considering launching a new product, which needs additional capital investment of $200,000. The selling price will be $10 per unit. The probability of demand of 50,000 units a year is 0.5, with a probability of 0.4 that demand will be 20% higher and 0.1 that it will be 20% lower.

The company expects to earn a contribution of 50% of the selling price, and fixed overheads will increase by $140,000 a year. The time horizon for the appraisal is 4 years; the machine will then be sold for $50,000. The cost of capital is 20% a year (4-year annuity factor 2.589; year 4 discount factor 0.482).

(a) Calculate the expected NPV. (b) Assuming instead that demand is certain at 50,000 units a year, calculate the expected NPV if fixed overheads are uncertain: $100,000 (probability 0.20), $140,000 (0.35), $180,000 (0.25) or $220,000 (0.20) a year.