Risk & Project Appraisal – WILLOW

The UK manufacturer of footwear, Willow, is considering a major investment in a new product area, novelty umbrellas. It hopes that these products will become fashion icons. The following information has been collected: • • • • • • • • The project will have a limited life of 11 years The initial investment in plant and machinery will be £1m and a marketing budget of £200,000 will be allocated to the first year The net cash flows before depreciation of plant and machinery and before marketing expenditure for each umbrella will be £1 The products will be introduced both in the UK and in France The marketing costs in years 2-11 will be £50,000 pa If the product catches the imagination of the consumer in both countries then sales in the first year are anticipated at 1m umbrellas If the fashion press ignore the new products in one country but become enthusiastic in the other the sales will be 700,000 umbrellas in year 1 If marketing launch is unsuccessful in both countries, first year sales will be 200,000 umbrellas

The probability of each of these events occurring is: • 1m sales: 0.3 • 0.7m sales: 0.4 • 0.2m sales: 0.3 If the first year is a success in both countries then two possibilities are envisaged: i. Sales levels are maintained at 1m units per annum for the next 10 years – probability 0.3 ii. The product is seen as a temporary fad and sales fall to 100,000 units for the remaining 10 years – probability 0.7 If success is achieved in only one country in the first year then the remaining 10 years there is: i. a 0.4 probability of maintaining the annual sales at 700,000 units ii. a 0.6 probability of sales immediately falling to 50,000 units per year If the marketing launch is unsuccessful in both countries then production will cease after the first year. The plant and machinery will have no alternative use once installed and will have no scrap value. The annual cash flows and marketing costs will be payable at each year end. Assume: • • • Required (a) (b) Calculate the expected NPV for the project Calculate the standard deviation for the project cost of capital 10% no inflation or taxation no exchange rate changes

3×0..000 units 1m units 727 2-11 1000 units ×£1=£1000 Less: Marketing Cost = (50) (950×6.D 0..00 NPV (A) @10 %( £000) Year 0 1 Cost 1000 units ×£1=£1000 Less: Marketing Cost = (200) (800×0..........09.............3×0....3 Probabilities 0....6 100.....21..16.7=0......C 0.4 0.. the annuity factor of 6..e........... 0.3..24...B 0...909) 5307 NPV (A) = 5034 Because the annuity cash flows start in year 2.4=0...145×0.3 0....3 -£1 m 0.4×0.............E ∑ =1.4 0.145 will give us the value in year-1..6=0..000 units 700..000 units 50....Solution: Required: a Time -0 Time-1 Time 2-11 0.4×0................A 0...909 ....000 units 07 0....3= 0........909) Present value (1000) 1 m units 700....000 units 200. This value must then be discounted to year 0 by using the present value factor for year 1 i...

909) 3631 NPV (C) =3085 NPV (D) @10 %( £000) Year 0 1 Cost 700 units ×£1=£700 Less: Marketing Cost = (200) (500×0.909) Present value (1000) 727 2-11 279 NPV (B) = 6 NPV (C) @10 %( £000) Year 0 1 Cost 700 units ×£1=£700 Less: Marketing Cost = (200) (500×0.909) 50 units ×£1=£50 Less: Marketing Cost = (50) 0 Present value (1000) 455 2-11 0 NPV (D) = (545) .145×0.909) Present value (1000) 455 2-11 50 units ×£1=£700 Less: Marketing Cost = (50) (650×6.909) 100 units ×£1=£100 Less: Marketing Cost = (50) (50×6.NPV (B) @10 %( £000) Year 0 1 Cost 1000 units ×£1=£1000 Less: Marketing Cost = (200) (800×0.145×0.

909) Present value (1000) 0 .21 0. NPV (E) = (1000) Project probabilities (p) 0. .24 0.NPV) ×P A 5034 453 4517 6 (511) 1 3085 494 (131) (545) (1000) (300) ∑ NPV =517 2568 (1062) (1517) σ2 = 3907341 σ =√3907341 =1977 54835 1055140 270683 690387 1836296 B C D E 0.16 0.NPV 2 (NPV.09 NPV P× NPV NPV.30 Required: A Expected NPV for the project=∑ NPV =517 Required: B The standard deviation for the project= σ =√3907341 =1977 .NPV (E) @10 %( £000) Year 0 1 Cost 200 units ×£1=£200 Less: Marketing Cost = (200) (0×0.

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