Question 1 (adapted from previous exam papers)
This relates to Lecture 2, TASKS 2.2 and 2.3
A hospital knows the cost of installing energy-saving timer switches to a lighting system. The NPV is positive. However, the firm’s accountant has been shown the calculation. She notes that (a) no account has been taken of the fact that the use of timer switches will increase insurance costs due to added risk and (b) that no account has been taken of the internal management costs of the project though there is currently spare capacity in the management team to effect the change. Discuss whether either (a) or (b) or both might change the basis of the calculations.
Question 2 (adapted from previous exam papers)
A Gymnasium bought a new set of exercise machines at a cost of £120,000 but it is now worth only £40,000 second hand. Net cash flows from continued use of this equipment are estimated at £25,000 for each of the remaining two years. An alternative and more advanced exercise system could be installed for £60,000 i.e. £20,000 extra, after taking account of income from selling the old system. That option would give net cash flows of £25,000 in the first year and 40,000 in the second. So you have two choices – keep the old system or adopt the replacement one. The speed of innovation means that both systems will be worth nothing two years from now. Sketch (without calculation) the cash outflow and inflows for years 0,1,2 for each of the two competing options – keep the old system OR buy the new system.
HINT. What is opportunity cost? Is the information on £120,000 relevant to the question? How much investment is the firm making by doing nothing i.e. just keeping the old system?
Question 3 (adapted from previous exam papers)
This relates to Lecture 2 TASK 2.4
- List some variables that affect Net Present Value (NPV). (b) Explain the use of sensitivity analysis to check the effect of variation from plan of a single variable on a project NPV. (c) Explain how sensitivity analysis can be generalised to check the riskiness of NPV when several variables may simultaneously be varying from what was assumed in the plan. How would you present the results of (c) to an audience? [Hint: graph]
Note: part 4c of the 2018 exam question required an answer “ on the use of sensitivity analysis in investment appraisal”.
- Review the tasks set in the lecture and make sure you have finished them.
- Make sure that you understand the worked example in the lecture slides on “profitability index”
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