Orbit Co: investment appraisal with inflation and tax

Tick each point that your answer made clearly and only once. Points here are this site's own. A real examiner may accept other valid points.

• Money contribution each year = 400,000 x 1.03 to the power of the year: year 1 $412,000, year 2 $424,360, year 3 $437,091, year 4 $450,204.
• Taxable profit each year is the contribution less the tax allowance of $200,000.
• Tax each year = 25% x taxable profit: year 1 $53,000, year 2 $56,090, year 3 $59,273, year 4 $62,551.
• Net cash flow each year = contribution less tax: year 1 $359,000, year 2 $368,270, year 3 $377,818, year 4 $387,653.
• Discount factors at 10 percent: year 1 0.9091, year 2 0.8264, year 3 0.7513, year 4 0.6830.
• Present value of the net cash flows = $1,179,351.
• NPV = 1,179,351 - 800,000 = $379,351.
• Depreciation is not a cash flow, so only the tax allowance (and not the accounting depreciation) is used, to calculate the tax.
• The cash flows are in money terms and are discounted at the money cost of capital, which is consistent.
• Conclusion: the NPV is positive, so the project is acceptable on financial grounds.

Marks counted: 0 of 10

Tick each point that your answer made clearly and only once. Points here are this site's own. A real examiner may accept other valid points.

• The present value of the after-tax contribution is $1,020,858 (contribution x (1 - 0.25), discounted).
• Sensitivity = NPV / PV of the after-tax contribution = 379,351 / 1,020,858 = 37.2%.
• The tax allowances are not affected by a change in contribution, which is why the after-tax contribution is used.
• Sensitivity analysis looks at one variable at a time and does not give the probability of the change happening.
• It shows the key variables that need close management.

Marks counted: 0 of 4

Tick each point that your answer made clearly and only once. Points here are this site's own. A real examiner may accept other valid points.

• Probability analysis: assign probabilities to outcomes, calculate the expected NPV and the standard deviation, and find the chance of a negative NPV. It is useful for repeated decisions, but the probabilities are subjective.
• Simulation: use random values from the probability distributions of key variables (such as contribution and inflation) to produce a distribution of NPVs. It handles many variables, but it needs more data and is complex.
• Risk-adjusted discount rate: add a premium to the cost of capital for a risky new product. It is simple but subjective, and it assumes that risk grows steadily over time.
• Adjusted payback: require a shorter payback period for risky projects, which gives early protection but ignores later cash flows.
• Any two methods are discussed with a benefit and a limitation of each, applied to Orbit Co (a new product with uncertain contribution).
• Sensitivity analysis shows which variable matters most, and the contribution is the most sensitive here, so more research on it is justified.

Marks counted: 0 of 6