Question 5.SE.3: Simonson Engineers plc is considering the building of a new ...
Simonson Engineers plc is considering the building of a new plant in Indonesia to produce products for the South-East Asian market. To date, £450,000 has been invested in market research and site surveys. The cost of building the plant will be £9 million and it will be in operation and paid for in one year’s time. Estimates of the likely cash flows from the plant and their probability of occurrence are set out as follows:
| Estimated net cash flows £m |
Probability of occurrence |
|
| Year 2 | 2.0 | 0.2 |
| 3.5 | 0.6 | |
| 4.0 | 0.2 | |
| Year 3 | 2.5 | 0.2 |
| 3.0 | 0.4 | |
| 5.0 | 0.4 | |
| Year 4 | 3.0 | 0.2 |
| 4.0 | 0.7 | |
| 5.0 | 0.1 | |
| Year 5 | 2.5 | 0.2 |
| 3.0 | 0.5 | |
| 6.0 | 0.3 |
Estimates for each year are independent of each other. The cost of capital for the business is 10 per cent.
Required:
(a) Calculate the expected net present value of the proposed plant.
(b) Calculate the net present value of the worst possible outcome and the probability of its occurrence.
(c) Should the business invest in the new plant? Why?
Simonson Engineers plc
(a) The steps in calculating the expected net present value of the proposed plant are as follows:
| (a) Estimated cash flows £m |
(b) Probability of occurrence |
(a) × (b) Expected value £m |
|
| Year 2 | 2.0 | 0.2 | 0.4 |
| 3.5 | 0.6 | 2.1 | |
| 4.0 | 0.2 | 0.8 | |
| 3.3 | |||
| Year 3 | 2.5 | 0.2 | 0.5 |
| 3.0 | 0.4 | 1.2 | |
| 5.0 | 0.4 | 2.0 | |
| 3.7 | |||
| Year 4 | 3.0 | 0.2 | 0.6 |
| 4.0 | 0.7 | 2.8 | |
| 5.0 | 0.1 | 0.5 | |
| 3.9 | |||
| Year 5 | 2.5 | 0.2 | 0.5 |
| 3.0 | 0.5 | 1.5 | |
| 6.0 | 0.3 | 1.8 | |
| 3.8 |
Taking into account the expected cash flows for each year:
| Year 1 £m |
Year 2 £m |
Year 3 £m |
Year 4 £m |
Year 5 £m |
|
| Expected cash flows | (9.0) | 3.3 | 3.7 | 3.9 | 3.8 |
| Discount factor | 0.909 | 0.826 | 0.751 | 0.683 | 0.621 |
| Expected present values | (8.18) | 2.73 | 2.78 | 2.66 | 2.36 |
| ENPV 2.35 | |||||
The expected net present value is £2.35 million
(b) To find the NPV of the worst possible outcome and the probability of its occurrence:
| Year 1 £m |
Year 2 £m |
Year 3 £m |
Year 4 £m |
Year 5 £m |
|
| cash flows | (9.0) | 2.0 | 2.5 | 3.0 | 2.5 |
| Discount factor | 0.909 | 0.826 | 0.751 | 0.683 | 0.621 |
| present values | (8.18) | 1.65 | 1.88 | 2.05 | 1.55 |
| ENPV (1.05) | |||||
Probability of occurrence = 0.2 × 0.2 × 0.2 × 0.2 = 0.0016.
(c) The ENPV of the project is positive and so acceptance will increase the wealth of shareholders.