190. Hraxin Co (June 15 – Amended)
Hraxin Co is appraising an investment project which has an expected life of four years and which will not be repeated. The initial investment, payable at the start of the first year of operation, is $5 million. Scrap value of $500,000 is expected to arise at the end of four years.
There is some uncertainty about what price can be charged for the units produced by the investment project, as this is expected to depend on the future state of the economy. The following forecast of selling prices and their probabilities has been prepared:
Future economic state 
Weak 
Medium 
Strong 
Probability of future economic state 
35% 
50% 
15% 
Selling price in current price terms 
$25 per unit 
$30 per unit 
$35 per unit 
These selling prices are expected to be subject to annual inflation of 4% per year, regardless of which economic state prevails in the future.
Forecast sales and production volumes, and total nominal variable costs, have already been forecast, as follows:
Year 
1 
2 
3 
4 
Sales and production (units) 
150,000 
250,000 
400,000 
300,000 
Nominal variable cost ($000 ) 
2,385 
4,200 
7,080 
5,730 
Incremental overheads of $400,000 per year in current price terms will arise as a result of undertaking the investment project. A large proportion of these overheads relate to energy costs which are expected to increase sharply in the future because of energy supply shortages, so overhead inflation of 10% per year is expected.
The initial investment will attract taxallowable depreciation on a straightline basis over the fouryear project life. The rate of corporation tax is 30% and tax liabilities are paid in the year in which they arise. Hraxin Co has traditionally used a nominal aftertax discount rate of 11% per year for investment appraisal.
Required:
A. Calculate the expected net present value of the investment project and comment on its financial acceptability.
Calculation of expected net present value

1 
2 
3 
4 

$000 
$000 
$000 
$000 
Revenue 
4,524 
7,843 
13,048 
10,179 
Variable cost 
(2,385) 
(4,200) 
(7,080) 
(5,730) 
Contribution 
2,139 
3,643 
5,968 
4,449 
Overhead 
(440) 
(484) 
(532) 
(586) 
Cash flow before tax 
1,699 
3,159 
5,436 
3,863 
Tax 
(510) 
(948) 
(1,631) 
(1,159) 
Depreciation benefits 
338 
338 
338 
338 
Cash flow after tax 
1,527 
2,549 
4,143 
3,042 
Scrap value 



500 
Project cash flow 
1,527 
2,549 
4,143 
3,542 
Discount at 11% 
0.901 
0.812 
0.731 
0.659 
Present values 
1,376 
2,070 
3,029 
2,334 
$000
PV of future cash flows 8,809
Initial investment (5,000)
Expected net present value (ENPV) 3,809
The investment project has a positive ENPV of $3,809,000. This is a mean or average NPV which will result from the project being repeated many times. However, as the project is not being repeated, the NPVs associated with each future economic state must be calculated as it is one of these NPVs which is expected to occur. The decision by management on the financial acceptability of the project will be based on these NPVs and the risk associated with each one.
Workings
Mean or average selling price = (25 × 0.35) + (30 × 0.5) + (35 × 0.15) = $29 per unit
Year 
1 
2 
3 
4 
Inflated selling price ($ per unit) 
30.16 
31.37 
32.62 
33.93 
Sales volume (units/year) 
150,000 
250,000 
400,000 
300,000 
Sales revenue ($000/year) 
4,524 
7,843 
13,048 
10,179 
Year 
1 
2 
3 
4 
Inflated overhead ($000/year) 
440 
484 
532 
586 
Total taxallowable depreciation = 5,000,000 – 500,000 = $4,500,000
Annual taxallowable depreciation = 4,500,000/4 = $1,125,000 per year
Annual cash flow from taxallowable depreciation = 1,125,000 × 0.3 = $337,500 per year.