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Copper Co (Mar/Jun 18)

Copper Co is concerned about the risk associated with a proposed investment and is looking for ways to incorporate risk into its investment appraisal process. The company has heard that probability analysis may be useful in this respect and so the following information relating to the proposed investment has been prepared:

Year 1

Year 2

Cash flow ($)

Probability

Cash flow ($)

Probability

1,000,000

0.1

2,000,000

0.3

2,000,000

0.5

3,000,000

0.6

3,000,000

0.4

5,000,000

0.1

However, the company is not sure how to interpret the results of an investment appraisal based on probability analysis.

The proposed investment will cost $3.5m, payable in full at the start of the first year of operation. Copper Co uses a discount rate of 12% in investment appraisal.

Required

A. Using a joint probability table:

(i) Calculate the mean (expected) NPV of the proposed investment.
(ii) Calculate the probability of the investment having a negative NPV.
(iii) Calculate the NPV of the most likely outcome.
(iv) Comment on the financial acceptability of the proposed investment.

B. Discuss TWO of the following methods of adjusting for risk and uncertainty in investment appraisal:

(i) Simulation
(ii) Adjusted payback
(iii) Risk-adjusted discount rates

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