Investment Appraisal and Expected Values

Apr 14, 2025

Lecture Notes on Investment Appraisal and Expected Values

Introduction

  • Lecture Series: Open Tuition
  • Chapter Focus: Chapter 10, Investor 470
  • Lecture Context: Second and last lecture
  • Previous Topics: Sensitivity analysis, Simulation

Key Concepts

Expected Values

  • Relevance: Important for decision-making under uncertainty.
  • Example Scenario: Tiger's new product launch
    • Capital Investment: $200,000
    • Product Price: $10/unit
    • Demand Probabilities:
      • 50,000 units/year with 50% probability
      • 20% higher demand with 40% probability
      • 20% lower demand with 10% probability
    • Contribution Margin: 50%
    • Fixed Costs Increase: $140,000/year
    • Project Timeline: 4 years
    • Cost of Capital: 20%

Calculating Expected Demand

  • Approach: Weighted average based on probabilities
  • Demand Scenarios:
    • 60,000 units (20% higher)
    • 50,000 units (base)
    • 40,000 units (20% lower)
  • Expected Demand: 53,000 units/year
    • Calculation: Multiply each demand level by its probability and sum

Financial Analysis

  • Initial Cost: $200,000
  • Contribution Revenue:
    • 53,000 units * $10/unit = $530,000
    • Contribution = 0.5 * Revenue = $265,000/year
    • Fixed Costs: Additional $140,000/year
  • Scrap Value: $50,000 at end of 4 years

Discounted Cash Flow Analysis

  • Present Value Calculation:
    • Discount rate: 20%
    • Use annuity factors and present value factors for calculations
    • Net Present Value (NPV): $147,725 (positive, so accept the project)

Considerations

  • Demand Uncertainty: Actual demand could be 40k, 50k, or 60k
  • Simulation: Could provide insights into all demand scenarios
  • Exercise for Students: Calculate NPV with fixed overhead uncertainty

Risk Adjusted Discount Rate

  • Concept: Adjust discount rate for project risk
  • Application:
    • Higher risk projects have higher discount rates
    • Forces higher expected cash flows for acceptability
  • Relation to Cost of Capital: Capital Asset Pricing Model will be covered later

Conclusion

  • Topic Completion: Investment appraisal chapter finished
  • Next Steps: Upcoming lectures on new topics

Note: For better understanding, download lecture notes from Open Tuition.