this is a lecture from open tuition to benefit from the lecture you should download the free lecture notes from open tuition com alright this is the second and the last lecture on chapter 10 investor 470 in the previous lecture I went through sensitivity analysis and then a quick mention of simulation the third exercise if you like is certainly got expected values which you should in fact be aware of from paper f5 which I know not all of you will have come to take and all he may have forgotten it but his paper I found to be honest very we will check but with an example Tiger is considering launching a new product it will need an additional capital investment of 200000 the selling price of the product will be $10 a unit and digress ascertained that the probability of a demand of 50,000 units a year is 0.5 or 50% chance there's a probability 0.4 it will be 20% higher and 10% probability it will be 20% lower we expect a contribution of 50% we expect fixed elements to increase by 140 thousand a year the time arises for years we go to sell at the end of four years to 50,000 the cost of couple is 20% well our problem here is slightly certainly a slightly certain are slightly different if the demand because dying is not certain of the demand when instead of the demand simply being answered you know it couldn't theory be anything she's found that the demand will either be 50,000 a year or it'll be 20% higher well 20% higher at under 750 is 10 so it might be 60,000 Oh it'll be 20% lower or 10% of 50 again is 10 10,000 lower is 40 so this is rather different in that we know the demand will be one of those three but it could be any one of those three however we do know the probability have you been 50,000 is point five and B being higher the probabilities point for enemy being low the probability is point one so a 50% chance or 2% chance 10% chance total obviously a hundred now I shouldn't need to say much about this because there's a lot of this in f5 but in that sort of situation where it's not so much answered could be anything it's one of those three with those probabilities then all we can do is base our decision on the average demand are what we call the expected demand it's a weighted average we multiply by the probabilities and Adam and so multiplied by the probabilities another gives us 25 49 53 thousands that's the weighted average or what we call the expected value here the expected demand and having done that we then carry on like any normal necklace of any question but based on demand of 53,000 units a year and so let's set it up and do it they'll be additionally less than 200 so x 0 we've got the cost of 200 thousand it's going to last for years so from 1 to 4 we've got our contribution which remember I reminded you in the last lecture that contribution is the revenue less the variable costs and so the contribution is 50% of the revenue and how much revenue a year it's 53 thousand units and revenue of $10 each so the revenue 55:11 30,000 a year if the coverage is 50% it means it's 50% of the revenue so the contribution to 65,000 a year for four years now what else no fixed uppers are going to increase so there are incremental overheads director incrementally relevance about 240,000 a year I finally there's a scrap value at four years time of fifty thousand it's a straight discounting now so the present value at 20 percent won't take me a moment the annuity factor for Latin America from the tables so release the annuity plant over four years at twenty percent is two point five eight nine so the present values to sixty five thousand times two point five eight nine six eight six zero eight five and the fixed over hundred forty thousand times two point five eight nine three six two four sixty and finally the scrap proceeds the ordinary present value tables twenty years a so four years at 20 percent but at this point four eight two also the present value 24/100 was e3 2005 it was fifty and so finally in the net present value nothing new here got to go to this stage but still I will finish it six eight six zero eight five plus twenty-four 100 minus three six two four sixteen minus 200,000 one four seven seven two five it's positive I mean except there is the expected NPV and that's what to be expected in the exam if there is any writing about it do appreciate and again it's basically paper at five written depreciated the one problem here his demand isn't actually going to be 53,000 at all daggers found it will either be fifty thousand or it will be sixty thousand or it could be a forty thousand it'll be one of those three if it turns out to be fifty thousand things aren't going to be quite as good as this we've assumed 53 if it turns out to be sixty thousand things are a lot better if he turns out to only forty thousand things again are worse perhaps simulation would have been better trying all the possibilities but unexpected values when there are probabilities give mindless we simply replace with he expected the weighted average Barbie it's really your exercise I'm not going to do this on the street I really shouldn't need same question but he says assume the demand is certainly fifty thousand perman whilst the NPV if the fixed overheads are uncertain and could be only one of those four and so you're going to do this not me as those with the back but then the this time the demand we assume is certainly fifty thousand so that will obviously be different however the fixed overheads instead of them being hundred and forty it's going to be the expected value so if shouldn't tell you many signals multiplied by the probabilities another whatever answer you get that is what you use a fixed overheads and then we okay so I mean that's a legal way the examiner can make a question it's a bit longer it can give you a full question tax inflation everything but then for one of the flows have you calculate the expected value but once you've got it then it's back to a normal question all right the list I think mentioned this chapter you can see for yourself is something called the risk adjusted discount rate and you see there are no numbers there you can read it yourself but the reason is not too much need is this the idea is that the more INSERM the project is the flows rather the more instead the flows are the more risk were taking by going ahead and he says okay if it is more risky let's discount the flows at a higher discount rate cost capital maybe just 10% discount 10% but if the project is very risky if instead of discounting at 10 I discovered at 15 think about it it means in order for it to be worthwhile going ahead to be positive the project is going to have to give us higher expected flows now I may or may not make sense the reason I'm going to say more though is that in fact when we come to look at cost of chemical how we calculate the rate at which we discount things there's a big topic called capital asset pricing model which is effectively working under discount rate based on the level of risk so there's a whole chapter on that later it's a part of calculating cost of capital is terribly important but I'll explain everything in it the relevant sites and so on when we come to up Junction as part of cost of capital it's over the moment by all means read what's on that page but I'm not too worried compactly later so there we are we finished that part of the syllabus investment appraisal the next lectures will carry on week the next part