Degnis Co is a company which installs kitchens and bathrooms to customer specifications. It is planning to invest $4,000,000 in a new facility to convert vans and trucks into motorhomes. Each motorhome will be designed and built according to customer requirements. Degnis Co expects motorhome production and sales in the first four years of operation to be as follows.
The selling price for a motorhome depends on the van or truck which is converted, the quality of the units installed and the extent of conversion work required. Degnis Co has undertaken research into likely sales and costs of different kinds of motorhomes which could be selected by customers, as follows:
Fixed costs of the production facility are expected to depend on the volume of motorhome production as follows:
Degnis Co pays corporation tax of 28% per year, with the tax liability being settled in the year in which it arises. The company can claim tax allowable depreciation on the cost of the investment on a straight-line basis over ten years. Degnis Co evaluates investment projects using an after-tax discount rate of 11%.
Required:
(a) Calculate the expected net present value of the planned investment for the first four years of operation. (7 marks)
(b) After the fourth year of operation, Degnis Co expects to continue to produce and sell 450 motorhomes per year for the foreseeable future.
Required:
Calculate the effect on the expected net present value of the planned investment of continuing to produce and sell motorhomes beyond the first four years and comment on the financial acceptability of the planned investment. (3 marks)
(c) Critically discuss the use of probability analysis in incorporating risk into investment appraisal. (5 marks)