- 10 Marks
FM – L2 – Q70 – DCF: Risk and uncertainty
Calculate the expected NPV of a project with uncertain cash inflows affected by multiple probabilistic factors, using a 10% cost of capital.
Question
A company is considering whether or not to invest in a project where the investment would be GH¢5,250,000. The project would have a five-year life, and estimated annual cash flows are as follows:
| Year | Cash inflows | Cash outflows |
|---|---|---|
| GH¢ | GH¢ | |
| 1 | 3,000,000 | 1,500,000 |
| 2 | 4,000,000 | 1,800,000 |
| 3 | 5,000,000 | 2,400,000 |
| 4 | 4,000,000 | 1,700,000 |
| 5 | 3,000,000 | 1,000,000 |
The cost of capital is 10%.
The estimates of cash outflows are considered fairly reliable. However, the estimates of cash inflows are much more uncertain. Several factors could make the annual cash flows higher or lower than expected.
Factor 1: There is a 20% probability that government measures to control the industry will reduce annual cash inflows by 20%.
Factor 2: There is a 30% probability that another competitor will also enter the market: this would reduce the estimated cash inflows by 10%.
Factor 3: There is a 40% probability that demand will be stronger than expected. The company would not be able to supply more products to the market, but it would be able to sell at higher prices and cash inflows would be 5% higher than estimated.
Required
Calculate the expected net present value of the project.
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