Risk & Project Appraisal – WILLOW

The UK manufacturer of footwear, Willow, is considering a major investment in a

new product area, novelty umbrellas. It hopes that these products will become
fashion icons. The following information has been collected:

• The project will have a limited life of 11 years

• The initial investment in plant and machinery will be £1m and a marketing
budget of £200,000 will be allocated to the first year
• The net cash flows before depreciation of plant and machinery and before
marketing expenditure for each umbrella will be £1
• The products will be introduced both in the UK and in France
• The marketing costs in years 2-11 will be £50,000 pa
• If the product catches the imagination of the consumer in both countries then
sales in the first year are anticipated at 1m umbrellas
• If the fashion press ignore the new products in one country but become
enthusiastic in the other the sales will be 700,000 umbrellas in year 1
• If marketing launch is unsuccessful in both countries, first year sales will be
200,000 umbrellas

The probability of each of these events occurring is:

• 1m sales: 0.3
• 0.7m sales: 0.4
• 0.2m sales: 0.3

If the first year is a success in both countries then two possibilities are envisaged:
i. Sales levels are maintained at 1m units per annum for the next 10 years –
probability 0.3
ii. The product is seen as a temporary fad and sales fall to 100,000 units for
the remaining 10 years – probability 0.7

If success is achieved in only one country in the first year then the remaining 10 years
there is:
i. a 0.4 probability of maintaining the annual sales at 700,000 units
ii. a 0.6 probability of sales immediately falling to 50,000 units per year

If the marketing launch is unsuccessful in both countries then production will cease
after the first year.
The plant and machinery will have no alternative use once installed and will have no
scrap value.
The annual cash flows and marketing costs will be payable at each year end.

Assume:
• cost of capital 10%
• no inflation or taxation
• no exchange rate changes

Required

(a) Calculate the expected NPV for the project

(b) Calculate the standard deviation for the project
Solution:

Required: a

Time -0 Time-1 Time 2-11

0.3 1m units
0.3 1 m units
07 100,000 units
-£1 m 0.4 700,000 units 0.4 700,000 units

0.6 50,000 units

0.3 200,000 units

Probabilities

0.3×0.3= 0.09...................A
0.3×0.7=0.21....................B
0.4×0.4=0.16.....................C
0.4×0.6=0.24.....................D
0.3......................................E
∑ =1.00

NPV (A) @10 %( £000)

Year Cost Present value

0 - (1000)

1 1000 units ×£1=£1000

Less: Marketing Cost = (200)
(800×0.909) 727

2-11 1000 units ×£1=£1000

Less: Marketing Cost = (50)
(950×6.145×0.909) 5307
NPV (A) = 5034

Because the annuity cash flows start in year 2, the annuity factor of 6.145 will
give us the value in year-1. This value must then be discounted to year 0 by using
the present value factor for year 1 i.e. 0.909
NPV (B) @10 %( £000)

Year Cost Present value

0 - (1000)

1 1000 units ×£1=£1000

Less: Marketing Cost = (200)
(800×0.909) 727

2-11 100 units ×£1=£100

Less: Marketing Cost = (50)
(50×6.145×0.909) 279
NPV (B) = 6

NPV (C) @10 %( £000)

Year Cost Present value

0 - (1000)

1 700 units ×£1=£700

Less: Marketing Cost = (200)
(500×0.909) 455

2-11 50 units ×£1=£700

Less: Marketing Cost = (50)
(650×6.145×0.909) 3631
NPV (C) =3085

NPV (D) @10 %( £000)

Year Cost Present value

0 - (1000)

1 700 units ×£1=£700

Less: Marketing Cost = (200)
(500×0.909) 455

2-11 50 units ×£1=£50

Less: Marketing Cost = (50)
0 0
NPV (D) = (545)
NPV (E) @10 %( £000)

Year Cost Present value

0 - (1000)

1 200 units ×£1=£200

Less: Marketing Cost = (200)
(0×0.909) 0

. .
NPV (E) = (1000)

Project probabilities NPV P× NPV

(p) NPV- NPV 2
(NPV- NPV) ×P

A 0.09 5034
453
4517 1836296

6 (511)
B 0.21 1 54835

3085
C 0.16 494 2568 1055140
(131)
D 0.24 (545) (1062) 270683
E 0.30 (1000) 690387
(300) (1517)

∑ NPV =517 σ2 = 3907341

σ =√3907341
=1977

Required: A
Expected NPV for the project=∑ NPV =517
Required: B
The standard deviation for the project= σ =√3907341
=1977