Still staying with the data in Example 6.1, let us assume not only that the sales volume has the same three possible outcomes, but that, independent of the sales volume, the cost of labour will be

● £3/unit (0.1 probable), or

● £4/unit (0.7 probable), or

● £5/unit (0.2 probable).

What are the possible outcomes and how likely is each one?

(Note that the word ‘independent’ in the above context means that the actual outcome as regards sales volume implies nothing about which level of labour is most likely.)

Data from Example 6.1

Greene plc has the opportunity to invest in a machine for the manufacture of a new product, the demand for which is estimated to be 5,000 units a year for five years. The business has made the following best estimates about the decision:
● The machine is estimated to cost £50,000 (payable immediately) and to have no residual value.
● The selling price per unit is planned to be £10.
● Labour and material costs are estimated to be £4 and £3 per unit, respectively.
● Overhead costs are not expected to be affected by the decision.
● The cost of capital for such a project is estimated to be 10 per cent p.a.
● The project is not expected to require any additional working capital.
● In the interests of simplicity, taxation will be ignored.
● Assume, also in the interests of simplicity, that all cash flows occur at year-ends.

(a) Assess the project (using NPV) on the basis of the above estimates.

(b) Carry out a sensitivity analysis of the above estimates.