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ACCA Applied Skills · Financial Management · Adjusting for risk and uncertainty in investment appraisal

An investment costs $150,000 now. Annual cash inflows for four years are $40,000 (probability 0.25), $60,000 (probability 0.45) or $80,000 (probability 0.30). The cost of capital is 10% and the four-year annuity factor is 3.170. What is the expected NPV?

The expected NPV is $43,370. The probability-weighted annual inflow is $61,000, which is discounted using the 3.170 annuity factor to give a present value of $193,370. Deducting the $150,000 initial investment leaves $43,370.

  1. A$43,370Correct
  2. B$193,370
  3. C$40,200
  4. D$94,000

Explanation

Expected annual inflow = 10,000 + 27,000 + 24,000 = $61,000. PV = 61,000 × 3.170 = $193,370. Less the $150,000 investment, the NPV is $43,370. $193,370 forgets the initial outlay. $40,200 uses $60,000, which is the most likely or simple average cash flow, rather than the expected value. $94,000 does not discount the cash flows.

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