ExpertACCA · Question 32 · Risk and Uncertainty in Decision Making
Section C - Constructed Response 2
NovaSteel is a multinational heavy manufacturing company considering the construction of a new smelting plant in a developing region. The project requires an initial capital investment of $50 million.
The financial success of the plant depends heavily on future global steel demand, which is highly uncertain over the next 5 years. The management accountant has modeled two possible demand scenarios and calculated the Net Present Value (NPV) for each:
- Scenario 1: High Demand (Probability 0.60). NPV = +$30 million.
- Scenario 2: Low Demand (Probability 0.40). NPV = -$10 million.
The Board of Directors is divided. The CEO is a risk-taker and wants to proceed based on the potential upside. The CFO is highly risk-averse and fears the $10 million loss could severely damage the company's liquidity.
Required:
(a) Calculate the Expected Value (EV) of the project's NPV and advise whether the project should be accepted based strictly on this EV. (5 marks)
(b) Discuss the limitations of using Expected Values for this specific investment decision. (7 marks)
(c) Explain how the decision would differ if the Board applied the Maximax and Maximin decision rules, and discuss which rule aligns best with the CFO's perspective. (8 marks)
Section C - Constructed Response 2
NovaSteel is a multinational heavy manufacturing company considering the construction of a new smelting plant in a developing region. The project requires an initial capital investment of $50 million.
The financial success of the plant depends heavily on future global steel demand, which is highly uncertain over the next 5 years. The management accountant has modeled two possible demand scenarios and calculated the Net Present Value (NPV) for each:
- Scenario 1: High Demand (Probability 0.60). NPV = +$30 million.
- Scenario 2: Low Demand (Probability 0.40). NPV = -$10 million.
The Board of Directors is divided. The CEO is a risk-taker and wants to proceed based on the potential upside. The CFO is highly risk-averse and fears the $10 million loss could severely damage the company's liquidity.
Required:
(a) Calculate the Expected Value (EV) of the project's NPV and advise whether the project should be accepted based strictly on this EV. (5 marks)
(b) Discuss the limitations of using Expected Values for this specific investment decision. (7 marks)
(c) Explain how the decision would differ if the Board applied the Maximax and Maximin decision rules, and discuss which rule aligns best with the CFO's perspective. (8 marks)
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