Managerial Accounting and Finance 334

MANAGERIAL ACCOUNTING AND FINANCE 334

(MAF 334)
2018

221
MODULE:
Risk and uncertainty

READING REFERENCES:
Drury 9th edition: Chapter 12.

TUTORIALS:

For objective test: week beginning 2 April 2018

RU01
RU02
RU03
RU04

Module: Risk and uncertainty Page 1

Managerial Accounting and Finance 334

Learning objectives

At the end of this module you should be able to:

i) Calculate the expected value of a project

ii) Explain how the existence of perfect information can be used to change the expected
value of a project and calculate the value of perfect information
iii) Identify and discuss the factors that should be taken into consideration when choosing
between alternative projects with uncertain outcomes
iv) Discuss the differences between discrete and continuous distributions
v) Choose between alternative projects based on the maximax, maximin and regret rules

Terminology

Expected value: The weighted average of all the possible outcomes based on the
probabilities attached to each outcome

Perfect information: Regardless of the probability of a certain outcome, the outcome can be
known by doing or buying research e.g. a survey

Maximax rule: Maximise the upside potential

Maximin rule: Minimise the downside risk

Regret criteria: Choose the option where the least regret will be experienced when the
outcome is unfavourable (i.e. minimises the relevant cost of choosing incorrectly)

Introduction

The future is always uncertain as it has not taken place yet. This causes risk in decision
making. If probabilities can be attached to different outcomes, the expected value (weighted
average) of the outcome can be calculated.

Expected values are only one method of analysing risk – they provide insight into the extent
to which the actual outcomes of the project, balanced against the probability of those
outcomes occurring, is positive or negative.

However, as the expected value is not an actual outcome, other insights into the risk
attached to the actual outcome remain very important, and so other forms of analysis are
also considered – e.g. balance of probabilities, the worst case scenario (e.g. whether the
firm could survive it), best case scenario and in the case of choosing between projects (or
the method of carrying out the project), maximax, maximin and regret criteria.

Module: Risk and uncertainty Page 2

Managerial Accounting and Finance 334

Module notes

1. Setting the big picture (Strategic risk management)

Decisions may be made based on historic information, but only to the extent that it is
believed that the future will approximate past events. The future is always uncertain as it has
not happened yet.

Whenever there is uncertainty involved in the decision making process, the use of
probabilities may be used to estimate the expected value of the outcome.

Outcomes are termed “discrete” if there are set possible outcomes. For example throwing a
dice has only six possible outcomes.

Outcomes are termed “continuous” if the actual outcome can be anywhere on a continuum
of possible outcomes (usually representing a normal curve). Examples of continuous
outcomes are the quoted share prices of listed equities on the JSE.

i) Risk management implications

Even though a project has a high (or positive) expected value, consideration should be given
to the worst case and best case scenarios, as well as the potential for making a loss
(balance of probabilities).

If for example the probability of making a large loss is only 2%, but the result of this unlikely
loss would mean the insolvency of the company, then the project should not be undertaken,
even if the expected value is very high.

The attitude of the decision maker towards risk (i.e. risk averse, neutral to risk or risk taking)
will influence which project will be chosen, but should not over-ride consideration of the risk
profile of the project, that is economically rational.

ii) Expected value versus actual outcome

The expected value is just the weighted average of all the possible outcomes based on the
probability of each outcome happening. If the project is once-off (e.g. drilling one oil well) the
expected value will not be the same as the actual outcome. If the project is repeated (e.g.
drilling multiple oil wells), over time the expected value becomes the average outcome.

Question: What about launching a new product? Is it once-off or repetitive?

In each of the following examples; do you think that the expected value will approximate the
average outcome?

- Oil exploration
- A company launches a new product launch
- Flipping a coin

Module: Risk and uncertainty Page 3

Managerial Accounting and Finance 334

2. Technical aspects

You should be able to master the following technical aspects of risk and uncertainty:

- Calculating the expected value of a project

- Calculating the value of perfect information and explain
- Choosing between two or more projects

Class example - Information

OilCo Ltd is in the business of extracting oil from the bottom of the ocean. The amount of
profit that will be made depends on the quantity of oil deposits under the ocean floor as well
as the state of the global economy. There is a 50/50 chance of the global economy either
recovering or dipping into another recession.

The probabilities of the different quantities of oil that might be found as well as the profits
that can be earned under the different states of the economy are as follows:

Yield of oil field Probability Profit / (loss) during Profit / (loss) during
recovery recession
Small quantity 50% (80 000) (100 000)
Moderately quantity 30% 20 000 (40 000)
Large quantity 20% 400 000 180 000

1.1. Expected value

The expected value is the weighted average of all the possible outcomes based on the
probabilities attached to each outcome.

The expected value will only approximate the average outcome if the project or outcomes
can be repeated many times over. If it is a once-off project the expected value will not be
equal to the actual outcome.

Probabilities

Probabilities are the likelihood of each outcome occurring. The probabilities might be
estimated based on historical information (including management experience and
professional judgement). If there is available information that suggests it is likely that the
future will differ from past events, this must be taken into consideration when estimating the
probabilities of future outcomes.

Exam technique hint: Probabilities must always add up to 100%

Joint probabilities

If there is more than one consecutive uncertain future event, the probability of the first event
must be multiplied by the probability of the subsequent event(s) to arrive at the joint
probability of arriving at the final outcome.

Module: Risk and uncertainty Page 4

Managerial Accounting and Finance 334

Class example REQUIRED 1

Calculate the expected value of the project using the framework set out below.

Quantity Probabilit State of Outcome: Probabilit Joint Expected

of oil y the Profit/ y probability value
economy (loss)
Small 50% Recession (100 000) 50%

Small 50% Recovery (80 000) 50%

Moderate 30% Recession (40 000) 50%

Moderate 30% Recovery 20 000 50%

Large 20% Recession 180 000 50%

Large 20% Recovery 400 000 50%

Discussion

Your discussion should be based on a general risk assessment of all the possible outcomes
and the probabilities attached to each. In your discussion you should include considerations
of the following:

- What is the worst case scenario? The absolute value of the loss that might be
sustained as well as the probability of not breaking even.
- What is the best case scenario? The value of the best possible outcome as well as
the probability of a positive outcome.
- Is it a once-off project or will it be repeated? If a project is repeated over and over,
the expected value becomes average outcome.

1.2. Perfect information

When dealing with uncertain future outcomes, in certain cases it may be possible to obtain
information telling us what the outcomes will actually be. In this module we will accept that
this information is 100% accurate.

It is VERY IMPORTANT to understand that perfect information does not change the
probabilities of the outcomes occurring; it merely determines what the outcomes will be.

Think for example of a performing a survey. Even though it might tell you whether a product
will be successful or whether it will fail, the survey itself will not change the probability of the
outcomes.

If so, then why does perfect information have value?

Perfect information will change how you act and thus change the expected value of the
outcome.

Module: Risk and uncertainty Page 5

Managerial Accounting and Finance 334

Class example (continues)

Survco Ltd specialised in doing oil exploration to determine the quality of oil deposits under
the ocean floor by sending ships with state of the art technology on board.

By scanning the ocean floor in grids they are able to determine with a very high level of
accuracy whether a certain oil deposit will yield a small, moderate or large quantity of oil.

REQUIRED

Calculate the maximum amount OilCo Ltd should pay for this information.

Exam technique hint: When setting your table for expected value – if there is perfect
information – put that set of probabilities first.

1.3. Choosing between projects

Class example (continues)

If OilCo Ltd subcontracts the extraction of the oil from the ocean floor and then does the
refining in-house, the following outcomes have been estimated:

Yield of oil field Probability Profit / (loss) during Profit / (loss) during
recovery recession
Small quantity 50% - (20 000)
Moderately quantity 30% 30 000 10 000
Large quantity 20% 60 000 40 000

REQUIRED

Calculated the expected value if the extraction process is subcontracted.

Decision trees

A decision tree is a diagrammatical representation of all the possible outcomes and the
probabilities attached to each outcome. Drawing a decision tree will aid decision making by
helping to understanding how each uncertain event will influence the expected value.

Exam technique hint: When calculating expected value, rather use table than decision tree
diagram.

Class example (continues)

OilCo Ltd has trouble in deciding whether to subcontract the extraction or do it themselves.

REQUIRED

Draw a decision tree portraying both options and discuss the factors OilCo Ltd should take
into consideration from a risk management perspective.

Module: Risk and uncertainty Page 6

Managerial Accounting and Finance 334

What if it is not possible to assign meaningful probabilities to alternative outcomes?

The estimation of probabilities is not an exact science and is more often than not based on
historical information that might not be repeated in future.

The following tools may be used to make a decision between different projects, based on the
risk profile of the decision maker: Maximax, maximin and regret criteria.

Maximax: Maximise the upside potential, i.e. choose the project with the highest possible
return if the best case scenario realises (very optimistic).

Maximin: Minimise the downside loss, i.e. choose the project with the lowest possible loss if
the worst case scenario realises (make the best of a bad situation).

Regret (minimax): Use relevant costing principles to minimise the lost opportunity should
you make the wrong decision.

Class example

Low demand High demand

Project A 50 000 120 000
Project B 10 000 150 000

REQUIRED

Calculate which project should be chosen based on the following rules:

1. Maximax
2. Maximin
3. Regret criteria

Module: Risk and uncertainty Page 7

Managerial Accounting and Finance 334

RU01 The Chick Farm (UCT adapted) (30 marks)

John Khumalo is seriously considering the purchase of The Chick Farm, a poultry-rearing
company situated 30 kilometres north of Cape Town. The company has been poorly
managed and has incurred large losses over the past few years. After investigating the
industry thoroughly, John believes that he can make a success of The Chick Farm.

The company purchases day-old broiler chicks, and rears them in a free-range environment
inside large, barn-like structures. After 32 weeks, the poultry is at the correct age and weight
for slaughter. At this stage, they are sold to an independent company, which culls, cleans
and packages them, for sale to supermarkets across the Western Cape.

After each 32-week cycle, the barns must be cleaned, fumigated and then left empty for 20
weeks. Failure to do this leads to the spread of highly infectious poultry diseases. This has
been a large part of The Chick Farm’s problems in recent times, and John has decided to
adhere strictly to the 32-week full, 20-week empty cycle for his barns. (32 + 20 weeks = One
full production year.)

The barn space available to John allows him to introduce 50 000 chicks into his barns at the
beginning of each production year.

The poultry industry is not without its risks, and John has identified the main risks as being:

Infectious diseases. Chicks can be inoculated against the most common diseases, but the
threat of unknown diseases remains;
Crushing. Chickens are very nervous creatures, and sudden loud noises (such as very loud
thunder, or the sound of an air-force jet flying low overhead) can cause the chickens to rush
towards the sides of the barns, where many of them will be crushed to death against the
walls of the barns.

Given the situation at The Chick Farm, John has come up with three possible scenarios for
the next production year:

Possible: No infectious disease outbreaks or crushing incidents. 5% of chickens will die of

other causes, at an average age of 16 weeks;

Probable: No infectious disease outbreak. 5% of chickens will die of other causes, and
10% in crushing incidents, both at an average age of 16 weeks;

Worst-case: Infectious disease outbreak and crushing incidents. 5% of chickens will die of
other causes, 10% from crushing incidents and 20% from infectious disease outbreaks, all at
an average age of 16 weeks.

The probability of these scenarios occurring has been determined as follows:

Possible 25%
Probable 45%
Worst-case 30%

(Please turn over)

Module: Risk and uncertainty Page 8

Managerial Accounting and Finance 334

Costs:

Day-old chicks are purchased at a cost of R1.00 each. Variable costs incurred in the rearing
of the chicks (e.g. medicines, food, vitamin supplements, lighting and heating etc.) amount to
R0.28 per chick, per week.

Fixed costs for The Chick Farm for the full production year amount to R90 000.00

Full-grown (32-week-old) chickens are sold at R15.00 each.

Crushed chickens are sold to pet food companies. The selling price exactly covers the cost
of transporting the dead chickens to the pet food companies. Infected chickens are not sold.
The disposal costs of these chickens are already included in the fixed cost figure of R90 000
per year.

REQUIRED

1. John will buy The Chick Farm if the expected value of the annual net income is positive.
He asks you to calculate this figure, using the information provided above.
(18 marks)

2. Professor Rooster, from the Onderstepoort Veterinary Institute, has developed a method
for forecasting the types of infectious poultry diseases which will affect South Africa in
any given year. This would allow John to medicate his chickens and thereby prevent all
deaths from disease (At no extra cost, other than the charge from Prof. Rooster)

What is the maximum price that John should pay for the perfect information from Prof.
Rooster regarding the expected diseases?
(8 marks)

3. If the price is acceptable and John buys the perfect information, will he definitely be
better off than if he had not bought the information? (Explain briefly – no more than
three or four sentences should be necessary!)
(3 marks)

4. In your opinion, what is the personality profile of an investor who always buys perfect
information if the price is right? (Briefly – One sentence is enough!)
(1 mark)

Module: Risk and uncertainty Page 9

Managerial Accounting and Finance 334

The Chick farm: Suggested Solution

1. Calculation of Net Income under each scenario:

Possible R’s
Deaths: 5% of 50 000 = 2 500 chickens
Sales: 47 500 X R15 712 500
Less: Cost of Sales: 47 500 X (R1 + [32 X R0.28]) = 47 500 X R9.96 (473 100)
Less: Cost of dead chickens: 2 500 X (R1 + [16 X R0.28]) = 2 500 X R5.48 (13 700)
Less: Fixed Costs (90 000)
Net Income 135 700

Probable R’s
Deaths: (5% + 10%) of 50 000 = 7 500 chickens
Sales: 42 500 X R15 637 500
Less: Cost of Sales: 42 500 X (R1 + [32 X R0.28]) = 42 500 X R9.96 (423 300)
Less: Cost of dead chickens: 7 500 X (R1 + [16 X R0.28]) = 7 500 X R5.48 (41 100)
Less: Fixed Costs (90 000)
Net Income 83 100

Worst-Case R’s
Deaths: (5% + 10% + 20%) of 50 000 = 17 500 chickens
Sales: 32 500 X R15 487 500
Less: Cost of Sales: 32 500 X (R1 + [32 X R0.28]) = 32 500 X R9.96 (323 700)
Less: Cost of dead chickens: 17 500 X (R1 + [16 X R0.28]) = 17 500 X R5.48 (95 900)
Less: Fixed Costs (90 000)
Net Income (22 100)

Expected Value of Net Income:

Possible: R 135 700 X 0.25 = R 33 925
Probable: R83 100 X 0.45 = R 37 395
Worst-Case: R(22 100) X 0.30 = R ( 6 630)
EV R 64 690

2. Maximum price of perfect information:

New net income under Worst-Case scenario = Deaths of (5% + 10%) X 50 000 = 7 500
chickens
This is the same as the Probable scenario, therefore Net Income = R83 100

Revised EV:
Possible R 33 925
Probable R 37 395
Worst-Case: R83 100 X 0.30 = R 24 930
EV with perfect information R 96 250
EV without perfect information R 64 690
Maximum value of perfect info. R 31 560

Module: Risk and uncertainty Page 10

Managerial Accounting and Finance 334

3. John will not always be better off with perfect information. For example, he may be
prepared to gamble that the Probable scenario will occur in the next year, with no
unknown infectious diseases. If he does not pay for perfect information, and the
Probable scenario occurs, he makes a net income of R 135 700 as shown under (a)
above. If he had paid for perfect information, his profit of R 135 700 would have been
reduced by the amount paid for perfect information, and he would have been worse off.

4. An investor who always pays for perfect information is likely to have a risk-averse
personality.

Module: Risk and uncertainty Page 11

Managerial Accounting and Finance 334

RU02 Focus (Pty) Ltd (UCT adapted) (32 marks)

Focus (Pty) Ltd is a local manufacturer of home appliances. The company has for many
years been attempting to become a supplier to Family Stores Ltd, a well-known national
retail chain. Although Focus is presently operating at close to full capacity, it has had
contingency plans in place to expand its facilities should Family Stores indicate a willingness
to establish a relationship.

The espresso coffee maker problem

Family Stores has recently indicated that it is prepared to place an order for quality espresso
coffee makers which it wants in its stores by mid-October, in time for the Christmas shopping
season.

Whilst Focus does not presently include an espresso machine in its product line, it has been
planning to introduce one for some time, and the specifications it developed are quite
suitable for the product required by Family Stores. Hence the approach by Family Stores
presents an opportunity, not only to establish a potentially very lucrative relationship with that
company, but also to provide an outlet for the new product.

Family Stores has indicated that it is prepared to place an order with Focus, but it is unable
to specify exactly what the size of the order will be. This is due to the fact that the company
has not yet finalised its merchandise plan for the Christmas period. However Family Stores
has advised that it will place an order for at least 1 000 units, but that it may, once it has
finalised its plans, wish to amend the order to either 1 500 units or 2 000 units. Therefore in
order to satisfy Family Stores, Focus must undertake that it will be able to meet the three
possible order levels. If it cannot make this undertaking, Family Stores will make use of
another manufacturer. Family Stores has advised that it is prepared to pay R80 per coffee
maker, irrespective of the size of the order.

Focus will not be able to purchase the necessary machinery in time to enable it to meet any
of the three order levels. However, it could satisfy the orders by a combination of hiring
additional equipment and outsourcing the manufacture of some coffee makers.

The company estimates that there is a 50% chance that Family Stores will order 1 000 units,
a 30% chance that the order will be for 1 500 units, and a 20% chance of 2 000 units. Focus
will be able to hire one of two machines that will enable it to produce the coffee makers.
Machines A and B have capacities of 1 000 units and 1 300 units respectively. The fixed
costs related to the hired machines will be R20 500 and R26 000 for Machines A and B
respectively, and the variable manufacturing costs per unit of production from using these
machines would be R6.00 for Machine A, and R5.00 for Machine B.

To the extent that Focus would be required to outsource the manufacture of the coffee
makers, it would have to pay a manufacturing fee of R38 per unit for the first 500 units, and
R33 per unit for any units above 500. They would only be able to outsource a maximum of 1
000 units, and the cost of materials would be borne by Focus, whether it manufactured the
products itself, or whether it outsourced the production of the units. Material costs will be
R50 per unit produced for up to 1 000 units. For any units above 1 000, a discount of 10%
would apply.

In light of the opportunities involved, Focus has decided that it will accept the order even if it
is expected to result in a loss, as forgoing the order will be detrimental to the company’s
growth prospects. Nevertheless the company wishes to assess the expected financial
outcome of giving Family Stores the undertaking it desires.

Module: Risk and uncertainty Page 12

Managerial Accounting and Finance 334

The purchasing manager of Focus has mentioned that there is an urgent need for 250
components for another unrelated small appliance. The company could purchase the
components from the supplier from which the materials for the coffee makers are to be
purchased. The supplier’s list price is R32.50 per unit, but it would grant a 20% discount if
the order were placed at the same time as the coffee maker materials. It has also been
ascertained that Machine A could be used to produce these components without interfering
with the production of the coffee makers in any way. The costing department has advised
that by using Machine A, the components could be produced for R30 each. This comprises a
portion of the rental cost of Machine A, amounting to R6 per unit, and materials and other
variable costs amounting to R24 per unit.

Retail Analysts (Pty) Ltd is a specialist market research company which has approached
Focus with a view to conducting a market survey in order to establish which level of demand
will materialise. Family Stores is willing to base their order quantity on the survey results, as
matching the quantity purchased to market demand would also be to Family Stores’
advantage. Retail Analysts have indicated that they would charge a fee of R3 000 for this
service.

REQUIRED

1. Advise the company as to which machine it should hire. Your answer should:

a. Include a suitable calculation considering expected values; (19 marks)

b. Consider other factors that should be taken into account, and draw
appropriate conclusions. (7 marks)

2. Advise Focus whether you believe it is worth engaging Retail Analysts to provide a
forecast regarding the level of the Family Stores order. Very briefly note any other
factors that should be considered.
(6 marks)

Module: Risk and uncertainty Page 13

 Managerial Accounting and Finance 334

RU02 - Suggested Solution with markers comments

Module: Risk and uncertainty Page 14

Managerial Accounting and Finance 334

Other considerations

Machine A has the highest expected value - but only just. Given the similarity in expected
values, other factors emerge as being of particular importance:

- There may be merit in producing as much as possible anyway - it can be sold at a later time
if the product takes off.
- Machine A is capped to modest profit, but would not be loss making i.e. 100% probablilty of
profit.
- Machine B has a 50% possibility of making a loss, but greater upside potential.
- Machine B places less reliance on the outsourcer (which is an unknown entity - might be
unreliable ito
- deliveries being on time, sufficient capacity, suitable quality. The outsourcer has the
potential to ruin the
- brand name.
- The reliability of the probability distribution needs to be considered.
- Maximin/Maximax/regret criteria could be considered if probability distribution considered
unreliable.

Markers comments on part 1

1. Calculation of expected values

1.1. The objective of this part of the question was to calculate the value of the
outcome for each level of demand for each machine. The decision was
whether to choose A or B, and not to choose a demand level as was done in
some instances.

1.2. In many cases students approached the question by calculating the expected
units, and then applied the figure of 1350 units to the selling price and
variable costs. This was unwieldy and prevented students from easily
calculating the values for outsourcing and materials, and ultimately, the
outcome for each order size.

1.3. Many students overlooked the fact that the quantity discount for materials
related to the second thousand units only.

1.4. In many cases students ignored revenue on the basis that it was common to
both machine. This is appropriate in a relevant costing context, but we
needed to calculate the expected values in terms of profit for each decision
alternative to fully appreciate the effects of the decision at hand.

1.5. Many answers very unstructured and untidy, with no proper tabulation of the
figures for various alternatives. This can lead to the loss of marks.

1.6. It is preferable to show the financial benefit of each option (either the 20%
discount or R8.50 cost saving per unit as a result of making, rather than
buying, the component) RATHER THAN just showing a net benefit of R500
(calculated above) under Machine A. Firstly note that either way is correct

Module: Risk and uncertainty Page 15

Managerial Accounting and Finance 334

from the perspective of determining the difference in financial impact of

Machine A and B. However, the added advantage of showing the benefit
that each option offers the firm (i.e. Opt 1: Make coffee maker using
Machine A verse No coffee maker, and Opt 2: make coffeemaker using
machine B verse no coffee maker) is that you are also determining the
actual amount to which the firm is better or worse off if the new product is
introduced, for each machine. If the difference of R500 was shown as a
benefit under machine A, then the fact that hiring machine B will actually
cause the firm to incur a net cash OUTFLOW if the coffeemaker was
launched (if only 1,000 units are ordered), is not apparent. This is important
in determining whether Machine A or B is preferable - can the company
afford to sustain the cash outflow that would occur if machine B were
accepted? (In this case the answer is hopefully yes, given that the outflow is
insignificant but in a situation involving larger numbers, the firm may choose
not to use the loss making alternative in an effort to reduce their risk. From
an exam technique perspective, you lose the opportunity to comment on this
in the discursive section, which has implications for the number of points you
are able to raise, and restrict yourself as regards the number of marks you
are able to score in the discursive part.

2. Other factors

2.1. In many cases students comments were not really relevant to the matter at
hand, e.g. a suggestion to purchase the machines rather than to hire them, or
comments on social responsibility and corporate governance.

2.2. Many students did not comment on the fact that there was a 50% probability
of a loss, albeit a small one, with machine B, and 100% probability of a profit
with machine A, or that that was significantly greater upside potential with
machine B.

Module: Risk and uncertainty Page 16

Managerial Accounting and Finance 334

Solution to part 2

Markers comments on part 2

In many cases students overlooked the aspect of what they would do if they had
“perfect information”. That is, that it would have assisted them in deciding which
machine to choose given different predictions of demand. Rather, they calculated
the values based only on one machine, despite in many cases having correctly
determined that machine A gave a better result at the 1000 unit demand level.

Module: Risk and uncertainty Page 17

Managerial Accounting and Finance 334

RU03 Nuvo Electronics (Pty) Ltd (UCT adapted) (42 marks)

Nuvo Electronics (Pty) Ltd (‘Nuvo’) manufactures electrical appliances (e.g. kettles, irons,
blenders, heaters etc.) suitable for both domestic use, and use in the hospitality industry.
The company’s products are sold to large retailers, who on-sell the products to the general
public.

Nuvo has noticed a slight decline in demand for its products in recent months, which the
company attributes to consumers purchasing gas appliances, in preference to electronic
appliances, given the uncertainty regarding power outages and increasing electricity tariffs.
Many consumers have purchased generators and inverter operated battery systems that
cannot power standard heating appliances, opting to use gas for cooking and boiling water
instead. The company believes it can increase sales, and win back it’s market, by
introducing appliances with low kilowatt consumption that are not only extremely energy-
efficient but can be run from the domestic size generator or battery bank. Consequently, the
company is considering launching a low-watt kettle, as kettles are considered to be one of
the most popular kitchen appliances.

If Nuvo were to launch the low-watt kettle, they believe that there is a 30% probability that
market acceptance would be low and that only 10,000 kettles would be sold to consumers, a
40% probability that market acceptance would be moderate and 20,000 kettles sold to
consumers, and a 30% probability that acceptance would be strong and 30,000 kettles
would be sold to consumers. Due to the nature of the distribution channel, long lead times
between production and eventual sale to consumers exist. This is necessary for Nuvo and
the retailers to contractually agree to the number of units of product that Nuvo will supply the
retailer with several months in advance, in order for the retailer to plan usage of shelf space.
Consequently, if Nuvo was to go ahead with this order they would produce the maximum
quantity (30,000 units) in order to test consumers’ response to the product, as the low-watt
kettles would have to be produced within the next 2 month period in order to time the sale of
low-watt kettles appropriately. Nuvo’s marketing team believes that the opportunity to
successfully launch a new product far outweighs the downside risk of not selling the full
quantity produced. Future production and sales would depend on consumer’s response to
the launch of the low-watt kettle.

Module: Risk and uncertainty Page 18

 Managerial Accounting and Finance 334

It has been suggested that the low-watt kettle be sold to the retailers at R240, which
represents cost plus a mark-up of 20% as per the costing below:

R’s

Material costs

- 1 heating element 1 35

- Plastic and other 2 35

Consumables and variable overheads 3 & 5 48

Labour 4 & 5 12

Other fixed manufacturing overheads3 & 5 70

Total Cost 200

20% mark up 40

Selling Price (to retailers) 6 240

1
Nuvo purchases elements from the sole national distributor in South Africa of an international
appliance component supplier, as these are regarded as being arguably the best quality
elements on the market. The heating element cost above of R35 represents the purchase
price of an element from the South African distributor. In terms of the licensing agreement
which exists between Nuvo, the international company and South African distributor, Nuvo
cannot purchase elements from any other supplier. The manufacturer already supplies
70,000 elements per month to Nuvo, and as a result of their own procurement constraints
and existing commitments to other parties, is only able to supply Nuvo with an additional
17,000 elements over the next two month period.

Nuvo has 2,000 of these elements in stock. These elements are used in the standard kettles
that the company produces (refer to the next page). One element is used per kettle. In
addition to using the element in the production of kettles, the company sells the element to
customers at R50 per element. Approximately 2,900 elements are sold to customers per
month. Customers would purchase these elements from competitors if Nuvo was out of
stock of these items.
2
The plastic and other materials to be used on the order are the same as those used in many
other products that Nuvo produces. The cost included in the calculation above reflects the
last invoice price at which these materials were purchased. Nuvo expects prices of these
materials to be 10% higher when they are next purchased due to inflation in the industry.
Nuvo has sufficient quantities of plastic and other materials on hand to produce 30,000 low-
watt kettles.
3
The company allocates consumables and overhead costs to its products on the basis of
machine hours. The company estimates that it will require 10 minutes of machine time per
low-watt kettle, and that production of the low-watt kettle will consume an equal amount of

Module: Risk and uncertainty Page 19

 Managerial Accounting and Finance 334

labour and machine time. The average machine time per kettle was determined by dividing
the total number of units of kettles to be produced by the total amount of machine time
required, including the time required to set up and clean the machinery (also refer note 5).
4
This labour cost applies to the permanent workforce (and is consequently regarded as a
fixed cost), and has been allocated based on labour hours per kettle (as per note 3 above).
5
Nuvo has determined that the company will have 4,000 spare machine hours over the next 2
month period, as well as 3,500 spare labour hours. Any shortfall in hours required to make
the minimum of 30,000 kettles can be sourced by reducing sales and production levels of
standard kettles. The company manufactures the standard kettle that sells at R275 (to
retailers, which represents a 30% mark up on cost) and earns a contribution margin of
R120.46 per unit. The standard kettle uses 7.5 minutes of machine time per kettle, and
requires only 1 hour of labour time for every 2 hours of machine time. Alternatively,
additional labour could be hired at R60 per hour.
6
The marketing manager has argued that his division should be allowed to carry out a market
survey in order to ascertain what level of market demand would be at the suggested price
level, in order to inform production levels. Nuvo has not carried out market surveys for the
last two years in order to save costs, as market surveys only produce reliable results where
extensive work is done, which is a very costly exercise. Nuvo had consequently taken the
policy decision that in the current economic environment where electronic appliances have
become more of a luxury product, than a necessity, for many consumers, and their profit
margin was under pressure due to decline in demand, that the company could not afford to
undertake market surveys, as they did not add sufficient value.

REQUIRED:

1. Calculate the financial impact of launching the low-watt kettle. (22 marks)

2. Calculate the maximum amount that Nuvo would be prepared to pay for a market survey
to be conducted, as suggested by the marketing manager. (10 marks)

3. Identify and discuss the considerations that should be taken into account in the decision
to launch the low-watt kettle. (10 marks plus 5 bonus marks*)

Note that an additional 5 bonus marks are available for particularly insightful, well argued
discussion.

Module: Risk and uncertainty Page 20

Managerial Accounting and Finance 334

RU03 SOLUTION

1.

Suggested Solution to Question 2

1. Marks
R's Workings
Expected Revenue 4,800,000 2

Material costs
- Elements 1,050,000 35 x 30,000 2
- Plastics and other 1,155,000 35 x 1.05 x 30,000 2

Consumables and variable overheads 1,440,000 48 x 30,000 1

Opportunity costs:
963,692 8,000 x 120.46 ( W2 ) or 1
Standard kettle sales W1 500 x 1,927.38
Lost element sales 45,000 W1 3,000 x (50-35) 1.5

Hire additional labour 60,000 1,000 x 60 1

Other fixed manufacturing overheads & existing labour -

force Not incremental 1
Relevant cost 86,308 1

Lack of internal consistency= -2.

W1 Constraints
Machine
Elements Hours Labour hours
Spare 19,000 4,000 3,500 1
Required -30,000 -5,000 -5,000 2
Short -11,000 -1,000 -1,500

From:
Std kettle sales 8,000 1,000 500 2.5
-3,000 0 -1,000 0.5
Element sales 3,000 1
Hire labour 1,000 1

W2 Cm/ std kettle

Contribution margin 120.46

per labour hour 1927.36 (120.46 x 60/3.75) 1.5

Cheaper to forego elements sales and hire labour (i.e. R15 + R60/6 = R25 per element obtained this way, than 3
reduce kettle sales further (R120.46 per element obtained in this way).
Total available 25
Additional marks availab le for justification and explanation.

Module: Risk and uncertainty Page 21

Managerial Accounting and Finance 334

2.

Relevant benefit at each possible demand level: 10,000 20,000 30,000 Expected value 1

Revenue (R240 x demand level) 2,400,000 4,800,000 7,200,000 1

Costs at each demand level
Variable costs (35 + 35x1.1 + 48) x10,000; x 20,000 - 1,215,000 - 2,430,000 - 4,886,308 (4,800,000 - 86,308) 3
Lost element sales at 20,000 units - 15,000 1

Finacial impact of each option 1,185,000 2,355,000 2,313,692

Probability 30% 40% 30% 1
Expected value of launch before paying for market survey 355,500 942,000 694,108 1,991,608 1
Expected value without the launch 86,308
Value of certainty as to the demand level 1,905,300 2

The opportunity costs (lost kettle sales and element sales) and additional hired labour will only be incurred if the final 10,000
units are produced, as spare capacity exceeds 2/3rds of the total machine and labour to produce 30,000 units of the low-watt
kettle. This is except for 1000 element sales that would be forgone if 20,000 kettles were produced - spare capacity was for
19,000 elements, 20,000 would be required. 3
Total available 13
Additional marks availab le for justification and explanation.

3.

Marks

 Without the survey, the expected outcome is only marginally positive, but 1
this is not an actual outcome.

 There is a 70 % probability that the launch of the kettle will have a positive 1
financial impact, if either 20,000 (Financial impact: R86,308) or 30,000 2
(Financial impact: R694,108) kettles are sold.

 If only 10,000 kettles are sold the company will incur a loss of –R2,313,692 2
(i.e. 86,308 – 4,800,000 + 2,400,000).

 However, Nuvo should not consider either changing the price as a result: 1
 The price suggested is based on a long term costing of the product –
i.e. it covers the fixed costs relating to the resources used, ignores 1
opportunity costs and provides a profit margin. This is appropriate in
order to provide an indication of product acceptance. A lower or 1
higher price would not be reflective of the price that the company
would charge in the long term, and consumers responses to a
different price would not provide a reasonable input into the decision
to continue with the product in the future, or not. Further, the price 1
that is set now will set a precedent for future sales.
 Alternatively, there may be an argument to set the price slightly 1
below the optimal long term price, in order to make it unattractive to
competitors to introduce competing low-watt kettles. Once Nuvo is 1
satisfied that they have sufficiently established their brand in the low-
watt market niche (and buying behaviour/brand loyalty is 1
established), they could slowly increase prices. The entry of
competitors at this point (now that better profit margins can be
achieved) will serve to reinforce the increased prices Nuvo now
charges. 1

Module: Risk and uncertainty Page 22

Managerial Accounting and Finance 334

 Nuvo should also not consider aborting the launch of the kettle as a result of 1
a 30% probability of incurring a loss, unless of course the company’s cash
flow situation is not sufficiently strong to sustain the loss. Even though there 1
is a 30% probability of a loss, all new products have a possibility of failing,
and the benefit of success over time, outweighs the cost of products that fail. 2
(The expected value, while not the actual outcome for a once off decision,
becomes the average outcome overtime, as similar projects are repeated, in
this case, launching new products).

 While the company should not consider aborting the launch of the kettle,
they should consider ways to improve the anticipated profitability of the 1
decision, and reduce cost and potential losses where possible.

 It is clear from part 2 that the launch has the possibility of contributing
1
generously to the company’s profit under any demand level, provided that
production is matched to demand. The cost of having to produce the
1
maximum quantity in full upfront, is high (R1,911,300 – part 2). Unless the
cost of undertaking a market survey exceeds this (unlike, surely?), the effect
of the company’s decision to not carry out market surveys would have been
to decrease the company’s profitability over the long term (unless other new 2
products did not carry similar probability profiles, and did not require the
maximum quantity to be manufactured in advance.)

 The market survey should be carried out, at a cost below R1,905,300. 1

 Is the cost allocation accurate for variable overheads and consumables? 1

The current financial benefit is marginal, and variable overheads account for
30% of the expected revenue figure. Further consideration should be given
as to whether allocating all overheads, including consumables, on a
proportional, volume based system (relative use of machine time) is correct, 1
and whether all costs behave in this manner. This would be unlikely. For
instance, consumables may be a batch level cost, if these relate to cleaning
of the machinery.

 The labour requirement per kettle may be able to be reduced in the future 1
(there is quite a significant discrepancy between the amount of labour time
required for a standard (16 kettles per hour) and low-watt (6 kettles per
hour) kettle. Why such a difference? Would the amount of labour time 1
reduce if larger quantities of the kettle were produced in the future? Does
the large amount of labour time currently estimated include an allowance for 1
the fact that staff are unfamiliar with the new product, and initial set up and
production might be unusually slow as a result? 1

Total available 30
Maximum available 12

Module: Risk and uncertainty Page 23

Managerial Accounting and Finance 334

Comments on RU03

Part 1

 Read the question! 2900 element sales per month may be dropped. Only the level of
sales is variable based on probabilities (expected sales of 20,000 units), 30,000 kettles
will be produced regardless.
 Treatment of the kettle elements is similar to that of the 'Saline solution' used for 'Chicken
pops' (relevant costing tutorial). You either needed to include purchase of all 30,000
elements as a cost and then use the contribution margin after the kettle element for sales
foregone (elements and standard kettle's) or you needed to follow the incremental
approach where 19,000 kettle's were reflected at replacement cost (R35), 3,000 at CM
forgone + the sunk element cost (R15 + R35) and 8,000 at the CM forgone + the sunk
element cost (R120.46 + R35)
 Consumables and variable overheads are incremental and therefore relevant.
 Do not double count! Standard kettles cut back must be reflected either under elements
or opportunity costs (to obtain machine and labour hours).
 Format of workings for constraints is very important for clarity of logic. Format marks were
included in this working (W1)
 State your assumptions and clearly indicate your thought pattern for decisions.
Outsourced labour was cheaper than further standard kettle cut-backs but you needed to
state that you had thought about this issue, calculated this and proven it as fact.

Part 2

 The value of perfect information is the difference between the expected value of a project
without the information vs. the expected value of a project with perfect information.
 The crux of this question was that, with perfect information, production will be variable
based on demand levels per the market survey. Associated production and opportunity
costs will thus vary accordingly.

Part 3

 Marks were awarded for application and insight. For example:

Sighting product cannibalisation as a potential problem is insufficient (generic) but
referring to the relatively cheaper sales price of the new low-watt kettle and the impact
this may have on standard kettle sales is both insightful and highly applicable.

Module: Risk and uncertainty Page 24

Managerial Accounting and Finance 334

RU04 Golf Haven Property Developers (35 Marks)

Golf Haven Property Developers (GH) has recently begun the development of a West Coast
Golf Estate. The foundations have been cast for the first luxury free-standing house, and the
brickwork has been built up to slab height, and the structure has been backfilled, compacted
and is now ready for the slab to be cast.

GH is currently trying to decide how much steel mesh should be put into the concrete slab.
The purpose of the mesh is to limit cracking. Cracking occurs over an 18 month period and
as a result the worst of the cracking will not be evident until after the house is completed and
sold. If the slab cracks, then repairs will be required, the cost of which is dependent on the
severity of the crack. If only minor cracking occurs, the repair costs are unlikely to exceed
R500. If the cracking is moderate, the costs of repair will amount to R4 000. However, if
major cracks develop, repair costs will probably amount to R15 000, as a substantial portion
of the travertine flooring would have to be replaced.

The degree to which the slab is likely to crack is dependent on two factors – the quality of
the sub-grade, and shrinkage.

The quality of the sub-grade refers to how well the sand has been compacted – i.e. the
degree and consistency of compaction. There is a 40% probability that the compaction is of
a mediocre quality, which will increase the extent to which the slab will crack, but a 60%
probability that the compaction will be of a high quality.

All concrete slabs exceeding 5.5m in length will crack due to shrinkage. Steel mesh is cast
into the slab in order to control this cracking and encourage a large number of minor cracks
to develop, rather than a few major cracks. The idea is to achieve a high probability of minor
cracks and a low probability of moderate and major cracks. Two different grades of mesh
could be used:

 Ref A193 mesh – this is a relatively light weight mesh built from steel bars that are
5.6mm in diameter. The quantity of mesh required for this house will cost R3 600.
 Ref A245 mesh – this is a heavier mesh constructed from steel bars that are 6.3mm in
diameter. The quantity of mesh required for this house will cost R9 200.

The probability of minor, moderate and major cracks developing (dependant on steel mesh
and sub-grade compaction), is as follows:

Compaction of High Quality Compaction of Mediocre Quality

Cracking type Ref A193 mesh Ref 245 mesh Ref A193 mesh Ref 245 mesh

Minor
50% 65% 5% 55%
Moderate
30% 25% 10% 30%
Major 20% 10% 85% 15%

GH needs to decide which reference mesh to put into the slab. It is possible to carry out a
compaction test on the sub-grade in order to establish the quality of the compaction – but
this will cost R1 000.

Module: Risk and uncertainty Page 25

Managerial Accounting and Finance 334

REQUIRED

1. Which reference mesh should be included in the slab? (20 marks)

2. Is carrying out the compaction test worthwhile? (8 marks)

3. GH is aware that it is possible to put a sufficient quantity of steel (roughly 0.5% of the
cross sectional area of the slab should be steel) into the slab in order to prevent major
cracks occurring (with almost 100% certainty). If this thicker mesh was used, there is a
5% probability of moderate cracks occurring given a high quality of compaction, and a
20% probability of moderate cracks occurring if the sub-grade quality is mediocre. What
is the maximum amount that GH should be willing to pay for this higher reference mesh?

(7 marks)

Module: Risk and uncertainty Page 26

Managerial Accounting and Finance 334

Solution to RU04 (Steel Mesh)

Expected
value for
each mesh Probability Expected
Repair Mesh Total cost of Probability for each of subgrade value for
1. cost + cost = each option x of crack = sub grade x quality = each mesh

50% Minor 500 3 600 4 100 50% 2 050

60% High Quality 30% Moderate 4 000 3 600 7 600 30% 2 280
20% Major 15 000 3 600 18 600 20% 3 720
A193 mesh used 8 050 x 60% = 4 830
(R3,600)
5% Minor 500 3 600 4 100 5% 205
40% Mediocre Quality 10% Moderate 4 000 3 600 7 600 10% 760
85% Major 15 000 3 600 18 600 85% 15 810
Decision 16 775 x 40% = 6 710
11 540

65% Minor 500 9 200 9 700 65% 6 305

60% High Quality 25% Moderate 4 000 9 200 13 200 25% 3 300
10% Major 15 000 9 200 24 200 10% 2 420
A245 mesh used 12 025 x 60% = 7 215
(R9,200)
55% Minor 500 9 200 9 700 55% 5 335
40% Mediocre Quality 30% Moderate 4 000 9 200 13 200 30% 3 960
15% Major 15 000 9 200 24 200 15% 3 630
12 925 x 40% = 5 170
12 385
Conclusion

Based on expected values, it would be cheaper to put the Ref A193 mesh in the slab.

However - expected values are limited in term of information content, and consideration should be given to the various scenarios themselves.
(A project could have a high EV due to a small probability of a very large positive outcome, despite a very large probability of a smaller negative outcome.)
Consideration should be given to the worst case scenario - major cracking.
There is a 46% (34% + 12%, i.e. (40% x 85%) + (60% x 20%)) probability of the worst case scenario happening if the A193 mesh is used. This is pretty high.
There is only a 12% ((10% x 60%) + (40% x 15%)) possiblility of major cracking occuring if the A245 mesh is used - a significant improvement.

Expected values do not represent an actual outcome if a project is once off. However, the EV does approximate the average actual outcome if the project is repeated several times.
In this case the project is going to be repeated many times as GH is a property developer, and is intending to build a number of houses.
This means that if the A193 is included, 46% of houses built will have major cracking.
The reputational damage from major cracking on a repeated basis (almost 50% of the house built develop major cracks!) could be severe.
But from a cost perspective it would be cheaper to use the A193 mesh in all houses built - the actually average cost per house would work out to be R11,774, as opposed to R12,385.

Module: Risk and uncertainty Page 27

Managerial Accounting and Finance 334

2.
Expected value without compaction test 11 540
less: Expected Value with compaction test (before paying for the test- see below) 10 000 w1
Maximum amount which could be paid for the compaction test 1 540

w1

There is a 60% probebility that the compaction test would come back with a "high" quality rating, and a 40% probability it would come back with a "mediocre" rating.

If a high rating was given, then we would choose to put the A193 mesh in the slab (the expected value achieved if the A193 mesh is used AND a high rating is achieved
is smaller than the expected cost of using the A245 mesh if a high rating was achieved). 8 050 < 12 025
If a mediocre rating was achieved, GH would rather put the A245 into the slab. 12 925 < 16 775

EV of EV of
each project
Calculation of Expected value option overall
High rating (60% probable) 8 050 60% 4 830
Mediocre rating (40% probable) 12 925 40% 5 170
10 000

Conclusion: The compaction test should be carried out as the cost of the test (R1,000) is less than the amount by which GH would expect to benefit from the results of the test (R1,540).

3.

95% Minor 500 ? 500 95% 475

60% High Quality 5% Moderate 4 000 ? 4 000 5% 200
0% Major 15 000 ? 15 000 0% -
"Super" mesh used 675 x 60% = 405
(cost = ?)
80% Minor 500 ? 500 80% 400
40% Mediocre Quality 20% Moderate 4 000 ? 4 000 20% 800
0% Major 15 000 ? 15 000 0% -
1 200 x 40% = 480
Note - total probabilities must always equal 100% - some cracking will always occur - thus: Cost before paying for steel mesh (i.e. EV of Repair Cost) = 885
0% probability of no cracking, and
0% probability of major cracking, and Maximum amount that would be spent if the A193 or A245 was purchased = 11 540
5% probability of moderate cracking, thus
95% (100% - 5%) probability of minor cracking Difference (Maximum amount that could be spent on "Super" Steel) = 10 655

Module: Risk and uncertainty Page 28

Managerial Accounting and Finance 334

RU05 Eastern Platinum Mine (40 Marks; 60 Minutes)

Eastern Platinum Mine is situated some 70 kilometers East of Kimberly and comprises an old mine
shaft (“Old Mine”) and a barren piece of land that is adjacent to the old mine and has not been mined
before. 150,000 tonnes of ore1 are extracted from the Old Mine per year.

Ore extracted from the old mine is transported to Eastern Platinum’s milling plant on a single conveyor
belt. The cost of operating this conveyer belt continuously is R10,000,000,000 per annum. All ore
mined is crushed at the milling plant and then transferred to the separation plant where the platinum
content is extracted from the crushed ore using a chemical solution. The leftover sludge is treated and
dumped at a cost of R 18,000,000 per year. This represents an unavoidable result of the mining
process.

Plans for a New Mine

The quality of the ore from the “Old Mine” is declining 2. Eastern Platinum consequently plans to sink a
new mine shaft (“New Mine”) in the barren land and expects to extract a higher quality ore than is
currently being mined from the Old Mine. The rate of production of the New Mine is dependent on the
quality of platinum deposits that are found. Since platinum deposits are getting scarcer the New Mine
shaft is expected to have to be at least 4 kilometers deep in order to reach platinum deposits that are
sufficiently concentrated in order for the New Mine to extract economically feasible quantities of
platinum. At this depth it is expected that only 20 000 tonnes of ore will be extracted per annum.

Ore from both the Old and New mines will be mixed and transported to the milling plant on the single
conveyor belt. The cost of operating the conveyer belt will be split between the two mines on the basis
of volumes of ore, for the purposes of determining the profitability of the two mines.

The upfront investment required to establish the new mine in 2013 is expected to amount to
R20,000,000,000. Consequently, Eastern Platinum has determined that based on the company’s
WACC, the New Mine will need to generate an annual cashflow of R5,000,000,000 per annum (before
tax) for the following 5 years, from 2014 – 2018 (inclusive), in order for the company to achieve a
breakeven NPV by the end of the fifth year of operation, i.e. 2018. (In terms of their risk management
policy the company will only accept new projects that are capable of breaking even within 5 years of
becoming operational. This is partly because mining related contracts are generally entered into for a
period of 5 years.)

Annual revenue and cost information for the New Mine follows:

The operations team compiled the following information related to ore quality for the new mine, based
on past experience and industry knowledge:

Probabilities relating to deposit quality in the “New Mine” at a depth of 4 kilometers:

Probability of yield quantity: Platinum content:

25% 0.3% platinum content*
45% 0.4% platinum content*
30% 0.9% platinum content*

* - “platinum content” refers to the % of ore which is made up of platinum.

In contrast, the “Old Mine” currently yields a platinum content of 0.15%.

Water: The depth of the “New Mine” shaft will be 4,000 meters and the shaft will have to be
continuously drained of water. 300,000,000 litres of water will have to be pumped out of the New Mine
shaft on a weekly basis. This water is of a very high quality and can be sold to Rand Water at R 5 per
kilolitre (1 kilolitre = 1,000 litres).

1
“Ore “means “rock containing platinum that is extracted from the mine”
2
Quality refers to the proportion of platinum contained in the ore. “Declining quality” consequently
means that the proportion of platinum content in the ore is declining.

Module: Risk and uncertainty Page 29

Managerial Accounting and Finance 334

Electricity: Electricity is used to maintain the mine shafts (24/7 lights and the water pumps), to extract
the ore (drilling) and to process the ore (milling). The mine’s finance department, based on historical
usage figures, estimated the following regression equation that describes electricity consumption in
Rand terms:

Electricity Cost = R 32,625,000 per kilometre + R 220,000 / tonne of ore.

Labour: Employees are either employed on a full-time basis and earn a salary or employed on a part-
time basis and earn a weekly wage. Wage earners work exclusively on extracting ore. In the previous
financial year a total of R 2,850,000,000 was spent on salaries and R 8,025,000,000 on wages.

Chemical solution: 1,400 litres of solution is needed to treat 1,000 tonnes of ore. The solution costs
R 99,830 per litre.

Depreciation: The “Old Mine” shaft is fully depreciated. Depreciation on the “New Mine” shaft is R
8,800,000 per year. The useful life of equipment used in the processing of the ore (drills and milling
machine) is based on the quantity of ore mined and is estimated to decline at a rate of R440 per tonne
of ore (1 tonne = 1,000 kgs).

Dumping Costs: The cost of treating and dumping the leftover sludge from the New Mine will amount
to R 23,000,000 per year.

Platinum price: The Economics Department of UWC was consulted on the likelihood of various
expected platinum prices for the next year and the results are:

Probability of platinum price: Rands per kilogram of platinum:

20% 150,000
40% 210,000
40% 280,000

Other information:

The mining license of the Eastern Platinum Mine was issued under the Apartheid South African
government and has not been changed into the new dispensation licence as required by law.

The mine has a very sketchy safety record.

Exploratory drilling:

Explore (Pty) Ltd is a company that specialises in exploratory virtual drilling using high-tech ultra
sound and X-ray equipment. They are able to determine with 100% certainty what the platinum
content of the ore of the “New Mine” will be at 4 kilometers. The quote for their services in this regard
amounts to R800,000,000.

Module: Risk and uncertainty Page 30

Managerial Accounting and Finance 334

REQUIRED

Note: Ignore inflation

Write a memo to the board of Eastern Areas in which you advise them as to their decision as to
whether to proceed with the introduction of the new mine, or not. Your memo should include the
following in support of the decision to be made:

1. A calculation of the expected annual cash flow that will be generated as a result of
operating the “New Mine”, from 2014 onwards.
(18 marks)

2. An identification and discussion of the risks and other factors that the company should
consider in deciding whether or not to proceed with the introduction of the “New Mine”.
Your discussion should include suitable interpretation of your calculation in (1) above.
(12 marks)

3. Critically analyse and discuss whether Eastern Platinum Mines should pay Explore (Pty)
Ltd to do the exploratory virtual drilling. Your analysis should include a calculation of the
maximum amount that Eastern Platinum Mines should be willing to pay for the virtual
drilling, presuming that the cost of the virtual drilling would be fully offset by the expected
benefit thereof within the first year.
(6 marks plus 2 bonus marks)

4. A calculation of the expected IRR before tax of the New Mine for the cashflows relating to
the period 2013 – 2018, assuming that the company does not choose to do the virtual
drilling (i.e. assuming the expected annual cashflow calculated in (1) above).
(4 bonus marks)

Note: in addition to the marks allocated above, 4 marks are allocated for clarity and logical
insight, as well as layout of solution.
(4 marks)

Module: Risk and uncertainty Page 31