Question

Your division is considering two inverstment projects, each of which required an upfront expenditure of $25million. You estimate that the cost of capital is 10 percent and that the investments will produce the following after-tax cash flows (in millions of dollars). I the firms WACC is 10 percent, and it uses a 2 percentage point (plus or minus) risk premium, and if project A is deemed riskier than usual project, what would its risk adjusted NPV be?

Year Project A project B

1 5 20

2 10 10

3 15 8

4 20 6

Answer 1

Cost of investment for Project A will be 10 + 2 i.e 12% while cost of capital shall be normal WACC of 10%.

To find the NPV we reduce the capital outlay from discounted future cash flows.

i.e NPV = PVCI - Capital Outlay

Discount Factor for each year = 1/(1+R)^N

i.e for year 1 = 1/(1+12%)^1 = 0.8929

The Project B is a better option than project A ,as effective NPV of Project B is higher than Project A.