Question

Sheila Goodman recently received her MBA from the Harvard Business School. She has joined the family business, Goodman Software Products Inc., as Vice-President of Finance. She believes in adjusting projects for risk. Her father is somewhat skeptical but agrees to go along with her. Her approach is somewhat different than the risk-adjusted discount rate approach, but achieves the same objective. She suggests that the inflows for each year of a project be adjusted downward for lack of certainty and then be discounted back at a risk-free rate. The theory is that the adjustment penalty makes the inflows the equivalent of riskless inflows, and therefore a risk-free rate is justified.

A table showing the possible coefficient of variation for an inflow and the associated adjustment factor is shown next:
  

Coefficient of Variation			Adjustment Factor
0	−	0.25		0.90
0.26	−	0.50		0.80
0.51	−	0.75		0.70
0.76	−	1.00		0.60
1.01	−	1.25		0.50

Assume a $125,000 project provides the following inflows with the associated coefficients of variation for each year.
  

Year	Inflow		Coefficient of Variation
1	$	38,700			0.15
2		51,200			0.23
3		78,200			0.48
4		58,900			0.75
5		66,500			1.05

  
Use Appendix B for an approximate answer but calculate your final answer using the formula and financial calculator methods.

a. Fill in the table below: (Do not round intermediate calculations. Round "Adjustment Factor" answers to 2 decimal places and other answers to the nearest whole dollar.)
  

  
b-1. If the risk-free rate is 6 percent, compute the net present value of the adjusted inflows. (Negative amount should be indicated by a minus sign. Do not round intermediate calculations and round your answer to 2 decimal places.)
  

Answer 1

Answer:

a.
Year	Inflow	Coefficient of variation	Adjustment factor	Adjusted inflow (Inflow*Adjustment factor)
1	$38,700	0.15	0.9	$34,830
2	$51,200	0.23	0.9	$46,080
3	$78,200	0.48	0.8	$62,560
4	$58,900	0.75	0.7	$41,230
5	$66,500	1.05	0.5	$33,250
Explanation: Look for coefficient of variation in the coefficient of variation and adjustment factor table given and find the adjustment factor based on the range of coefficient of variation
b-1
Year	Adjusted inflow	Discount factor @ 6%	Present value
1	34830	0.94340	$32,858.49
2	46080	0.89000	$41,011.04
3	62560	0.83962	$52,526.58
4	41230	0.79209	$32,658.02
5	33250	0.74726	$24,846.33
		Present value of cash inflows	$183,900.46
		Less: Present value of cash outflows	-$125,000.00
		Net Present value	$58,900.46
.

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