Question

A corporation is assessing the risk of two capital budgeting proposals. The financial analysts have developed pessimistic, most likely, and optimistic estimates of the annual cash inflows which are given in the following table. The firm’s cost of capital is 10 percent.

 

Project A

Initial Investment

$20,000

Annual Cash Inflow; Outcome

$5,000; Pessimistic

10,000; Most likely

15,000; Optimistic

 

Project B

Initial Investment

$100,000

Annual Cash Inflow; Outcome

$20,000; Pessimistic

40,000; Most likely

100,000; Optimistic

 

Questions:

The expected net present value of project A if the outcomes are equally probable and the project has five-year life is

A) -1045

B) 17910

C) 36865

D) 93730

Answer 1

The right option is (B).

 

Explanation:

Calculation of net present value of project A 

Initial outlay = $20,000

Annual cash flow       Outcome

$5,000                       Pessimistic

$10,000                     Most Likely

$15,000                     Optimistic

Chances of outcome is equally probable i.e, probability of each outcome is 0.3333

 

Expected cash flow(Annual) = 0.3333($5,000)+0.3333($10,000)+0.3333($15,000)

= $1,666.5 + $3,333 + $$4,999.5 = $9999 or $10000

Project life is 5 years

Cost of capital is 10%

Present value of cash flow for 5 years = $10,000(1/1+10%)1 + $10,000(1/1+10%)2 + $10,000(1/1+10%)3+ $10,000(1/1+10%)4 + $10,000(1/1+10%)5

= $9,091 + $8,264 + $,7513 + $6,830 +$6,209 = $37,907

 

Net Present value = Present value of cash flows - Initial outlay

                              = $37,907 - $20,000 

                              = $17,910 or $17,910 (Difference is due to decimals in calculation)

 

Hence, answer is B.

Hence, answer is B.