Question

1. Brandt Enterprises is considering a new project that has an estimated cost of $900,000 and cash inflows of $286,000 each year in next 5 years. The project’s WACC is 8%. After estimating the cash flows of the project, the CFO conducted a scenario analysis and found the CV (coefficient of variation) of the project’s NPV is 3.8

1. Given that the CV of an average project of the company is in the range of 1.0 to 2.0, how will you interpret the result of the scenario analysis?
2. If the CFO uses a subjective adjustment of 3% in the discount rate to differentiate projects with various risk levels, what will be the risk-adjusted NPV? What do you conclude from the calculation?

Answer 1

A

The coefficient of variation (CV) is a statistical measure of the dispersion of data points in a data series around the mean. The coefficient of variation represents the ratio of the standard deviation to the mean, and it is a useful statistic for comparing the degree of variation from one data series to another, even if the means are drastically different from one another.

The coefficient of variation shows the extent of variability of data in a sample in relation to the mean of the population. In finance, the coefficient of variation allows investors to determine how much volatility, or risk, is assumed in comparison to the amount of return expected from investments.

The coefficient of variation is helpful when using the risk/reward ratio to select investments. For example, an investor who is risk-averse may want to consider assets with a historically low degree of volatility and a high degree of return, in relation to the overall market or its industry. Conversely, risk-seeking investors may look to invest in assets with a historically high degree of volatility.

Based on the approximate figures given in the problem, Brandt Enterprises is risky as their CV is comparatively higher than the average industry CV.

B)

Risk Adjusted NPV

The theoretical structure of a risk-adjusted NPV calculation is of a probability tree, which details all likely scenarios and the ensuing cash flows, as well as the probability of each likely scenario occurring. Incorporating probability into a cash flow estimate is relatively simple.

Risk Adjusted Discount Rate = 8% - (8% x 3%)

= 7.76 %

Risk Adjusted NPV

PV of Outflows - PV of Inflows

= $900,000 x 1 - ($286,000 x 4.018)

= $249,148