Question

2. The MB Company is considering investment in one of the following mutually exclusive projects. Cash inflows of foreseeable next 4 year are given below:

Cash inflows ($000)

Probability Project K Project L

0.15 4,250 4,250

0.20 4,750 5,250

0.30 5,250 6,250

0.20 5,750 7,250

0.15 6,250 8,250

2.a. Calculate the expected cash inflow and standard deviation of both project.

2.b. Which project has the greater risk, in terms of variation of coefficient and what other factors should be considered for selecting one of the mutually exclusive projects?

Answer 1

Expected Cash inflows

Expected cash inflows=Sum(probability*cash inflows)

Project K=0.15*4250+0.20*4750+0.30*5250+0.20*5750+0.15*6250=5250.00

Project L=0.15*4250+0.20*5250+0.30*6250+0.20*7250+0.15*8250=6250.00

Standard deviation

Standard deviation=Sqrt(Sum(probability*(cash inflows-expected cash inflows)^2))

Project K=sqrt(0.15*(4250-5250.00)^2+0.20*(4750-5250.00)^2+0.30*(5250-5250.00)^2+0.20*(5750-5250.00)^2+0.15*(6250-5250.00)^2)=632.46

Project L=sqrt(0.15*(4250-6250.00)^2+0.20*(5250-6250.00)^2+0.30*(6250-6250.00)^2+0.20*(7250-6250.00)^2+0.15*(8250-6250.00)^2)=1264.91

Coefficient of variation=Standard deviation/Expected cash inflows

Coefficient of variation

Project K=632.46/5250.00=0.12

Project L=1264.91/6250.00=0.20

Higher coefficient of variation means higher risk hence Project L is more risky

Factors to be considered is the initial investment and therefore NPV (using risk adjusted discounted rate)