Question

Risky Cash Flows The Bartram-Pulley Company (BPC) must decide between two mutually exclusive investment projects. Each project costs $7,250 and has an expected life of 3 years. Annual net cash flows from each project begin 1 year after the initial investment is made and have the following probability distributions: Project A Project B Probability Cash Flows Probability Cash Flows 0.2 $7,000 0.2 $        0   0.6 6,750 0.6 6,750 0.2 8,000 0.2 20,000 BPC has decided to evaluate the riskier project at a 13% rate and the less risky project at a 8% rate. What is the expected value of the annual cash flows from each project? Do not round intermediate calculations. Round your answers to the nearest dollar. Project A Project B Net cash flow $ $ What is the coefficient of variation (CV)? (Hint: σB=$6,522 and CVB=$0.81.) Do not round intermediate calculations. Round σ values to the nearest cent and CV values to two decimal places. σ CV Project A $ Project B $ What is the risk-adjusted NPV of each project? Do not round intermediate calculations. Round your answers to the nearest cent. Project A $ Project B $ If it were known that Project B is negatively correlated with other cash flows of the firm whereas Project A is positively correlated, how would this affect the decision? This would tend to reinforce the decision to -Select-acceptrejectItem 9 Project B. If Project B's cash flows were negatively correlated with gross domestic product (GDP), would that influence your assessment of its risk? -Select-YesNoItem 10

Answer 1

The answers are as under :

Project "A"

Expected value of annual cash inflow

= (0.2 * 7000) = 1400

(0.6 * 6750) = 4050

(0.2 * 8000)= 1600

---------

Total 7050

To calculate Present Value of annal cash flow, we need to multiply ACF by present value interest factor for an annuity (PVIFA) @ 8% for 3 years.

Important Note: Project A is less risky than Project B because Project B has high variation in cash flows, whereas Project A has less variation in cash flows.}

Present value of cash inflows = 7050 * PVIFA8%,3years

= $ 7050 * 2.577 = $ 18168

Therefore : NPV = Present value of total cash inflows - Initial cost of project

= 18168 - 7250 = $ 10918

Project "B"

Expected value of annual cash inflow

= (0.2 * 0) = 0

(0.6 * 6750) = 4050

(0.2 * 20000) = 4000

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Total 8050

To calculate Present Value of annal cash flow, we need to multiply ACF by present value interest factor for an annuity (PVIFA) @ 13% for 3 years.

Present value of cash inflows = 8050 * PVIFA 13%,3years

= $ 8050 * 2.3611 = $ 19007

Therefore : NPV = Present value of total cash inflows - Initial cost of project

= 19007 - 7250 = $ 11757

(a) Project - A

Mean = (1400+4050+1600)/3 = 2346.66

Std. deviation : = 1469.87

Therefore : Co-efficient of variation (CV) = Std Dev / Mean

  1469.87 / 2346.66 = 0.6263

Project - B

Mean = (0+4050+4999)/3 = 2680

Std. deviation : = 2321

Therefore : Co-efficient of variation (CV) = Std Dev / Mean

  2321 / 2680 = 0.8660

(b) risk-adjusted NPV of each project

PROJECT - A = $ 10918

PROJECT - B = $ 19007

(c) If project B is negetively correlated be known to us, it represent less risky, hence we must accept PROJECT B -------------------- Ans is Accept

It is to be noted that, if negatively correlated it would indicate that it is profitable , therefore, PROJECT B is to be accepted ----------- Ans is Yest