Question

TB12 corp is considering a project that will cost $20 million initial investment. The company projects to have payoffs of $5 mil, $8 mil, $8 mil, $6 mil, $4 mil in years 1, 2, 3, 4 and 5 respectively. Due to COVID-19, there is a 10% chance that the company can get nothing back from their initial investment. The company current cost of capital is 10% p.a. compounded annually. Answer two questions below:

Question 12: What are the two methods that you can use to take into account the additional risk of 10%? Provide the project NPV for each method.

Question 13: Which method is preferred? Why?

Answer 1

12. The two methods that can be used here are as follows. In the first method, we can calculate the cash flows according to the probabilities. Hence, since we are expecting the given payoffs with a 90% probability and no return with a 10% probability, we can first calculate the PV of the given cash flows without accounting for the risk. Then after that we can use probability to find out the expected cash flows by using the formula: 0.9*PV + 0.1*0.

With this we will get the total NPV and we will discount it with the given 10% cost of capital. We do this method and find the PV. PV = 5/1.1 + 8/1.1^2 + 8/1.1^3 + 6/1.1^4 + 4/1.1^5 = 23.75. Now we find the probability adjusted value which will be 23.75*0.9 = 21.374. Hence NPV = 21.374 - 20 = 1.374 million.

The other method is by changing the cost of capital such that the risk associated with COVID-19 is inherent in the cost of capital. This will require some judgment on our part and it is slightly difficult to reach the exact value of cost of capital which doesn't have inherent assumptions in it.

13. The method associated with changing the cash flows is preferred over the method in which we change the cost of capital. This is because it is difficult to reach at one specific value of the cost of capital and while calculating the cash flows, we can simply use the probabilities provided to reach at the final NPV value.