Question

Basic scenario analysis   Prime Paints is in the process of evaluating two mutually exclusive additions to its processing capacity. The​ firm's financial analysts have developed​pessimistic, most​ likely, and optimistic estimates of the annual cash inflows associated with each project. These estimates are shown in the following table.

	Project A	Project B
Initial investment ​(CF 0CF0​)	​$12,800	​$12,800
Outcome	Annual cash inflows ​(CFCF ​)
Pessimistic	​$860	​$1,530
Most likely	1,680	1,680
Optimistic	2,500	1,780

a. Determine the range of annual cash inflows for each of the two projects.

b. Assume that the​ firm's cost of capital is 10.4% and that both projects have 17​-year

lives. Construct a table showing the NPVs for each project for each of the possible outcomes. Include the range of NPVs for each project.

c. Do parts ​(a​) and ​(b​)

provide consistent views of the two​ projects? Explain

d. Which project do you​ recommend? Why?

Answer 1

Ans a) Range of annual cash inflows for each of the two projects.

Range is the difference between highest and lowest value in the data set.

Project A – Range of Project A

Highest – Lowest = 2500 – 860 = 1640

Project Lifetime Range = 1640 * 17 (No of Years) = 27880

Project B – Range of Project B

Highest – Lowest = 1780 – 1530 = 250

Project Lifetime Range = 250 * 17 (No of Years) = 4250

Ans b) NPV and Range of NPV

Cost of Capital = 10.4%

Number of Years = 17Years

As cash flow amount is consistent for 17 years in both the period and in every scenario so we can use Present Value of Annuity formula to calculate present value and net present value.

Net Present Value = Cash Flow * (1- ((1+r)^-n) / r) – Initial Investment

Project A – Initial Cost = 12800

Pessimistic = ((860*(1- ((1+0.104)^-17)) /0.104) – 12800) = - 6,068.89

Most likely = ((1680*(1- ((1+0.104)^-17)) /0.104) – 12800) = 349.14

Optimistic = ((2500*(1- ((1+0.104)^-17)) /0.104) – 12800) = 6767.18

Project A NPV Range = 6767.18 – (-6068.89) = 12836.07

Project B – Initial Cost = 12800

Pessimistic = ((1530*(1- ((1+0.104)^-17)) /0.104) – 12800) = -433.54

Most likely = ((1680*(1- ((1+0.104)^-17)) /0.104) – 12800) = 349.14

Optimistic = ((1780*(1- ((1+0.104)^-17)) /0.104) – 12800) = 1131.83

Project B NPV Range = 1131.83-(-433.54) = 1565.37

Ans c) Project A with high range of both Cash Flow and NPV is more volatile than Project B. We can see clear difference in Pessimistic and Optimistic situation where Project A is highly volatile in case of free cash flow however Project B is more stable, whereas both have same cash flow in most likely scenario. So Project B is considered to be more safe.

Ans d) I would recommend Project B as even if project experience Pessimistic situation our losses are very restricted where as Project A can be a big loss making deal in Pessimistic situation. Project B is less risky than Project A.

Hope this helps . Thanks !! Feel free to share your views.