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Case 12: Risk Analysis

Foods, Inc., is a leading grocery retailer in the greater Washington,


D.C. metropolitan area. The company is currently engaged in an aggressive
store refurbishing program and is contemplating expansion of its in-store
delicatessen department. A number of investment alternatives are being
considered including the construction of facilities for a new restaurant-quality
carryout service for Chinese food. This investment project is to be evaluated
using the certainty equivalent adjustment factor method and the risk-
adjusted discount rate method. If the project has a positive value when both
methods are employed, the project will be undertaken. The project will not
be undertaken if either evaluation method suggests that the investment will
fail to increase the value of the firm. Expected cash flow after tax (CFAT)
values over the five-year life of the investment project and relevant certainty
equivalent adjustment factor information are as follows:

Hot Food Carryout Counter

Investment Project

Time Period Project E


Alpha
(Years) (CFAT)
0 1.00 ($75,000)
1 0.95 22,500
2 0.90 25,000
3 0.85 27,500
4 0.75 30,000
5 0.70 32,500
Total $62,500

At the present time, an 8% annual rate of return can be obtained on


short-term U.S. government securities; the company uses this rate as an
estimate of the risk-free rate of return.

A. Use the 8% risk-free rate to calculate the present value of the investment
project.
B. Using this present value as a basis, utilize the certainty equivalent
adjustment factor information given previously to determine the risk-
adjusted present value of the project.
C. Use an alternative risk-adjusted discount rate method of project valuation
on the assumption that a 15% rate of return is appropriate in light of the
level of risk undertaken.
D. Compare and contrast your answers to Parts B and C. Should the
investment be made?