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Rushen Chahal

CHAPTER 11

**Capital Budgeting and Risk Analysis
**

CHAPTER ORIENTATION

The focus of this chapter will be on how to adjust for the riskiness of a given project or combination of projects.

CHAPTER OUTLINE

I. Risk and the investment decision A. Up to this point we have treated the expected cash flows resulting from an investment proposal as being known with perfect certainty. We will now introduce risk. The riskiness of an investment project is defined as the variability of its cash flows from the expected cash flow. In capital budgeting, a project can be looked at on three levels. 1. First, there is the project standing alone risk, which is a project’s risk ignoring the fact that much of this risk will be diversified away as the project is combined with the firm’s other projects and assets. Second, we have the project’s contribution-to-firm risk, which is the amount of risk that the project contributes to the firm as a whole; this measure considers the fact that some of the project’s risk will be diversified away as the project is combined with the firm’s other projects and assets, but ignores the effects of diversification of the firm’s shareholders. Finally, there is systematic risk, which is the risk of the project from the viewpoint of a well-diversified shareholder; this measure considers the fact that some of a project’s risk will be diversified away as the project is combined with the firm’s other projects, and, in addition, some of the remaining risk will be diversified away by shareholders as they combine this stock with other stocks in their portfolio.

B. II.

What measure of risk is relevant in capital budgeting? A.

2.

3.

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**Prof. Rushen Chahal
**

B. Because of bankruptcy costs and the practical difficulties involved in measuring a project’s level of systematic risk, we will give consideration to the project’s contribution-to-firm risk and the project’s systematic risk. The certainty equivalent approach involves a direct attempt to allow the decision maker to incorporate his or her utility function into the analysis. 1. In effect, a riskless set of cash flows is substituted for the original set of risky cash flows, between which the financial manager is indifferent. To simplify calculations, certainty equivalent coefficients (t's) are defined as the ratio of the certain outcome to the risky outcome between which the financial manager is indifferent. Mathematically, certainty equivalent coefficients can be defined as follows: αt 4. = certain cash flow t risky cash flow t

III.

Methods for incorporating risk into capital budgeting A.

2.

3.

The appropriate certainty equivalent coefficient is multiplied by the original cash flow (which is the risky cash flow) with this product being equal to the equivalent certain cash flow. Once risk is taken out of the cash flows, those cash flows are discounted back to present at the risk-free rate of interest and the project's net present value or profitability index is determined. If the internal rate of return is calculated, it is then compared with the risk-free rate of interest rather than the firm's required rate of return. Mathematically, the certainty equivalent approach can be summarized as follows: NPV where αt = =

5.

6. 7.

∑

t =1

n

α t FCFt - IO (1 + k rf ) t

the certainty equivalent coefficient for time period t the annual expected free cash flow in time period t the initial cash outlay the project's expected life the risk-free interest rate

FCFt = IO n krf = = =

35

**Prof. Rushen Chahal
**

B. The use of the risk-adjusted discount rate is based on the concept that investors demand higher returns for more risky projects. 1. If the risk associated with the investment is greater than the risk involved in a typical endeavor, then the discount rate is adjusted upward to compensate for this risk. The expected cash flows are then discounted back to present at the risk-adjusted discount rate. Then the normal capital budgeting criteria are applied, except in the case of the internal rate of return, in which case the hurdle rate to which the project's internal rate of return is compared now becomes the risk-adjusted discount rate. Expressed mathematically, the net present value using the riskadjusted discount rate becomes NPV where FCFt IO k* n IV. A. = = = = =

2.

3.

∑

t =1

n

FCFt - IO (1 + k*) t

the annual expected free cash flow in time period t the initial outlay the risk-adjusted discount rate the project's expected life

Methods for measuring a project's systematic risk Theoretically, we know that systematic risk is the "priced" risk, and thus, the risk that affects the stock's market price and thus the appropriate risk with which to be concerned. However, if there are bankruptcy costs (which are assumed away by the CAPM), if there are undiversified shareholders who are concerned with more than just systematic risk, if there are factors that affect a security's price beyond what the CAPM suggests, or if we are unable to confidently measure the project's systematic risk, then the project's individual risk carries relevance. Moreover, in general, a project's individual risk is highly correlated with the project's systematic risk, making it a reasonable proxy to use. In spite of problems in confidently measuring an individual firm's level of systematic risk, if the project appears to be a typical one for the firm, then using the CAPM to determine the appropriate risk return tradeoffs and then judging the project against them may be a warranted approach. If the project is not a typical project, we are without historical data and must either estimate the beta using accounting data or use the pure-play method for estimating beta. 1. Using historical accounting data to substitute for historical price data in estimating systematic risk: To estimate a project's beta using accounting data we need only run a time series regression of the

B.

C.

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**Prof. Rushen Chahal
**

division's return on assets on the market index. The regression coefficient from this equation would be the project's accounting beta and serves as an approximation for the project's true beta. 2. The pure play method for estimating a project's beta: The pure play method attempts to find a publicly traded firm in the same industry as the capital-budgeting project. Once the proxy or pure-play firm is identified, its systematic risk is determined and then used as a proxy for the project's systematic risk.

V.

Additional approaches for dealing with risk in capital budgeting A. A simulation imitates the performance of the project being evaluated by randomly selecting observations from each of the distributions that affect the outcome of the project, combining those observations to determine the final output of the project, and continuing with this process until a representative record of the project's probable outcome is assembled. 1. The firm's management then examines the resultant probability distribution, and if management considers enough of the distribution lies above the normal cutoff criterion, it will accept the project. The use of a simulation approach to analyze investment proposals offers two major advantages: a. The financial managers are able to examine and base their decisions on the whole range of possible outcomes rather than just point estimates. They can undertake subsequent sensitivity analysis of the project.

2.

b. B.

A probability tree is a graphical exposition of the sequence of possible outcomes; it presents the decision maker with a schematic representation of the problem in which all possible outcomes are graphically displayed. Many times, especially with the introduction of a new product, the cash flows experienced in early years affect the size of the cash flows experienced in later years. This is called time dependence of cash flows, and it has the effect of increasing the riskiness of the project over time.

VI.

Other sources and measures of risk A.

**ANSWERS TO END-OF-CHAPTER QUESTIONS
**

11-1. The payback period method is frequently used as a rough risk screening device to eliminate projects whose returns do not materialize until later years. In this way, the earliest returns are emphasized, which in all likelihood have less uncertainty surrounding them.

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**Prof. Rushen Chahal
**

11-2. The use of the risk-adjusted discount rate assumes that risk increases over time. When using the risk-adjusted discount rate method, we are adjusting downward the value of future cash flows that occur later in the future more severely than earlier ones. This assumption can be justified because flows that are expected further out in the future are more difficult to forecast and less certain than are flows that are expected in the near future.

11-3. The primary difference between the certainty equivalent approach and the riskadjusted discount rate approach is where the adjustment for risk is incorporated into the calculations. The certainty equivalent approach penalizes or adjusts downwards the value of the expected annual free cash flows, while the risk-adjusted discount rate leaves the cash flows at their expected value and adjusts the required rate of return, k, upwards to compensate for added risk. In either case the net present value of the project is being adjusted downwards to compensate for additional risk. An additional difference between these methods is that the risk-adjusted discount rate assumes that risk increases over time and that cash flows occurring later in the future should be more severely penalized. The certainty equivalent method, on the other hand, allows each cash flow to be treated individually. 11-4. A probability tree is a graphical exposition of the sequence of possible outcomes, presenting the decision maker with a schematic representation of the problem in which all possible outcomes are graphically displayed. Moreover, the computations and results of the computations are shown directly on the tree, so that the information can be easily understood. Thus the probability tree allows the manager to quickly visualize the possible future events, their probabilities, and outcomes. In addition, the calculation of the expected internal rate of return and enumeration of the distribution should aid the financial manager in his decision-making process. 11-5. The idea behind simulation is to imitate the performance of the project being evaluated. This is done by randomly selecting observations from each of the distributions that affect the outcome of the project, combining each of those observations and determining the final outcome of the project, and continuing with this process until a representative record of the project's probable outcome is assembled. In effect, the output from a simulation is a probability distribution of net present values or internal rates of return for the project. The decision maker then bases his decision on the full range of possible outcomes. 11-6. The time dependence of cash flows refers to the fact that, many times, cash flows in later periods are dependent upon the cash flows experienced in earlier periods. For example, if a new product is introduced and the initial public reaction is poor, resulting in low initial cash flows, then cash flows in future periods are likely to be low also. Examples include the introduction of any new products, for example, the Edsel on the negative side, and hopefully this book on the positive side.

38

**Prof. Rushen Chahal
**

SOLUTIONS TO END-OF-CHAPTER PROBLEMS

Solutions to Problem Set A

11-1A. (a) A =

∑

i =1

n

Xi P(Xi)

= $4,000 (0.15) + $5,000 (0.70) + $6,000 (0.15) = $600 + $3,500 + $900 = $5,000

B

= $2,000 (0.15) + $6,000 (0.70) + $10,000 (0.15) = $300 + $4,200 + $1,500 = $6,000

(b)

NPV NPVA

=

∑

t =1

n

FCFt - I0 (1 + k*) t

= $5,000 (3.605) - $10,000 = $18,025 - $10,000 = $8,025

NPVB

= $6,000 (3.352) - $10,000 = $20,112 - $10,000 = $10,112

(c)

One might also consider the potential diversification effect associated with these projects. If the project's cash flow patterns are cyclically divergent from those of the company, the overall risk of the company may be significantly reduced.

39

**Prof. Rushen Chahal
**

11-2A. (a) A =

∑

i =1

n

Xi P(Xi)

= $35,000 (0.10) + $40,000 (0.40) + $45,000 (0.40) + $50,000 (0.10) = $3,500 + $16,000 + $18,000 + $5,000 = $42,500 = $10,000 (0.10) + $30,000 (0.20) + $45,000 (0.40) + $60,000 (0.20) + $80,000 (0.10) = $1,000 + $6,000 + $18,000 + $12,000 + $8,000 = $45,000

B

(b)

NPV NPVA

=

∑

t =1

n

FCFt - IO (1 + k*) t

= $42,500 (3.605) - $100,000 = $153,212.50 - $100,000 = $53,212.50

NPVB

= $45,000 (3.517) - $100,000 = $158,265 - $100,000

(c)

= $58,265 One might also consider the potential diversification effect associated with these projects. If the project's cash flow patterns are cyclically divergent from those of the company, the overall risk of the company may be significantly reduced.

11-3A. Project A: (A) Year 0 1 2 3 4 Expected Cash Flow -$1,000,000 500,000 700,000 600,000 500,000 (B) αt 1.00 .95 .90 .80 .70 (A x B) Present Value (Expected Factor at Present Cash Flow ) × (αt) 5% Value -$1,000,000 1.000 -$1,000,000 475,000 .952 452,200 630,000 .907 571,410 480,000 .864 414,720 350,000 .823 288,050 NPVA = $ 726,380

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**Prof. Rushen Chahal
**

Project B: (A) Year 0 1 2 3 4 Expected Cash Flow -$1,000,000 500,000 600,000 700,000 800,000 (B) αt 1.00 .90 .70 .60 .50 (A x B) Present Value (Expected Factor at Present Cash Flow ) × (αt) 5% Value -$1,000,000 1.000 -$1,000,000 450,000 .952 428,400 420,000 .907 380,940 420,000 .864 362,880 400,000 .823 329,200 NPVB = $ 501,420

Thus, project A should be selected, as it has a higher NPV. 11-4A. (A) Year 0 1 2 3 4 5 Expected Cash Flow -$90,000 25,000 30,000 30,000 25,000 20,000 (B) αt 1.00 0.95 0.90 0.83 0.75 0.65 (A x B) Present Value (Expected Factor at Present Cash Flow ) × (αt) 7% Value -$90,000 1.000 -$90,000 23,750 .935 22,206 27,000 .873 23,571 24,900 .816 20,318 18,750 .763 14,306 13,000 .713 9,269 NPV = $ -330

**Thus, this project should not be accepted because it has a negative NPV. 11-5A. NPVA =
**

n

∑

t =1

FCFt - I0 (1 + k*) t + $90,000(.636) + $130,000(.567) - $250,000

= $30,000 (.893) + $40,000(.797) + $50,000(.712) = $26,790 + $31,880 + $35,600 + $57,240 + $73,710 - $250,000 = - $24,780 NPVB =

n

∑

t =1

FCF - I0 (1 + k*) t

= $135,000(3.127) - $400,000 = $422,145 - $400,000 = $22,145 41

**Prof. Rushen Chahal
**

11-6A. Project A: (A) Year 0 1 2 3 4 Expected Cash Flow -$ 50,000 15,000 15,000 15,000 45,000 Project B: (A) Year 0 1 2 3 4 Expected Cash Flow -$ 50,000 20,000 25,000 25,000 30,000 (B) αt 1.00 .90 .85 .80 .75 (A x B) (Expected Cash Flow ) × (αt) -$ 50,000 18,000 21,250 20,000 22,500 Present Value Factor at Present 6% Value 1.000 -$ 50,000.00 .943 16,974.00 .890 18,912.50 .840 16,800.00 .792 17,820.00 NPVB = $ 20,506.50 (B) αt 1.00 .95 .85 .80 .70 (A x B) (Expected Cash Flow ) × (αt) -$ 50,000 14,250 12,750 12,000 31,500 Present Value Factor at Present 6% Value 1.000 -$ 50,000.00 .943 13,437.75 .890 11,347.50 .840 10,080.00 .792 24,948.00 NPVA = $ 9,813.25

Thus project B should be selected, as it has a higher NPV

42

Internal Rate of Return for 0 Year

11-7A. (a – c)

1 Year

p = 0.3 p = 0.6 $700,000 P = 0.1

2 Years $300,000 $700,000 $1,100,000

Joint each Branch -12.95% 10.92% 29.25% 3.15% 19.60% 33.33% 45.36% 23.74% 37.77% 46.08%

Probability 0.18 0.36 0.06 0.06 0.15 0.06 0.03 0.01 0.05 0.04 1.00

(A)(B) -2.33% 3.93% 1.76% 0.19% 2.94% 2.00% 1.36% 0.24% 1.89% 1.84%

p = 0.6 p = 0.2 p = 0.5 p = 0.3 - $1,200,000 $850,000 p = 0.2

**$400,000 $700,000 $1,000,000
**

p = 0.1

299

p = 0.1 p = 0.1

**$1,300,000 $600,000
**

p = 0.5

$900,000 $1,100,000

$1,000,000 p = 0.4

**Prof. Rushen Chahal
**

Expected internal rate of return d. The range of possible IRR’s from –12.95% to 46.08% = 13.82%

2

of Return for 0 Year

1 Year

2 Years

p = 0.5 p = 0.5 $200,000

3 Years $230,000

Internal Rate Joint each Branch 130.25%

11-8A. (a – c)

Probability 0.09

(A)(B) 11.72%

$180,000

124.68%

0.09

11.22%

p = 0.3 p = 0.5 p = 0.5 p = 0.5 $175,000 p = 0.6 $100,000 p = 0.2 p = 0.5 $-100,000 p = 0.5 $150,000 p = 0.4 p = 0.6 $10,000 $10,000 p = 1.0 p = 0.4 $0 p = 1.0

$205,000

121.09%

0.15

18.16%

$155,000

114.96%

0.15

17.24%

300

d.

$180,000

111.30%

0.06

6.68%

$130,000

104.46%

0.06

6.27%]

$10,000

-42.44%

0.24

-10.19%

$0

-90.00%

0.16

-14.40% 46.70%

1.00 Expected internal rate of return =

The range of possible IRR’s from –90.00% to 130.25%.

**Prof. Rushen Chahal
**

SOLUTIONS TO INTEGRATIVE PROBLEM

1. First there is the project standing alone risk, which is a project's risk ignoring the fact that much of this risk will be diversified away as the project is combined with the firm's other projects and assets. Second, we have the project's contribution-to-firm risk, which is the amount of risk that the project contributes to the firm as a whole; this measure considers the fact that some of the project's risk will be diversified away as the project is combined with the firm's other projects and assets, but ignores the effects of diversification of the firm's shareholders. Finally, there is systematic risk, which is the risk of the project from the viewpoint of a well diversified shareholder; this measure considers the fact that some of a project's risk will be diversified away as the project is combined with the firm's other projects, and, in addition, some of the remaining risk will be diversified away by the shareholders as they combine this stock with other stocks in their portfolio. According to the CAPM, systematic risk is the only relevant risk for capital budgeting purposes; however, reality complicates this somewhat. In many instances a firm will have undiversified shareholders; for them the relevant measure of risk is the project's contribution to firm risk. The possibility of bankruptcy also affects our view of what measure of risk is relevant. Because the project's contribution to firm risk can affect the possibility of bankruptcy, this may be an appropriate measure of risk since there are costs associated with bankruptcy. The primary difference between the certainty equivalent approach and the riskadjusted discount rate approach is where the adjustment for risk is incorporated into the calculations. The certainty equivalent approach penalizes or adjusts downwards the value of the expected annual free cash flows, while the risk-adjusted discount rate leaves the cash flows at their expected value and adjusts the required rate of return, k, upwards to compensate for added risk. In either case the net present value of the project is being adjusted downwards to compensate for additional risk. An additional difference between these methods is that the risk-adjusted discount rate assumes that risk increases over time and that cash flows occurring later in the future should be more severely penalized. The certainty equivalent method, on the other hand, allows each cash flow to be treated individually. A probability tree is a graphical exposition of the sequence of possible outcomes, presenting the decision maker with a schematic representation of the problem in which all possible outcomes are graphically displayed. Moreover, the computations and results of the computations are shown directly on the tree, so that the information can be easily understood. Thus the probability tree allows the manager to quickly visualize the possible future events, their probabilities, and outcomes. In addition, the calculation of the expected internal rate of return and enumeration of the distribution should aid the financial manager in his decision-making process. The idea behind simulation is to imitate the performance of the project being evaluated. This is done by randomly selecting observations from each of the distributions that affect the outcome of the project, combining each of those

2.

3.

4.

5.

40

**Prof. Rushen Chahal
**

observations and determining the final outcome of the project, and continuing with this process until a representative record of the project's probable outcome is assembled. In effect, the output from a simulation is a probability distribution of net present values or internal rates of return for the project. The decision maker then bases his decision on the full range of possible outcomes. 6. Sensitivity analysis involves determining how the distribution of possible net present values or internal rates of return for a particular project is affected by a change in one particular input variable. This is done by changing the value of one input variable while holding all other input variables constant. The time dependence of cash flows refers to the fact that, many times, cash flows in later periods are dependent upon the cash flows experienced in earlier periods. For example, if a new product is introduced and the initial public reaction is poor, resulting in low initial cash flows, then cash flows in future periods are likely to be low also. Examples include the introduction of any new products, for example, the Edsel on the negative side, and hopefully this book on the positive side. Project A: (A) Year 0 1 2 3 4 Project B: (A) Expected YearCash Flow -$200,000 50,000 60,000 60,000 50,000 (B) αt 1.00 .95 .85 .80 .75 (A x B) (Expected Cash Flow ) × (αt) -$200,000 47,500 51,000 48,000 37,500 Present Value Factor at Present 7% Value 1.000 -$200,000 .935 44,413 .873 44,523 .816 39,168 .763 28,613 NPVB = - $ 43,283 Expected Cash Flow -$150,000 40,000 40,000 40,000 100,000 (B) αt 1.00 .90 .85 .80 .70 (A x B) (Expected Cash Flow ) × (αt) -$150,000 36,000 34,000 32,000 70,000 Present Value Factor at 7% Present Value

7.

8.

1.000 -$150,000 .935 33,660 .873 29,682 .816 26,112 .763 53,410 NPVA = - $ 7,136

0 1 2 3 4

Thus, neither project should be selected, as they both have negative NPVs.

41

Internal Rate of Return for 0 Year

Part 9

1 Year

p = 0.3

**2 Years $200,000
**

p = 0.7

Joint each Branch -12.08%

Probability 0.12

(A)(B) -1.45%

$300,000 p = 0.4 p = 0.2 p = 0.5 p = 0.3 $350,000

$300,000

0.00%

0.28

0.00%

$250,000

0.00%

0.08

0.00%

p = 0.4 -$600,000

$450,000

20.55%

0.20

4.11%

298

$650,000

p = 0.2

37.26%

0.12

4.47%

p = 0.2

$300,000

17.54%

0.04

0.70%

$500,000

p =0.5

36.19%

0.10

3.62%

p = 0.2 $450,000 p = 0.1

$700,000

51.84%

0.04

2.07%

$1,000,000

71.94%

0.02 1.00

1.44%

**Prof. Rushen Chahal
**

Expected internal rate of return The range of possible IRR’s from -12.08% to 71.94%. = 14.96%

43

**Prof. Rushen Chahal
**

Solutions to Problem Set B

11-1B. (a) X XA = = = = XB = = = (b) NPV =

∑

i =1

n

Xi P(Xi)

$5,000 (0.20) + $6,000 (0.60) + $7,000 (0.20) $1,000 + $3,600 + $1,400 $6,000 $3,000 (0.20) + $7,000 (0.60) + $11,000 (0.20) $600 + $4,200 + $2,200 $7,000

∑

t =1

n

FCFt - I0 (1 + k*) t

NPVA = = = NPVB = = = (c)

$6,000 (3.517) - $10,000 $21,102 - $10,000 $11,102 $7,000 (3.127) - $10,000 $21,889 - $10,000 $11,889

One might also consider the potential diversification effect associated with these projects. If the project's cash flow patterns are cyclically divergent from those of the company, the overall risk of the company may be significantly reduced.

44

**Prof. Rushen Chahal
**

11-2B. (a) X XA = =

∑

i =1

n

Xi P(Xi)

$40,000 (0.10) + $45,000 (0.40) + $50,000 (0.40) + $55,000 (0.10)

= = XB =

$4,000 + $18,000 + $20,000 + $5,500 $47,500 $20,000 (0.10) + $40,000 (0.20) + $55,000 (0.40) + $70,000 (0.20) + $90,000 (0.10)

= = (b) NPV =

$2,000 + $8,000 + $22,000 + $14,000 + $9,000 $55,000

∑

t =1

n

FCFt - I0 (1 + k*) t

NPVA = = = NPVB = = = (c)

$47,500 (3.696) - $125,000 $175,560 - $125,000 $50,560 $55,000 (3.517) - $125,000 $193,435 - $125,000 $68,435

One might also consider the potential diversification effect associated with these projects. If the project's cash flow patterns are cyclically divergent from those of the company, the overall risk of the company may be significantly reduced.

45

**Prof. Rushen Chahal
**

11-3B. Project A: (A) Year 0 1 2 3 4 Expected Cash Flow -$100,000 600,000 750,000 600,000 550,000 (B) αt 1.00 .90 .90 .75 .65 (A x B) (Expected Cash Flow ) × (αt) -$100,000 540,000 675,000 450,000 357,500 Present Value Factor at Present 5% Value 1.000 -$100,000 .952 514,080 .907 612,225 .864 388,800 .823 294,222.50 NPVA = $ 1,709,327.50

Project B: (A) Year 0 1 2 3 4 Expected Cash Flow -$100,000 600,000 650,000 700,000 750,000 (B) αt 1.00 .95 .75 .60 .60 (A x B) (Expected Cash Flow ) × (αt) -$100,000 570,000 487,500 420,000 450,000 Present Value Factor at Present 5% Value 1.000 -$100,000 .952 542,640 .907 442,162.50 .864 362,880 .823 370,350 NPVB = $1,618,032.50

Thus, project A should be selected, as it has a higher NPV. 11-4B. (A) (B) Expected Cash Flow -$100,000 30,000 25,000 30,000 20,000 25,000 (A x B) αt 1.00 0.95 0.90 0.83 0.75 0.65 Present Value (Expected Factor at Present .( αt) Cash Flow ) × 8% Value -$100,000 1.000 -$100,000 28,500 .926 26,391 22,500 .857 19,283 24,900 .794 19,771 15,000 .735 11,025 16,250 .681 11,066 NPV = -$ 12,464

Year 0 1 2 3 4 5

Thus, this project should not be accepted because it has a negative NPV.

46

**Prof. Rushen Chahal
**

11-5B. NPVA = = = = NPVB = = = = 11-6B. Project A: (A) Year 0 1 2 3 4 Project B: (A) Year 0 1 2 3 4 Expected Cash Flow -$ 75,000 25,000 30,000 30,000 25,000 (B) αt 1.00 .95 .85 .80 .75 (A x B) (Expected Cash Flow ) x (αt) -$ 75,000 23,750 25,500 24,000 18,750 Factor at 7% Present Value Present Value Expected Cash Flow -$ 75,000 20,000 20,000 15,000 50,000 (B) αt 1.00 .95 .85 .80 .70 (A x B) (Expected Cash Flow ) x (αt) -$ 75,000 19,000 17,000 12,000 35,000 Present Value Factor at Present 7% Value 1.000 -$ 75,000.00 .935 17,765.00 .873 14,841.00 .816 9,792.00 .763 26,705.00 NPVA = ($ 5,897.00)

∑

t =1

n

FCFt - IO (1 + k*) t + $80,000(.613) + $120,000(.543) - $300,000

$30,000 (.885) + $40,000(.783) + $50,000(.693) $26,550 + $31,320 + $34,650 + $49,040 + $65,160 - $300,000 - $93,280

n

∑

t =1

FCF - IO (1 + k*) t

$130,000(3.127) - $450,000 $406,510 - $450,000 -$43,490

1.000 -$ 75,000.00 .935 22,206.25 .873 22,261.50 .816 19,584.00 .763 14,306.25 NPVB = $ 3,358.00

47

**Prof. Rushen Chahal
**

Thus project B should be selected, as it has a higher NPV.

48

of Return for 0 Year

1 Year

p = 0.1 p = 0.5 $750,000 p = 0.4

2 Years $300,000 $700,000 $1,100,000 $400,000 $700,000

Internal Rate Joint each Branch -15.12% 7.69% 25.25% 0.00% 15.75%

11-7B. (a – c)

Probability 0.06 0.30 0.24 0.06 0.15

(A)(B) -0.9072% 2.3070% 6.0600% 0.0000% 2.3625%

p = 0.6 p = 0.2 p = 0.3 $900,000 p = 0.1 p = 0.5 p = 0.2

303

-$1,300,000

$900,000 $1,300,000

24.73% 40.44% 46.82% 58.94% 66.27%

0.06 0.03 0.03 0.06

1.4838%] 1.2132% 1.4046% 3.5364% 0.6627% = 18.1230%

p = 0.1

p = 0.3 p = 0.6 $1,500,000 p = 0.1

$600,000 $900,000 $1,100,000

0.01 1.00 Expected internal rate of return

**Prof. Rushen Chahal
**

(d) The range of possible IRR’s from -15.12% to 66.27

50

of Return for 0 Year

1 Year

2 Years

p = 0.5 p = 0.5 $225,000

3 Years $255,000

Internal Rate Joint each Branch 115.83%

11-8B. (a – c)

Probability .105

(A)(B) 12.16227%

$205,000

110.76%

.105

11.6298%

p = 0.3 p = 0.5 p = 0.5 p = 0.7 $100,000 -$120,000 $140,000 p = 0.3 p = 0.6 $10,000 $10,000 p = 1.0 p = 0.4 $0 p = 1.0 $180,000 p = 0.2 p = 0.5 p = 0.5

$210,000

101.15%

.175

17.7013%

$160,000

95.18%

.175

16.6565%

304

(d)

$170,000

p = 0.5

86.57%

.070

6.0599%

$120,000

79.42%

.070

5.5594%

$10,000

-46.70%

.180

-8.4060%

$0

-91.67%

.120 1.00 =

-11.0004% 50.3627%

Expected internal rate of return The range of possible IRR’s from –91.67% to 115.83%

Prof. Rushen Chahal

MADE IN THE U. S. A., DUMPED IN BRAZIL, AFRICA, . . . (Ethics in Capital Budgeting) OBJECTIVE: To force the student to recognize the role ethical behavior plays in all areas of Finance. Easy

DEGREE OF DIFFICULTY: Case Solution:

With ethics cases there are no right or wrong answers - just opinions. Try to bring out as many opinions as possible without being judgmental. In this case the question centers around what to do when a product is no longer salable.

49

- Exam 1
- Chapter 10 IM 10th Ed
- chapter 2
- Financial Management Chapter 11 answer
- Bussiness Finance McQs
- Cost
- After a While - Veronica A. Shoffstall
- Multiple Choices Questions
- VOUCHER ENSOGO.pdf
- מסקנות הוועדה לבחינת המדיניות הפיסקאלית בנושא משאבי נפט וגז בישראל - נספח ד - חוות דעת פרופ' רוברט פינדייק
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- Important Points to Remember for PMP Exam[1]
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- POF_Week_5_SB
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- PROIECT INGINERIE
- TB_ch07
- Slm Unit 09 Mbf201
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- Important Points to Remember for PMP Exam

- Team Building and Teamwork Slideshow (Final)
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- Financial Management Chapter 16 IM 10th Ed
- Theories of Learning
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- Final Question Paper- Question Bank - Production and Operations Management -MBA 025
- MBA HR 03 - Leadership Questions
- Training Need Analysis
- MBA HR 01 - Personal Training Growth and Developement - MTU
- Financial Management Chapter 01 IM 10th Ed
- Financial Management Chapter 06 IM 10th Ed
- Financial Management Chapter 02 IM 10th Ed
- Financial Management Chapter 07 IM 10th Ed
- Financial Management Chapter 05 IM 10th Ed
- Financial Management - Super Project Questions
- Financial Management Chapter 03 IM 10th Ed
- Financial Management - Sun Micro Systems Questions
- Financial Management Chapter 04 IM 10th Ed
- Financial Management Chapter 12 IM 10th Ed
- Financial Management Chapter 08 IM 10th Ed
- Financial Management Chapter 13 IM 10th Ed
- Financial Management Chapter 09 IM 10th Ed
- Financial Management Chapter 10 IM 10th Ed

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