ch13 Risk and Capital Budgeting- numerical excercise
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Question #1 – Analyze Investment Risk Mary Beth Clothes is considering opening an additional suburban
outlet. An after tax cash flow of $100 per day (expected value) is projected for each of the two locations
being evaluated. Which of these sites would you select based on the distribution of these cash flows?
(Use the coefficient of variation as your measure of risk.)
Probability Cash Flows Probability Cash Flows
Site A
Site B
probability
Cash flow
Probability
Cash flow
.20
50
.10
20
.30
100
.20
50
.30
110
.40
100
.20
135
.20
150
.10
180
Expected value
100
Expected value
100
Cash
flow
Expected
value
Deviation
(D-D)
Squared
deviation
(D-D)
2
probability
50
100
-50
2500
.20
500
100
100
0
0
.3
0
110
100
10
100
.30
30
135
100
35
1225
.2
245
775
775
under score=
27.8
Standard deviation =27.8
Coefficient of Variation(V)=27.8/100=.278
Site B
Cash flow
Expected
value
deviation
Squared
deviation
Probability
(P)
product
20
100
-80
6400
.10
640
50
100
-50
2500
.20
500
100
100
0
0
0
0
150
100
50
2500
.20
500
180
100
80
6400
.10
640
2280
2280 square root= 47.75
Coefficient of Variation(V)=47.75/100=.4775
Which investment is preferred?
Site A is the preferred site since it has the smallest coefficient of variation. Because both alternatives
have the same expected value, the standard deviation alone would have been enough for a decision. Site
A will be just as profitable as B but with less risk.
Question #1 – Analyze an Investment Cash Flows
Silverado Mining Company is analyzing the purchase of two silver mines. Only one investment will be
made. The Yukon mine will cost $2 million, The Yukon Mine will produce $400,000 per year in Years 5
through 15 and $800,000 per year in Years 16 through 25. The Labrador mine will cost $2.4 million and
will produce $300,000 per year for the next 25 years. The cost of capital is 10 percent. a. Which
investment should be made? b. If the Yukon mine justifies an extra 4 percent premium over the normal
cost of capital because of its riskiness and relative uncertainty of flows, does the investment decision
change?
Investment 1
Cost=2,000,000
Cash flow year 5-15=400,000/year
Cash flow year 16-25=800,000/year
Investment 2
Cost=2,400,000
Cash flow=300,000/year
Cost of capital=10
Pv of cash flow year 5-15
n=10,pmt-400,000, i=10 pv=?
2,457,827
pv of cash flow now
= n=5, i=5, fv=2457827 pv=?
1,526,117
Pv of investment 1 year 16-25
n=10,pmt-800,000, i=10 pv=?
4,915,654
Pv of cash flow year 1-15
1,176,768
Present value of all the cash flows =(1,176,768+
1,526,117= =2,702,885
Cast of capital
=2,000,000
NPV
=702,885
Pv of investment 2 year
2,723,112
Cost of capital
2400,000
NPV
323,112
Which investment should be made? Both projects have a positive NPV: therefore, both projects should
be accepted. However, if the projects are mutually exclusive, then select the Yukon mine with the higher
NPV.
If the Yukon project justifies an extra 5 percent premium over the normal cost of capital because of its
riskiness and relative uncertainty of flows, does the investment decision change?
Discount rate = 15%
Pv of 5-15 years cash flow= 998086
Pv of 16-25 years cash flow=493423
Pv of cash flows=1,491,509
Cost of capital=
2,000,000
NPV
Which investment should be made? Now the decision should be made to reject the
purchase of the Yukon Mine and proceed with the Labrador mine. smelter.
Question #1 – Analyze Investment Risk Western Dynamite Company is evaluating two methods of
blowing up old buildings for commercial purposes over the next five years. Method one (implosion) is
relatively low in risk for this business and will carry a 10 percent discount rate. Method two (explosion) is
less expensive to perform but more dangerous and will call for a higher discount rate of 15 percent.
Either method will require an initial capital outlay of $100,000. The inflows from projected business over
the next five years are given below. Which method should be selected using net present value analysis?
year
Product1
Product 2
1
25,000
28,000
2
30,000
32,000
3
38,000
39,000
4
31,000
33,000
5
19,000
25,000
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