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Understanding Financial Management: A Practical Guide
Problems and Answers
Chapter 9
Risk Analysis
9.1 Types of Risk in Capital Budgeting
1.
Schweser Inc. is evaluating a new project. Based on experience, industry data, and
economic indicators, a financial manager has estimated the project’s possible returns and
associated probabilities as follows:
Return ($)
10,000,000
0
5,000,000
12,000,000
25,000,000
Probability (%)
10
20
40
20
10
A. What is the expected return of the project?
B. What is the standard deviation of the return?
C. What is the coefficient of variation?
2.
An analyst at Sinergo Inc. was asked to evaluate three project proposals. Based on
symmetrical return distributions for each project, the analysts calculated the following
expected values and standard deviations.
Project
A
B
C
Expected value
$2,000,000 $500,000 $850,000
Standard deviation
720,111
462,106
603,462
A. Which of these projects has the lowest absolute or total risk?
B. Which of these projects has the lowest relative risk?
9.2 Assessing SingleProject Risk
3.
Primus Corporation operates in a fastgrowing market. Management is considering buying
new equipment, which would increase the firm’s operational capacity and efficiency. The
new equipment is expected to increase the firm’s annual operating revenues by
$1,200,000, while increasing annual operating costs, excluding depreciation, by $600,000
for each of the next six years. Net working capital is expected to increase by $50,000 in
year 0 and to be recovered at the end of year 6. The depreciable basis of the new
equipment is $1,500,000. The new equipment belongs in the 5year MACRS property
class and has an expected salvage value of $100,000 at the end of year 6. The firm’s
marginal tax rate is 40%. Management is uncertain about its cost of capital for this normal
risk expansion project. Although the most likely estimate is 15.0%, management believes
the firm’s cost of capital could be as low as 13.5% or as high as 16.5%. What effect do
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these assumptions involving the cost of capital have on the NPV and the decision
involving the purchase of the new equipment?
4.
An analyst at Orbit Company identified four key input variables to a project and developed
the following NPVs.
Net Present Value
Change from
Most Likely Value
Operating
Revenues
Operating
Costs
Discount
Rate
Salvage
Value
10%
$142,442
$192,595
$185,819
$159,452
Most Likely
165,000
165,000
165,000
165,000
10%
188,274
138,689
144,266
170,235
A. What is the NPV percentage change from the most likely scenario for each input
variable?
B. For what input variable is the NPV most sensitive to changes?
5.
Gymtech Corporation is evaluating a new product line. Over its 5year life, company
analysts expect that the project will generate annual operating revenues of $12 million with
operating cost at 40% of revenues. Analysts call this the basecase scenario. Under the
bestcase scenario, there is a 20% chance that the new product will have higher sales
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 Spring '08
 POPE
 Net Present Value, analyst

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