CH09Problems - Understanding Financial Management: A...

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1 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 Single-Project Risk 3. Primus Corporation operates in a fast-growing 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 5-year 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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2 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 5-year 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 base-case scenario. Under the best-case scenario, there is a 20% chance that the new product will have higher sales
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CH09Problems - Understanding Financial Management: A...

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