Understanding Financial Management: A Practical Guide
Problems and Answers
9.1 Types of Risk in Capital Budgeting
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:
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?
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.
$2,000,000 $500,000 $850,000
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
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