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Pmt solution 131474 the table calculator and

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Unformatted text preview: PMT Solution 1314.74 The table, calculator, and spreadsheet values indicate that for the projects to be acceptable, they must have annual cash inflows of at least $1,315. Given this breakeven level of cash inflows, the risk of each project could be assessed by determining the probability that the project’s cash inflows will equal or exceed this breakeven level. The various statistical techniques that would determine that probability are covered in more advanced courses.1 For now, we can simply assume that such a statistical analysis results in the following: Probability of CFA Probability of CFB $1,315 → 100% $1,315 → 165% Because project A is certain (100% probability) to have a positive net present value, whereas there is only a 65% chance that project B will have a positive NPV, project A is less risky than project B. Of course, the expected level of annual cash inflow and NPV associated with each project must be evaluated in view of the firm’s risk preference before the preferred project is selected. The example clearly identifies risk as it is related to the chance that a project is acceptable, but it does not address the issue of cash flow variability. Even though project B has a greater chance of loss than project A, it might result in higher potential NPVs. Recall from Chapters 5 through 7 that it is the combination of risk and return that determines value. Similarly, the worth of a capital expenditure and its impact on the firm’s value must be viewed in light of both risk and return. The analyst must therefore consider the variability of cash inflows and NPVs to assess project risk and return fully. Sensitivity and Scenario Analysis Two approaches for dealing with project risk to capture the variability of cash inflows and NPVs are sensitivity analysis and scenario analysis. As noted in Chapter 5, sensitivity analysis is a behavioral approach that uses several possi- 1. Normal distributions are commonly used to develop the concept of the probability of success—that is, of a project having a po...
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