Unformatted text preview: es of return using CAPM Centennial Catering, Inc., is considering two mutually exclusive investments. The company wishes to use a riskadjusted rate of return in its analysis. Centennial’s cost of capital (similar to the
market return in CAPM) is 12%, and the current riskfree rate of return is 7%.
Cash flows associated with the two projects are as follows:
Project X Project Y $70,000 $78,000 Initial investment (CF0)
Year (t) Cash inflows (CFt) 1 $30,000 $22,000 2 30,000 32,000 3 30,000 38,000 4 30,000 46,000 a. Use a riskadjusted rate of return approach to calculate the net present
value of each project, given that Project X has a RADR factor of 1.20 and
Project Y has a RADR factor of 1.40. The RADR factors are similar to
project betas. (Use Equation 10.5 to calculate the required project return
for each.)
b. Discuss your findings in part a, and recommend the preferred project.
LG4 10–10 Risk classes and RADR Moses Manufacturing is attempting to select the best
of three mutually exclusive projects, X, Y, and Z. Though all the projects have
5year lives, they possess differing degrees of risk. Project X is in class V, the
highestrisk class; project Y is in class II, the belowaveragerisk class; and project Z is in class III, the averagerisk class. The basic cash flow data for each
project and the risk classes and riskadjusted discount rates (RADRs) used by the
firm are shown in the following tables.
Project X
Initial investment (CF0) Project Y Project Z $180,000 $235,000 $310,000 Year (t) Cash inflows (CFt) 1 $80,000 $50,000 $90,000 2 70,000 60,000 90,000 3 60,000 70,000 90,000 4 60,000 80,000 90,000 5 60,000 90,000 90,000 458 PART 3 LongTerm Investment Decisions Risk Classes and RADRs
Risk Class
I
II Description Riskadjusted
discount rate (RADR) Lowest risk 10% Belowaverage risk 13 III Average risk 15 IV Aboveaverage risk 19 Highest risk 22 V a. Find the riskadjusted NPV for each project.
b. Which project, if any, would you recommend that the firm
undertake?
LG5 10–11 Unequal lives—ANPV approach Eva...
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 Fall '13
 Finance, Net Present Value, NPVs

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