Level of Difficulty 3 Learning Goal 4 Topic Risk Adjusted Discount Rate

Level of difficulty 3 learning goal 4 topic risk

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Level of Difficulty: 3 Learning Goal: 4 Topic: Risk-Adjusted Discount Rate (Equation 10.2 and Equation 10.5) 3. A firm is evaluating two mutually exclusive projects that have unequal lives. The firm must evaluate the projects using the annualized net present value approach and recommend which project they should select. The firm’s cost of capital has been determined to be 18 percent, and the projects have the following initial investments and cash flows: Project W Project Y Initial investment: $40,000 $58,000 Cash flows: 1 $20,000 $30,000 2 20,000 35,000 3 20,000 40,000 4 20,000 5 20,000
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Chapter 1 The Role and Environment of Managerial Finance 83 Answer: Project W: NPV $20,000(3.127) $40,000 $22,540 Project Y: $30,000(0.847) $25,410 35,000(0.718) 25,130 40,000(0.609) 24,360 $74,900 58,000 NPV $16,900 ANPV of Project W: $22,540/3.127 $7,208 ANPV of Project Y: $16,900/2.174 $7,774 Select Project Y, highest ANPV. Level of Difficulty: 4 Learning Goal: 5 Topic: Annualized Net Present Value (Equation 10.6) Nico Manufacturing is considering investment in one of two mutually exclusive projects X and Y which are described below. Nico Manufacturing’s overall cost of capital is 15 percent, the market return is 15 percent and the risk-free rate is 5 percent. Nico estimates that the beta for project X is 1.20 and the beta for project Y is 1.40. Table 10.6 Project X Project Y Initial Investment $3,500,000 $3,900,000 Year Cash Inflows (CF) 1 $1,500,000 $1,100,000 2 1,500,000 1,600,000 3 1,500,000 1,900,000 4 1,500,000 2,300,000 4. Calculate the risk-adjusted discount rates for project X and project Y. (See Table 10.6) Answer: k X 5% 1.20 (15% 5%) 17% k Y 5% 1.40 (15% 5%) 19% Level of Difficulty: 2 Learning Goal: 4 Topic: Risk-Adjusted Discount Rate (Equation 10.2 and Equation 10.5) 5. Using the risk-adjusted discount rate method of project evaluation, find the NPV for projects X and Y. Which project should Nico select using this method? (See Table 10.6)
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Chapter 1 The Role and Environment of Managerial Finance 84 Answer: Time Project X PVIF @ 17% PV of CFs 0 $(3,500,000) 1.0000 $(3,500,000) 1 1,500,000 0.8547 1,282,051 2 1,500,000 0.7305 1,095,770 3 1,500,000 0.6244 936,556 4 1,500,000 0.5337 800,475 NPV x $614,853 Time Project Y PVIF @ 19% PV of CFs 0 $(3,900,000) 1.0000 $(3,900,000) 1 1,100,000 0.8403 924,370 2 1,600,000 0.7062 1,129,864 3 1,900,000 0.5934 1,127,490 4 2,300,000 0.4987 1,146,938 NPV Y $428,662 Level of Difficulty: 2 Learning Goal: 4 Topic: Risk-Adjusted Discount Rate (Equation 10.2 and Equation 10.5) 6. Calculate the NPV of projects X and Y assuming that the firm did not employ the RADR method and instead used the firm’s overall cost of capital to evaluate projects X and Y. (See Table 10.6) Answer: Time Project X PVIF @ 16% PV of CFs 0 $(3,500,000) 1.0000 $(3,500,000) 1 1,500,000 0.8696 1,304,348 2 1,500,000 0.7561 1,134,216 3 1,500,000 0.6575 986,274 4 1,500,000 0.5718 857,630 NPV x $782,468 Time Project Y PVIF @ 15% PV of CFs 0 $(3,900,000) 1.0000 $(3,900,000) 1 1,100,000 0.8696 956,522 2 1,600,000 0.7561 1,209,830 3 1,900,000 0.6575 1,249,281 4 2,300,000 0.5718 1,315,032 NPV Y $830,665 The NPV of X is less than the NPV of Y using the firms overall cost of capital. Choose Project Y. Level of Difficulty: 2 Learning Goal: 4 Topic: Risk-Adjusted Discount Rate (Equation 10.2 and Equation 10.5)
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Chapter 1 The Role and Environment of Managerial Finance 85 7. What potential biases exist in project selection if Nico Manufacturing did not adjust for the difference in risk between projects X and Y (See Table 10.6). Answer: The danger of not accounting for differences in project risk is that the firm may potentially unacceptable high-risk projects (with negative NPVs) may be chosen over potentially acceptable low-risk projects (with positive NPVs).
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