the projects will be repeated.
The following table summarizes the cash
flows, internal rate of return (IRR), and risk of each of the projects.
Year (t)
Project A
Project B
Project C
Project D
Project E
0
-$200,000
-$100,000
-$100,000
-$100,000
-$100,000
1
66,000
30,000
30,000
30,000
40,000
2
66,000
30,000
30,000
30,000
25,000
3
66,000
40,000
30,000
40,000
30,000
4
66,000
40,000
40,000
50,000
35,000
IRR
12.110%
14.038%
10.848%
16.636%
11.630%
Project
Risk
Below
Average
Below
Average
Average
Above Av-
erage
Above Av-
erage
Which projects will the firm select for investment?
a.
Projects:
A, B, C, D, E
b.
Projects:
B, C, D, E
c.
Projects:
B, D
d.
Projects:
A, D
e.
Projects:
B, C, D
Page 18
Chapter 13: Capital Budgeting: Cash Flows and Risk

(13.6) Scenario analysis
Answer: c
Diff: M
66
.
Klott Company encounters significant uncertainty with its sales volume
and price in its primary product. The firm uses scenario analysis in
order to determine an expected NPV, which it then uses in its budget.
The base case, best case, and worse case scenarios and probabilities
are provided in the table below. What is Klott's expected NPV, standard
deviation of NPV, and coefficient of variation of NPV?
Probability
Unit Sales
Sales
NPV
of Outcome
Volume
Price
(In Thousands)
Worst case
0.30
6,000
$3,600
-$6,000
Base case
0.50
10,000
4,200
+13,000
Best case
0.20
13,000
4,400
+28,000
a.
Expected NPV = $35,000;
σ
NPV
= 17,500; CV
NPV
= 2.00.
b.
Expected NPV = $35,000;
σ
NPV
= 11,667; CV
NPV
= 0.33.
c.
Expected NPV = $10,300;
σ
NPV
= 12,083; CV
NPV
= 1.17.
d.
Expected NPV = $13,900;
σ
NPV
=
8,476; CV
NPV
= 0.61.
e.
Expected NPV = $10,300;
σ
NPV
= 13,900; CV
NPV
= 1.35.
(13.8) Risk-adjusted NPV
Answer: a
Diff: M
67
.
Virus Stopper Inc., a supplier of computer safeguard systems, uses a
cost of capital of 12 percent to evaluate average-risk projects, and it
adds or subtracts 2 percentage points to evaluate projects of more or
less risk. Currently, two mutually exclusive projects are under consid-
eration. Both have a cost of $200,000 and will last 4 years. Project A,
a riskier-than-average project, will produce annual end of year cash
flows of $71,104. Project B, of less than average risk, will produce
cash flows of $146,411 at the end of Years 3 and 4 only. Virus Stopper
should accept
a.
B with a NPV of $10,001.
b.
Both A and B because both have NPVs greater than zero.
c.
B with a NPV of $8,042.
d.
A with a NPV of $7,177.
e.
A with a NPV of $15,968.
Chapter 13: Capital Budgeting: Cash Flows and Risk
Page 19

(13.8) Risk-adjusted NPV
Answer: c
Diff: M
68
.
Real Time Systems Inc. is considering the development of one of two mu-
tually exclusive new computer models. Each will require a net invest-
ment of $5,000. The cash flow figures for each project are shown below:
Period
Project A
Project B
1
$2,000
$3,000
2
2,500
2,600
3
2,250
2,900
Model B, which will use a new type of laser disk drive, is considered a
high-risk project, while Model A is of average risk. Real Time adds 2
percentage points to arrive at a risk-adjusted cost of capital when
evaluating a high-risk project. The cost of capital used for aver-
age-risk projects is 12 percent. Which of the following statements re-
garding the NPVs for Models A and B is most correct?
a.
NPV
A
= $380;
NPV
B
= $1,815.

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