ch13 Risk and Capital Budgeting- numerical excercise

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NorQuest College *

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Finance

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Jan 9, 2024

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Question #1 – Analyze Investment Risk Mary Beth Clothes is considering opening an additional suburban outlet. An after tax cash flow of $100 per day (expected value) is projected for each of the two locations being evaluated. Which of these sites would you select based on the distribution of these cash flows? (Use the coefficient of variation as your measure of risk.) Probability Cash Flows Probability Cash Flows Site A Site B probability Cash flow Probability Cash flow .20 50 .10 20 .30 100 .20 50 .30 110 .40 100 .20 135 .20 150 .10 180 Expected value 100 Expected value 100 Cash flow Expected value Deviation (D-D) Squared deviation (D-D) 2 probability 50 100 -50 2500 .20 500 100 100 0 0 .3 0 110 100 10 100 .30 30 135 100 35 1225 .2 245 775 775 under score= 27.8 Standard deviation =27.8 Coefficient of Variation(V)=27.8/100=.278 Site B Cash flow Expected value deviation Squared deviation Probability (P) product 20 100 -80 6400 .10 640 50 100 -50 2500 .20 500 100 100 0 0 0 0 150 100 50 2500 .20 500 180 100 80 6400 .10 640 2280 2280 square root= 47.75 Coefficient of Variation(V)=47.75/100=.4775 Which investment is preferred? Site A is the preferred site since it has the smallest coefficient of variation. Because both alternatives have the same expected value, the standard deviation alone would have been enough for a decision. Site A will be just as profitable as B but with less risk.

Question #1 – Analyze an Investment Cash Flows Silverado Mining Company is analyzing the purchase of two silver mines. Only one investment will be made. The Yukon mine will cost $2 million, The Yukon Mine will produce $400,000 per year in Years 5 through 15 and $800,000 per year in Years 16 through 25. The Labrador mine will cost $2.4 million and will produce $300,000 per year for the next 25 years. The cost of capital is 10 percent. a. Which investment should be made? b. If the Yukon mine justifies an extra 4 percent premium over the normal cost of capital because of its riskiness and relative uncertainty of flows, does the investment decision change? Investment 1 Cost=2,000,000 Cash flow year 5-15=400,000/year Cash flow year 16-25=800,000/year Investment 2 Cost=2,400,000 Cash flow=300,000/year Cost of capital=10 Pv of cash flow year 5-15 n=10,pmt-400,000, i=10 pv=? 2,457,827 pv of cash flow now = n=5, i=5, fv=2457827 pv=? 1,526,117 Pv of investment 1 year 16-25 n=10,pmt-800,000, i=10 pv=? 4,915,654 Pv of cash flow year 1-15 1,176,768 Present value of all the cash flows =(1,176,768+ 1,526,117= =2,702,885 Cast of capital =2,000,000 NPV =702,885 Pv of investment 2 year 2,723,112 Cost of capital 2400,000 NPV 323,112 Which investment should be made? Both projects have a positive NPV: therefore, both projects should be accepted. However, if the projects are mutually exclusive, then select the Yukon mine with the higher NPV.

If the Yukon project justifies an extra 5 percent premium over the normal cost of capital because of its riskiness and relative uncertainty of flows, does the investment decision change? Discount rate = 15% Pv of 5-15 years cash flow= 998086 Pv of 16-25 years cash flow=493423 Pv of cash flows=1,491,509 Cost of capital= 2,000,000 NPV Which investment should be made? Now the decision should be made to reject the purchase of the Yukon Mine and proceed with the Labrador mine. smelter. Question #1 – Analyze Investment Risk Western Dynamite Company is evaluating two methods of blowing up old buildings for commercial purposes over the next five years. Method one (implosion) is relatively low in risk for this business and will carry a 10 percent discount rate. Method two (explosion) is less expensive to perform but more dangerous and will call for a higher discount rate of 15 percent. Either method will require an initial capital outlay of $100,000. The inflows from projected business over the next five years are given below. Which method should be selected using net present value analysis? year Product1 Product 2 1 25,000 28,000 2 30,000 32,000 3 38,000 39,000 4 31,000 33,000 5 19,000 25,000

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