The Textile Manufacturing Company Ltd. is considering one of two mutually exclusive proposals, Projects M and N which require cash outlays of Rs. 8,50,000 and Rs. 8,25,000 respectively. The certainty-equivalent (C.E.) approach is used in incorporating risk in capital budgeting decisions. The current yield on government bonds is 6% and this is used as the risk-free rate. The expected net cash flows and their certainty equivalent are as follows: Year-ended Project M Project N Cash flow (Rs) Certainty equivalent Cash flow (Rs) Certainty equivalent 1 4,50,000 0.8 4,50,000 0.9 2 5,00,000 0.7 4,50,000 0.8 3 5,00,000 0.5 5,00,000 0.7 Present value factors of Rs.1 discounted at 6% at the end of year 1, 2 and 3 are 0.943, 0.890 respectively. Required: (i) Which project should be accepted? (ii) If risk adjusted discount rate method is used, which project would be appraised with a higher rate.
The Textile Manufacturing Company Ltd. is considering one of two mutually exclusive proposals, Projects M and N which require cash outlays of Rs. 8,50,000 and Rs. 8,25,000 respectively. The certainty-equivalent (C.E.) approach is used in incorporating risk in capital budgeting decisions. The current yield on government bonds is 6% and this is used as the risk-free rate.
The expected net cash flows and their certainty equivalent are as follows:
|
Year-ended |
Project M |
Project N |
||
|
Cash flow (Rs) |
Certainty equivalent |
Cash flow (Rs) |
Certainty equivalent |
|
|
1 |
4,50,000 |
0.8 |
4,50,000 |
0.9 |
|
2 |
5,00,000 |
0.7 |
4,50,000 |
0.8 |
|
3 |
5,00,000 |
0.5 |
5,00,000 |
0.7 |
Required:
(i) Which project should be accepted?
(ii) If risk adjusted discount rate method is used, which project would be appraised with a higher rate.
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