Question

Two possible improvements are under consideration for AIRBN. One is the addition of a new bar , something that the BIG apartment has long needed and that clients analysis suggests would fill a need i. If the bar succeeds, it could produce significant profits for the apartment. If the client´s analysis is wrong, the new bar addition  will be profitable, but not significantly so. The second improvement is a new, high-efficiency stove that should provide large fuel cost savings over the life of the stove. Both of these options cost the same, approximately $100,000. The NPV for the lounge is $25,000, using conservative assumptions, whereas the NPV on the boiler is $22,500.Based purely on NPV, the bar is clearly the way to go. But does a risk analysis change this calculus? Which is the more risky of the two ventures, and why?

Based purely on NPV, the bar is clearly the way to go. But does a risk analysis change this calculus? Which is the more risky of the two ventures?

Answer 1

The Bar is the more risky investment of the two alternatives as it may or may not be successful, whereas the stove is likely to remain so,

The question here arises as to what was the discount rate used to find the NPV of the two ventures. If a higher discount rate was applied to the bar venture (appropriate to its risk), then risk has been accounted for and one should go with the higher NPV option (bar)

If the same discount rate is applied for evaluating NPV of both ventures , one must recalculate the NPV using appropriate discount rates and then choose the correct option