Question

Mike is searching for a project for his companyy to invest in. He is interested in Hi-Tech Smart Watch Project. He has been impressed with the product and believes Hi-Tech Smart Watch is an innovative product. However, Mike realizes that any time you consider a project, risk is a major concern. The rule he follows is to only invest in projects with a coefficient of variation of returns below 0.90. Mike has obtained the following NPV information and associated probabilities for Hi-Tech project. Calculate (1) the expected NPV (2) the standard deviation of NPV and (3) the coefficient variation. (4) Finally, should Mike invest in Hi-Tech? Scenario Probability NPV Best Case 30% $278,940 Base Case 30% $88,010 Worst Case 40% -48527

Answer 1

1) Expected NPV

Expected NPV = Probability_Best x NPV_Best + Probability_Base x NPV_Base + Probability_Worst x NPV_Worst

or, Expected NPV = (30% x $278,940) + (30% x $88,010) + (40% x -$48,527) = $90,674.20

2) Standard Deviation

or $135,595.44

3) Coefficient of Variation (CV)

CV = Standard Deviation / Expected Return = $135,595.436706 / $90,674.20 = 1.4954136 or 1.50

4) Decision

Mike should not invest in Hi-Tech as the coefficient of variation of the product is higher than the acceptable coefficient of variation of 0.90.