Sheila Goodman recently received her MBA from the Harvard
Business School. She has joined the family business, Goodman
Software Products Inc., as Vice-President of Finance. She believes
in adjusting projects for risk. Her father is somewhat skeptical
but agrees to go along with her. Her approach is somewhat different
than the risk-adjusted discount rate approach, but achieves the
same objective. She suggests that the inflows for each year of a
project be adjusted downward for lack of certainty and then be
discounted back at a risk-free rate. The theory is that the
adjustment penalty makes the inflows the equivalent of riskless
inflows, and therefore a risk-free rate is justified.
A table showing the possible coefficient of variation for an
inflow and the associated adjustment factor is shown next:
Coefficient of Variation |
Adjustment Factor |
||||
0 | − | 0.25 | 0.90 | ||
0.26 | − | 0.50 | 0.80 | ||
0.51 | − | 0.75 | 0.70 | ||
0.76 | − | 1.00 | 0.60 | ||
1.01 | − | 1.25 | 0.50 | ||
Assume a $200,000 project provides the following inflows with the
associated coefficients of variation for each year.
Year | Inflow | Coefficient of Variation | ||||
1 | $ | 34,700 | 0.13 | |||
2 | 55,300 | 0.21 | ||||
3 | 70,100 | 0.49 | ||||
4 | 60,200 | 0.79 | ||||
5 | 68,000 | 1.11 | ||||
Use Appendix B for an approximate answer but calculate your final
answer using the formula and financial calculator methods.
a. Fill in the table below: (Do not round
intermediate calculations. Round "Adjustment Factor" answers to 2
decimal places and other answers to the nearest whole
dollar.)
b-1. If the risk-free rate is 4 percent, compute
the net present value of the adjusted inflows. (Negative
amount should be indicated by a minus sign. Do not
round intermediate calculations and round your answer to 2 decimal
places.)
b-2. Should this project be accepted?
Yes
No
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