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The Butler-Perkins Company (BPC) must decide between two mutually exclusive projects. Each project has an initial outflow of $7,000 and has an expected life of 3 years. Annual project cash flows begin 1 year after the initial investment and are subject to the following probability distributions:
Project A | Project B | |||
Probability | Cash Flows | Probability | Cash Flows | |
0.2 | $6,250 | 0.2 | $ 0 | |
0.6 | 7,000 | 0.6 | 7,000 | |
0.2 | 7,750 | 0.2 | 17,000 |
BPC has decided to evaluate the riskier project at 12% and the less-risky project at 9%.
Project A: | $ |
Project B: | $ |
σ_{A}: | $ |
CV_{A}: |
a. Project expected annual cash flows of Project
A=0.2*6250+0.6*7000+0.2*7750 =7000
Project expected annual cash flows of Project
B=0.2*0+0.6*7000+0.2*17000 =7600
b. Standard Deviation of A
=(0.2*(6250-7000)^2+0.6*(7000-7000)^2+0.2*(7750-7000)^2)^0.5=474.3416
or 474.34
CVa =Standard Deviation of A/Project expected annual cash flows of
Project A =474.34/7000=0.07
c. NPV of risk adjusted A =PV of Cash flows-Initial Investment
=7000*((1-(1+12%)^-3)/12%)-7000 =9812.82
NPV of risk adjusted B =PV of Cash flows-Initial Investment
=7600*((1-(1+12%)^-3)/12%)-7000 =11253.97
Project B should be chosen
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