Question

Risky Cash Flows

The Bartram-Pulley Company (BPC) must decide between two mutually exclusive investment projects. Each project costs $6,000 and has an expected life of 3 years. Annual net cash flows from each project begin 1 year after the initial investment is made and have the following probability distributions:

Project A		Project B
Probability	Cash Flows	Probability	Cash Flows
0.2	$6,000	0.2	$        0
0.6	6,750	0.6	6,750
0.2	7,500	0.2	17,000

BPC has decided to evaluate the riskier project at a 11% rate and the less risky project at a 8% rate.

1. What is the expected value of the annual cash flows from each project? Do not round intermediate calculations. Round your answers to the nearest dollar.

   	Project A	Project B
   Net cash flow	$	$

   What is the coefficient of variation (CV)? (Hint: σ_B=$5,444 and CV_B=$0.73.) Do not round intermediate calculations. Round σ values to the nearest cent and CV values to two decimal places.

   	σ	CV
   Project A	$
   Project B	$

2. What is the risk-adjusted NPV of each project? Do not round intermediate calculations. Round your answers to the nearest cent.

   Project A		$
   Project B		$

3. If it were known that Project B is negatively correlated with other cash flows of the firm whereas Project A is positively correlated, how would this affect the decision?

   This would tend to reinforce the decision to -Select-acceptrejectItem 9 Project B.

   If Project B's cash flows were negatively correlated with gross domestic product (GDP), would that influence your assessment of its risk?

   -Select-YesNo

Answer 1

1.
Expected Value
Project A=0.2*6000+0.6*6750+0.2*7500=6750

Project B=0.2*0+0.6*6750+0.2*17000=7450

2.
Standard Deviation
Project A=sqrt(0.2*(6000-6750)^2+0.6*(6750-6750)^2+0.2*(7500-6750)^2)=474.341649

Project B=sqrt(0.2*(0-7450)^2+0.6*(6750-7450)^2+0.2*(17000-7450)^2)=5443.803817

Coefficient of variation
Project A=474.341649/6750=0.070272837

Project B=5443.803817/7450=0.730711922

3.
Risk adjusted NPV
Project A=-6000+6750/8%*(1-1/1.08^3)=11395.40466

Project B=-6000+7450/11%*(1-1/1.11^3)=12205.67463

4.
This would tend to reinforce the decision to accept Project B.

5.
Yes