Question

Adidas management team is considering two projects, a golf club project and a helmet project.

WACC = 9.3%

Adidas:

% of debt in capital structure 25%

% of equity in capital structure 75%

Before-tax required cost of debt 6%

Tax rate 30%

Cost of equity 11%

B. Capital Budgeting

Project information:

Golf club project           Helmet project

Upfront costs                           (10,000,000)                (8,000,000)

Annual cash flows Year 1                     $0                    $3,000,000

Year 2                                                  $0                    $3,000,000

Year 3                                      $4,000,000                  $2,000,000

Year 4                                      $10,000,000                $2,000,000

IRR = Golf club = 9.51%

IRR = Helmet = 10.47%

NPV with WACC as discount rate

Golf club = 70164.4

Helmet = 188981.1

Question #1: The data provided above does not contain any measure of the riskiness of the projects. What are two ways that we could adjust the analysis if it were determined that the golf club project was a much riskier project whose cash flow projections were much more uncertain?

Question #2: What specific information would the management team need to gather if they wanted to consider the relative riskiness in terms of the “portfolio effect”?

Answer 1

1. There are 2 ways in which the riskiness of a project can be adjusted in project cash flow analysis

a.) the required discount rate used for discounting the cash flows can be increased to reflect the increased risk of the project cash flows which will result in a lower present value

b.) the cash flows can be assigned probabilities to determine expected cash flow in each period

2. To assess the relative riskiness of the project, we need to assess the correlation between both project cash flows and diversification among the 2 projects