Question

Country Wallpapers is considering investing in one of three mutually exclusive projects, E, F, and G. The firm's cost of capital, r ,is 14.8 %, and the risk-free rate, Upper R Subscript Upper F, is 9.7 %. The firm has gathered the following basic cash flow and risk index data for each project

Project | |||

E | F | G | |

Initial Investment (CF0) | 15700 | 11000 | 19900 |

Year | Cash Flows | ||

1 | 6300 | 5600 | 4200 |

2 | 6300 | 3800 | 5700 |

3 | 6300 | 4900 | 9000 |

4 | 6300 | 1800 | 12700 |

Risk index (RI) | 1.83 | 0.96 | 0.58 |

a. Find the net present value (NPV) of each project using the firm's cost of capital. Which project is preferred in this situation?

b. The firm uses the following equation to determine the risk-adjusted discount rate,

RADR Subscript j, for each project nbsp j : RADR Subscript j equals Upper R Subscript Upper F plus RI Subscript j times left parenthesis r minus Upper R Subscript Upper F right parenthesis where Upper R Subscript Upper F = risk-free rate of return, RI Subscript j = risk index for project nbsp j , and r = cost of capital.Substitute each project's risk index into this equation to determine its RADR.

c. Use the RADR for each project to determine its risk-adjusted NPV. Which project is preferable in this situation?

d. Compare and discuss your findings in parts (a) and (c). Which project do you recommend that the firm accept?

Answer #1

a)

Project E=-15700+6300/14.8%*(1-1/1.148^4)=2359.37512601096

Project F=-11000+5600/1.148+3800/1.148^2+4900/1.148^3+1800/1.148^4=1036.45924096477

Project G=-19900+4200/1.148+5700/1.148^2+9000/1.148^3+12700/1.148^4=1344.21429126822

Choose Project E

b)

Project E

=9.7%+1.83*(14.8%-9.7%)=19.033%

Project F

=9.7%+0.96*(14.8%-9.7%)=14.596%

Project G

=9.7%+0.58*(14.8%-9.7%)=12.658%

c)

Project E=-15700+6300/19.033%*(1-1/1.19033^4)=912.5637897

Project F=-11000+5600/1.14596+3800/1.14596^2+4900/1.14596^3+1800/1.14596^4=1080.1441474

Project G=-19900+4200/1.12658+5700/1.12658^2+9000/1.12658^3+12700/1.12658^4=2497.7697968

Choose Project G as it has highest NPV

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