Question

You are considering Project B that requires an initial investment of $70. The current present value of its cash flows is estimated to be $100 based on today’s market conditions. You can undertake Project B now or wait for one month to decide. The current risk-free rate is 0.25%, and the standard deviation of project return is 10%. What should you do? Suppose instead that the initial investment for Project B is $100, the current present value of its cash flows is $70, the risk-free rate is 1%, and the standard deviation of project return is 20%. What should you do?

Answer #1

In the first case:

Project B has standard deviation of 10%. The present value of inflows is $100. Hence the PV of inflow may fluctuate between $90 and $110. Considering the lower side too, the NPV of the project is positive i.e. $90-$70= $20. Hence this project should be taken.

In the second case:

Outflow is $100, PV of inflow is $70. Without considering the standard deviation , the project NPV is negative. Hence, the project should not be taken. With SD of 20%, the PV of inflow may fluctuate between $56 ($70-$70*20%) and $84 ($70+$70*20%). Taking the higher side too, the project gives negative NPV. Also, high SD means higher degree of risk. So the project should be avoided.

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