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CHAPTER 10 Without Answer

The document summarizes data about two mutually exclusive projects, Project P and Project Q, that a company named Johnson Farm Implement is considering. It provides the initial investment, project life, annual cash flow, risk-adjusted discount rate, and risk-free rate of return for each project. It also presents questions about evaluating the projects, determining which to recommend, and calculating net present values using risk-adjusted discount rates. Finally, it provides data on two other mutually exclusive projects, X and Y, under consideration by another company, and questions about calculating risk-adjusted discount rates and net present values for those projects.

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166 views

CHAPTER 10 Without Answer

The document summarizes data about two mutually exclusive projects, Project P and Project Q, that a company named Johnson Farm Implement is considering. It provides the initial investment, project life, annual cash flow, risk-adjusted discount rate, and risk-free rate of return for each project. It also presents questions about evaluating the projects, determining which to recommend, and calculating net present values using risk-adjusted discount rates. Finally, it provides data on two other mutually exclusive projects, X and Y, under consideration by another company, and questions about calculating risk-adjusted discount rates and net present values for those projects.

Uploaded by

lenaka
Copyright
© © All Rights Reserved
Available Formats
Download as DOC, PDF, TXT or read online on Scribd
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CHAPTER 10

Johnson Farm Implement is faced with two mutually exclusive projects, P and Q. The
following are the data about the two projects.
Table 10.5
Project P Q
Initial Investment $40,000 $50,000
Project Life 3 years 3 years
Annual Cash Flow $15,000 $25,000
Risk Adjusted Discount Rate 10% 14%
Risk-Free Rate of Return 6% 6%

1. Evaluate the projects using risk-adjusted discount rates. (See Table 10.5.)

2. Which project do you recommend? (See Table 10.5.)

3. A firm is evaluating two mutually exclusive projects that have unequal lives. The firm
must evaluate the projects using the annualized net present value approach and
recommend which project they should select. The firm’s cost of capital has been
determined to be 18 percent, and the projects have the following initial investments and
cash flows:

Project W Project Y
Initial investment: $40,000 $58,000
Cash flows: 1 $20,000 $30,000
2 20,000 35,000
3 20,000 40,000
4 20,000
5 20,000
Nico Manufacturing is considering investment in one of two mutually exclusive projects X
and Y which are described below. Nico Manufacturing’s overall cost of capital is 15 percent,
the market return is
15 percent and the risk-free rate is 5 percent. Nico estimates that the beta for project X is 1.20
and the beta for project Y is 1.40.
Table 10.6
Project X Project Y
Initial Investment $3,500,000 $3,900,000
Year Cash Inflows (CF)
1 $1,500,000 $1,100,000
2 1,500,000 1,600,000
3 1,500,000 1,900,000
4 1,500,000 2,300,000

4. Calculate the risk-adjusted discount rates for project X and project Y. (See Table 10.6)

5. Using the risk-adjusted discount rate method of project evaluation, find the NPV for
projects X and Y. Which project should Nico select using this method? (See Table
10.6)
6. Calculate the NPV of projects X and Y assuming that the firm did not employ the
RADR method and instead used the firm’s overall cost of capital to evaluate projects X
and Y. (See Table 10.6)

7. What potential biases exist in project selection if Nico Manufacturing did not adjust for
the difference in risk between projects X and Y (See Table 10.6).
Answer: The danger of not accounting for differences in project risk is that the firm
may potentially unacceptable high-risk projects (with negative NPVs) may be
chosen over potentially acceptable low-risk projects (with positive NPVs).
Level of Difficulty: 3
Learning Goal: 4
Topic: Risk-Adjusted Discount Rate (Equation 10.2 and Equation 10.5)

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