Case 1 Bridget’s Modeling Studios is considering opening in a new location

in Miami. An after tax cash flow of $120 per day (expected value) is projected
for each of the two locations being evaluated.
Which of these sites would you select based on the distribution of these
cash flows (use the coefficient of variation as your measure of risk)?
Site A Site B

Probability Cash Flows Probability Cash Flows

.15 $ 80 .10 $ 50
.50 110 .20 80
.30 140 .40 120
.05 220 .20 160
.10 190
Expected $120 Expected $120
value value

Case 1​ Solution:
Bridget’s Modeling Studios
Standard Deviations of Sites A and B

Site A

D P P
$ 80 $120 $–40 $ 1,600 .15 $240
110 120 –10 100 .50 50
140 120 +20 400 .30 120
220 120 +100 10,000 .05 500
$910

Site B

D P P
$ 50 $120 $–70 $4,900 .10 $ 490
80 120 –40 1,600 .20 320
120 120 –0– –0– .40 –0–
160 120 +40 1,600 .20 320
190 120 +70 4,900 .10 490
$1,620

Coefficient of variation (V) = standard deviation/expected value.

 VA =​ $30.17/$120 = .2514
VB =​ $40.25/$120 = .3354
Site A is the preferred site since it has the smallest coefficient of
variation. Because both alternatives have the same expected value,
the standard deviation alone would have been enough for a decision.
A will be just as profitable as B but with less risk.

Case 2 Dixie Dynamite Company is evaluating two methods of blowing up

old buildings for commercial purposes over the next five years. Method
one (implosion) is relatively low in risk for this business and will carry a
12 percent discount rate. Method two (explosion) is less expensive to
perform but more dangerous and will call for a higher discount rate of 16
percent. Either method will require an initial capital outlay of $75,000.
The inflows from projected business over the next five years are given
below. Which method should be selected using net present value analysis?

Years Method 1 Method 2

1 $18,00 $20,000
​ 0
2 24,000 25,000
​
3 34,000 35,000
​
4 26,000 28,000
​
5 14,000 15,000
​

Case 2 .​Solution:
Dixie Dynamite Co.
​ Method 1​ Method 2
PVIF PVIF
@ @
Year Inflows 12% PV Inflows 16% PV
1 $18,000 .893 $16,074 $20,000 .862 $17,240
2 24,000 .797 19,128 25,000 .743 18,575
3 34,000 .712 24,208 35,000 .641 22,435
4 26,000 .636 16,536 28,000 .552 15,456
5 14,000 .597 7,938 15,000 .476 7,140
PV of Inflows $83,884 $80,846
Investment –75,000 –75,000
NPV $ 8,884 $ 5,846

Select Method 1
Case 3. (3 pts) Larry’s Athletic Lounge is planning an expansion program to
increase the sophistication of its exercise equipment. Larry is considering
some new equipment priced at $20,000 with an estimated life of five
years. Larry is not sure how many members the new equipment will
attract, but he estimates his increased yearly cash flows for each of the
next five years will have the probability distribution given below. Larry’s
cost of capital is 14 percent.
P​
(probability) Cash Flow
.2 $2,400
​
.4 4,800
​
.3 6,000
​
.1 7,200
​
​ a.​ What is the expected value of the cash flow? The value you compute
will apply to each of the five years.
​ b.​ What is the expected net present value?
​ c.​ Should Larry buy the new equipment?

Case 3 .​Solution:
Larry’s Athletic Lounge
a.​ Expected Cash Flow

$2,400 × .2 $ 480
4,800 × .4 1,920
6,000 × .3 1,800
7,200 × .1 720
Expected cash flow $4,920

b.​ $4,920 × 3.433 (PVIFA @ 14%, n = 5) = (Appendix D)

$16,890​ Present value of inflows
20,000​ Present value of outflows
$(3,110)​ Net present value

c.​ Larry should not buy this equipment because the net present
value is negative.
Case 4 ​ Silverado Mining Company is analyzing the purchase of two silver
mines. Only one investment will be made. The Alaska mine will cost
$2,000,000 and will produce $400,000 per year in years 5 through 15 and
$800,000 per year in years 16 through 25. The Montana mine will cost
$2,400,000 and will produce $300,000 per year for the next 25 years. The
cost of capital is 10 percent.
​ a.​ Which investment should be made? (Note: In looking up present
value factors for this problem, you need to work with the concept of
a deferred annuity for the Alaska mine. The returns in years 5
through 15 actually represent 11 years; the returns in years 16
through 25 represent 10 years.)
​ b.​ If the Alaska mine justifies an extra 5 percent premium over the
normal cost of capital because of its riskiness and relative
uncertainty of flows, does the investment decision change?

Case 4.​ Solution:

Silverado Mining Company
a.​ Calculate the net present value for each project.
The Alaska Mine

Years Cash Flow n Factor PVIFA@10% Present Value

5–15 $400,000 (15 – 4) (7.606 – 3.170) $1,774,400

16–25 $800,000 (25 – 15) (9.077 – 7.606) $1,176,800

​ Present value of inflows​ $2,951,200

​ Present value of outflows​ 2,000,000
​ Net present value​ $ 951,200
The Montana Mine

Years Cash Flow n Factor PVIFA@10% Present Value

1–25 $300,000 9.077 $2,723,100

​ Present value of inflows​ $2,723,100

​ Present value of outflows​ 2,400,100
​ Net present value​ $ 323,100
​ Select the Alaska Mine.

b.​ Recalculate the net present value of the Alaska Mine at a ​

15 percent discount rate.
Years Cash Flow n Factor PVIFA@15% Present Value
5–15 $400,000 (15 – 4) (5.847 – 2.855) $1,196,800
16–25 $800,000 (25 – 15) (6.464 – 5.847) $ 493,600

​ Present value of inflows​ $1,690,000

​ Present value of outflows​ $2,000,000
​ Net present value​ $ (309,600)

Now the decision should be made to reject the purchase of the Alaska Mine and
purchase the Montana Mine.
Case 5 ​ Mr. Monty Terry, a real estate investor, is trying to decide between
two potential small shopping center purchases. His choices are the
Wrigley Village and Crosley Square. The anticipated annual cash inflows
from each are as follows:

Wrigley Village Crosley Square

Yearly Yearly Aftertax
Aftertax Cash Cash Inflow ​
Inflow ​ Probabilit (in thousands) Probabilit
(in y y
thousands)
$10 .1 $20​ .1
​
30 .2 30​ .3
​
40 .3 35​ .4
​
50 .3 50​ .2
​
60 .1
​

​ a.​ Find the expected value of the cash flow from each shopping center.
​ b.​ What is the coefficient of variation for each shopping center?
​ c.​ Which shopping center has more risk?

Case 5​ Solution:

Wrigley Village Crosley Square

D P DP D P DP
10 0.1 $1 20 0.1 $2
30 0.2 6 30 0.3 9
40 0.3 12 35 0.4 14
50 0.3 15 50 0.2 10
60 0.1 6 Expected Cash Flow $35
Expected Cash Flow $40

b.​ First find the standard deviation and then the coefficient of
variation.

Wrigley Village
 D P P
$10 $40 $–30 $900 .1 $ 90
30 40 –10 100 .2 20
40 40 0 0 .3 0
50 40 +10 100 .3 30
60 40 +20 400 .1 40
$180

V= $13.42/$40 = .336

Crosley Square

D P P
$20 $35 $–15 $225 .1 $22.5
30 35 –5 25 .3 7.5
35 35 0 0 .4 0
50 35 +15 225 .2 45.0
$75.0

V=$8.66/$35=.247

c.​ Based on the coefficient of variation, Wrigley Village has more

risk (.336 vs. .247).