Principles of Managerial Finance

c. The firm has estimated the probabilities of achieving various ranges of cash

inflows for the two projects, as shown in the following table. What is the

probability that each project will achieve the breakeven cash inflow found

in part b?

d. Which project is more risky? Which project has the potentially higher NPV?

Discuss the risk-return tradeoffs of the two projects.

e. If the firm wished to minimize losses (that is, NPV$0), which project

would you recommend? Which would you recommend if the goal, instead,

was achieving the higher NPV?

10–4 Basic sensitivity analysis Murdock Paints is in the process of evaluating two

mutually exclusive additions to its processing capacity. The firm’s financial ana-

lysts have developed pessimistic, most likely, and optimistic estimates of the

annual cash inflows associated with each project. These estimates are shown in

the following table.

a. Determine the range of annual cash inflows for each of the two projects.

b. Assume that the firm’ s cost of capital is 10% and that both projects have 20-

year lives. Construct a table similar to this for the NPVs for each project.

Include the rangeof NPVs for each project.

c. Do parts aand bprovide consistent views of the two projects? Explain.

d. Which project do you recommend? Why?

10–5 Sensitivity analysis James Secretarial Services is considering the purchase of

one of two new personal computers, P and Q. Both are expected to provide ben-

efits over a 10-year period, and each has a required investment of $3,000. The

firm uses a 10% cost of capital. Management has constructed the following

Project A Project B

Initial investment (CF 0 ) $8,000 $8,000

Outcome Annual cash inflows (CF)

Pessimistic $ 200 $ 900

Most likely 1,000 1,000

Optimistic 1,800 1,100

Probability of achieving

cash inflow in given range

Range of cash inflow Project X Project Y

$0 to $5,000 0% 5%

$5,000 to $7,500 10 10

$7,500 to $10,000 60 15

$10,000 to $12,500 25 25

$12,500 to $15,000 5 20

$15,000 to $20,000 0 15

Above $20,000 0 10

454 PART 3 Long-Term Investment Decisions

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