Problems 329
The Bartram-Pulley Company (BPC) must decide between two mutually exclusive investment
projects. Each project costs $6,750 and has an expected life of 3 years. Annual net cash flows
from each project begin 1 year after the initial investment is made and have the following prob-
ability distributions:
Project A Project B
Probability Net Cash Flows Probability Net Cash Flows
- 2$6,000 0. 2$ 0
0.6 6,750 0.6 6,750
- 27,500 0. 218,000
BPC has decided to evaluate the riskier project at a 12 percent rate and the less risky project at
a 10 percent rate.
a.What is the expected value of the annual net cash flows from each project? What is the coef-
ficient of variation (CV)? (Hint: B$5,798 and CVB0.76.)
b.What is the risk-adjusted NPV of each project?
c.If it were known that Project B was negatively correlated with other cash flows of the firm
whereas Project A was positively correlated, how would this knowledge affect the decision?
If Project B’s cash flows were negatively correlated with gross domestic product (GDP),
would that influence your assessment of its risk?
Singleton Supplies Corporation (SSC) manufactures medical products for hospitals, clinics, and
nursing homes. SSC may introduce a new type of X-ray scanner designed to identify certain
types of cancers in their early stages. There are a number of uncertainties about the proposed
project, but the following data are believed to be reasonably accurate.
Probability Value Random Numbers
Developmental costs 0.3 $2,000,000 00–29
0.4 4,000,000 30–69
0.3 6,000,000 70–99
Project life 0. 23 years 00–19
0.6 8 years 20–79
- 213 years 80–99
Sales in units 0. 2100 00–19
0.6 200 20–79
- 2300 80–99
Sales price 0.1 $13,000 00–09
0.8 13,500 10–89
0.1 14,000 90–99
Cost per unit (excluding developmental 0.3 $5,000 00–29
costs) 0.4 6,000 30–69
0.3 7,000 70–99
SSC uses a cost of capital of 15 percent to analyze average-risk projects, 12 percent for low-risk
projects, and 18 percent for high-risk projects. These risk adjustments reflect primarily the un-
certainty about each project’s NPV and IRR as measured by the coefficients of variation of NPV
and IRR. SSC is in the 40 percent federal-plus-state income tax bracket.
a.What is the expected IRR for the X-ray scanner project? Base your answer on the expected
values of the variables. Also, assume the after-tax “profits” figure you develop is equal to an-
nual cash flows. All facilities are leased, so depreciation may be disregarded. Can you deter-
mine the value of IRRshort of actual simulation or a fairly complex statistical analysis?
b.Assume that SSC uses a 15 percent cost of capital for this project. What is the proj-
ect’s NPV? Could you estimate NPVwithout either simulation or a complex statistical
analysis?
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SIMULATION
8–8
RISKY CASH FLOWS
328 Cash Flow Estimation and Risk Analysis
