Chapter 9 Risk and the Cost of Capital 245bre44380_ch09_221-248.indd 244 10/09/15 09:59 PM bre44380_ch09_221-248.indd 245 10/09/15 09:59 PM
a. What happens to the operating leverage and business risk of the encabulator machine if
you agree to this fixed-price contract?
b. Calculate the present value of the encabulator machine with and without the fixed-price
contract.- Political risk Mom and Pop Groceries has just dispatched a year’s supply of groceries to
the government of the Central Antarctic Republic. Payment of $250,000 will be made one
year hence after the shipment arrives by snow train. Unfortunately there is a good chance of a
coup d’état, in which case the new government will not pay. Mom and Pop’s controller there-
fore decides to discount the payment at 40%, rather than at the company’s 12% cost of capital.
a. What’s wrong with using a 40% rate to offset political risk?
b. How much is the $250,000 payment really worth if the odds of a coup d’état are 25%? - Fudge factors An oil company is drilling a series of new wells on the perimeter of a pro-
ducing oil field. About 20% of the new wells will be dry holes. Even if a new well strikes oil,
there is still uncertainty about the amount of oil produced: 40% of new wells that strike oil
produce only 1,000 barrels a day; 60% produce 5,000 barrels per day.
a. Forecast the annual cash revenues from a new perimeter well. Use a future oil price of
$100 per barrel.
b. A geologist proposes to discount the cash flows of the new wells at 30% to offset the risk
of dry holes. The oil company’s normal cost of capital is 10%. Does this proposal make
sense? Briefly explain why or why not. - Certainty equivalents A project has the following forecasted cash flows:
Cash Flows ($ thousands)
C 0 C 1 C 2 C 3- 100 + 40 + 60 + 50
The estimated project beta is 1.5. The market return rm is 16%, and the risk-free rate rf is 7%.
a. Estimate the opportunity cost of capital and the project’s PV (using the same rate to dis-
count each cash flow).
b. What are the certainty-equivalent cash flows in each year?
c. What is the ratio of the certainty-equivalent cash flow to the expected cash flow in each
year?
d. Explain why this ratio declines.- Changing risk The McGregor Whisky Company is proposing to market diet scotch.
The product will first be test-marketed for two years in southern California at an initial
cost of $500,000. This test launch is not expected to produce any profits but should reveal
consumer preferences. There is a 60% chance that demand will be satisfactory. In this
case McGregor will spend $5 million to launch the scotch nationwide and will receive an
expected annual profit of $700,000 in perpetuity. If demand is not satisfactory, diet scotch
will be withdrawn.
Once consumer preferences are known, the product will be subject to an average degree of
risk, and, therefore, McGregor requires a return of 12% on its investment. However, the initial
test-market phase is viewed as much riskier, and McGregor demands a return of 20% on this
initial expenditure.
What is the NPV of the diet scotch project?