Engineering Economic Analysis

I

RiskVersus Return 325

Project Financing

1 2 3 4 5 6 7 8 F

SOLUTION

IRR

13.1%

12.0

7.5

6.5

9.4

16.3

15.1

15.3

4.0

Standard Deviation

6.5%

3.9

1.5

3.5

8.0

10.0

7.0

9.4

0.0

Answering the question is far easier if we use Figure 10-7. Since a larger expected return is better,

we want to select projects that are as "high up" as possible. Since a lower risk is better, we.want

to select project~ that are as "far left" as possible. The graph lets us examine the trade-off of

accepting more risk for a higher return.

FIGURE 10-7 Risk-versus-retum

graph.

20

6.

(^7).
8
.
5
(^5) .,
F

.

4

o 246 8

Standard Deviation of 1M (%)

10

First, we can eliminate Projects 4 and 5.They are dominated projects. Dominated alternatives

are no better than another alternative on all measures and inferior on at least one measure. Project 4.

is dominated by Project 3, which has a higher expected return and a lower risk. Project 5 is

dominated by Projects 1, 2, and 7. All three have a higher expected return and a lower risk.

Second, we look at the efficient frontier. This is the blue line in Figure 10-7 that connects

Proj~ctE,P' 3, 2~..7,and 6. I)epencijng, on the trade"of( that~we want to make betweell risk and

return, any of these could be the best choice.

Project 1 appears to be inferior to Projects 2 and 7. Project 8 appears to be inferior to Projects

:::7"and6. Pmjects 1 and 8 are inside and not on the efficient frontier."= = ;;:; ==z:=:= = ~

.,

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