10.4 The staff of Jefferson Medical Services has estimated the following net cash flows for a food services operation that it may open in its outpatient clinic:

Year Expected Net Cash Flow

0 ($100,000)

1 30,000

2 30,000

3 30,000

4 30,000

5 30,000

5(salvage value) 20,000

The year 0 cash flow is the net investment outlay, while the final amount is the terminal cash flow. (The clinic is expected to move to a new building in five years.) All other flows represent net operating cash flows. Jeffersons corporate cost of capital is 10 percent.

• What is the projects IRR?
• Assuming the project has average risk, what is its NPV
• Now, assume that the operating cash flows in years 1 through 5 could be as low as $20,000 or as high as $40,000. Furthermore, the salvage value cash flow at the end of year 5 could be as low as $0 or as high as $30,000. What are the worst case and best case IRRs? The worst case and best case NPVs?

10.6 The managers of United Medtronics are evaluating the following four projects for the coming budget period. The firms corporate cost of capital is 14 percent.

Project Cost IRR

A $15,000 17%

B 15,000 16%

C 12,000 15%

D 20,000 13%

• What is the firms capital budget?
• Now, suppose Medtronics managers want to consider differential risk in the capital budgeting process. Project A has average risk, B has below-average risk, C has above-average risk, and D has average risk. What is the firms optimal capital budget when differential risk is considered? (Hint: The firms managers lower the IRR of high-risk projects by 3 percentage points and raise the IRR of low-risk projects by the same amount.)