A project requires an initial investment of $100,000 to purchase equipment. The equipment will be depreciated on a straight-line basis over the five-year life of the project. The company expects the project to generate $50,000 of additional revenue per year and $15,000 of additional expenses per year. Management is also concerned about potential product liability losses. The company’s risk manager developed the following annual loss distribution:

Loss Amount    Probability

$0                          70%

$5,000                  20%

$10,000                 8%

$50,000                  2%

a. Calculate the project’s net present value assuming the company has a required return of 10% and faces a marginal tax rate of 40%.

b. Should the company invest the $100,000 to buy the equipment? As part of your answer, explain the risk involved when using expected loss amounts in capital budgeting and how the cost of worry could be used to modify the calculation of net present value in part a.

c. Calculate the breakeven cost of worry, that is, above this amount the project will not be accepted, and below this amount the project will be accepted.