CHAPTER 10 Johnson Farm Implement is faced with two mutually exclusive projects, Pad Q. The following are the data about the two projects. Table 10.5 Nico Manufacturing is considering investment in one of two mutually exclusive projects X and Y which are described below. Nico Manufacturing's overall cost of capital is 15 percent, the market retum is 15 percent and the risk-free rate is 5 percent. Nico estimates that the beta for project X is 1.20 and the beta for project Y is 1.40. Table 10.6 Project Initial Investment Project Life Annual Cash Flow Risk Adjusted Discount Rate Risk-Free Rate of Return P $40,000 3 years $15,000 10% 6% Q $50,000 3 years $25,000 14% 6% Initial Investment Year Project X Project Y $3,500,000 $3,900,000 Cash Inflows (CF) $1,500,000 $1,100,000 1,500,000 1,600,000 1,500,000 1,900,000 1,500,000 2,300,000 1 Evaluate the projects using risk-adjusted discount rates. (See Table 10.5.) 2 3 4 2 Which project do you recommend? (See Table 10.5.) 4. 5. 3. A firm is evaluating two mutually exclusive projects that have unequal lives. The fim must evaluate the projects using the annualized net present value approach and recommend which project they should select. The fim's cost of capital has been determined to be 18 percent, and the projects have the following initial investments and cash flows: Calculate the risk-adjusted discount rates for project X and project Y. (See Table 10.6) Using the risk-adjusted discount rate method of project evaluation, find the NPV for projects X and Y. Which project should Nico select using this method? (See Table 10.6) Initial investment: Cash flows: 1 2 Project W Project Y $40,000 $58,000 $20,000 $30,000 20,000 35,000 20,000 40,000 20,000 20,000 4 5 6. Calculate the NPV of projects X and Y assuming that the firm did not employ the RADR method and instead used the firm's overall cost of capital to evaluate projects X and Y. (See Table 10.6) What potential biases exist in project selection if Nico Manufacturing did not adjust for the difference in risk between projects X and Y (See Table 10.6). Answer: The danger of not accounting for differences in project risk is that the fim may potentially unacceptable high-risk projects (with negative NPVs) may be chosen over potentially acceptable low-risk projects with positive NPV) Level of Difficulty: 3 Leaming Goal: 4 Topic: Risk-Adjusted Discount Rate (Equation 10.2 and Equation 10.5)