Problem 11-15

Riisky Cash Flows

The Bartrm Pulley Company (BPC) must decide between two mutually exclusive investment projects. Each project costs $6,750 and has an expected life of 3 years. Annual net cash flows from each project begins 1 year after the initial investment is made and have the following probability distributions:

Project A Project B

Probability Net Cash Flows Probablity Net Cash Flows

0.2 $6,000 0.2 $ 0

0.6 6,750 0.6 6,750

0.2 7,500 0.2 18,000

BPC has decided to evaluate the riskier project at 12% rate and the less risky project at 10% rate.

a. what is the expected value of the annual net cash flows from each project? What is the coefficient of variation (CV)? Hint: oB= $5,798 and CVb = 0.76

b What is the risk adjusted NPV of each project?

c. If it were known that project b is negatively correlated with other cash flows of the firm whereas project A is positively correlated how would this affect the decisions? If project B cash flows were negatively correlated with gross domestic product (GDP) would that influence your assesment of its risk?

The answers are as follows:

a. Expected CFa = $6,750

Expected CFb = $7,650

CVa = 0.0703

b. NPVa = $10,036

NPVb = $$11, 624

Show all work and formulas to support answers!!!