The Seminole Production Company is analyzing the investment in a new line of business machines. The initial outlay required is $35 million. The net cash flows expected from the investment are as follows:
Year Net Cash Flow (Million)
1 ........ $5
2 ........ 8
3 ........ 15
4 ........ 20
5 ........ 15
6 ........ 10
7 ........ 4
The firm’s cost of capital (used for projects of average risk) is 15 percent.
a. Compute the net present value of this project assuming it possesses average risk.
b. Because of the risk inherent in this type of investment, Seminole has decided to employ the certainty equivalent approach. After considerable discussion, management has agreed to apply the following certainty equivalents to the project’s cash flows:
Year αt
0 ..... 1.00
1 ..... 0.95
2 ..... 0.90
3 ..... 0.80
4 ..... 0.60
5 ..... 0.40
6 ..... 0.35
7 ..... 0.30
If the risk-free rate is 9 percent, compute the project’s certainty equivalent net present value.
c. On the basis of the certainty equivalent analysis, should the project be accepted?