Question

Chapter 14: Capital Budgeting under Uncertainty 297 PROBLEMS n has two investment projects under the different states nomy: above normal, normal, and below normal. The probab the economy and their corresponding net cash flows are as follows: The Wellington Corporation has two investment 14-1 these states of the economy and their co $900 Net Cash Flows State of Economy Probability Project A Project B Above normal 0.50 $700 Normal 0.30 500 700 Below normal 0.20 550 (a) Determine the following: expected value, standard deviation, and coeffi- cient of variation. (b) Interpret the measures. 350

everything is the same except that probability of above normal is 0.3 and normal is 0.5

ahow your work

Answer 1

a). Expected value (or mean) = sum of probability weighted cash flows

Expected value for project A = (0.3*900) + (0.5*500) + (0.2*350) = 590

Expected value for project B = (0.3*700) + (0.5*700) + (0.2*550) = 670

Variance = sum of [probability*(cash flow for a state of economy - mean)^2]

Variance for project A = 0.3*(900 - 590)^2 + 0.5*(500-590)^2 + 0.2*(350-590)^2] = 44,400

Variance for project B = 0.3*(700-670)^2 + 0.5*(700-670)^2 + 0.2*(550-670)^2 = 3600

Standard deviation = variance^0.5

Standard deviation for project A = 44,400^0.5 = 210.71

Standard deviation for project B = 3,600^0.5 = 60

Coefficient of variation (CV) = standard deviation/man

CV for project A = 210.71/590 = 0.3571

CV for project B = 60/670 = 0.0896

b). Project B appears to be a better project as it has a higher expected value with much less CV implying that the risk is quite less compared to project A.