Question

Project A Project B Probability Cash Flows Probability Cash Flows $6,250 0.6 0.6 $6,500 $6,750 $6,500 $17,000 BPC has decided to evaluate the riskier project at 13% and the less-risky project at 10%. The data has been collected in the Microsoft Excel Online file below. Open the spreadsheet and perform the required analysis to answer the questions below. Open spreadsheet a. What is each project's expected annual cash flow? Round your answers to two decimal places. Project A: $ 6500 Project B: $ 7300 Project B's standard deviation (g) is $5,464.43 and its coefficient of variation (CVE) is 0.75. What are the values of (CA) and (CVA)? Round your answers to two decimal places. A = $ CVA = b. Based on the risk-adjusted NPVs, which project should BPC choose? c. If you knew that Project B's cash flows were negatively correlated with the firm's other cash flow, but Project A's cash flows were positively correlated, how might this affect the decision? If Project B's cash flows were negatively correlated with gross domestic product (GDP), while A's cash flows were positively correlated, would that influence your risk assessment?

Answer 1

a)

1) Expected Cash flow

Expected Cash flow of Project A & Project B is worked out below:

Project A				Project B
Probability (P)	CashFlow (CF)	Expected CF (P x CF)		Probability (P)	CashFlow (CF)	Expected CF (P x CF)
0.2	6250	1250		0.2	0	0
0.6	6500	3900		0.6	6500	3900
0.2	6750	1350		0.2	17000	3400
Total		6500		Total		7300

2) Standard deviation and Coefficient of Variation for Project A

Variance of Cashflow for Project A is derived as below

Project A
Probability (P)	CashFlow (CF)	Expected CF (P x CF)	Mean of Cash flows (CF Mean)	Variance of Cashflows ((CF-CF Mean)^2)* (P))
0.2	6250	1250	6500	12500
0.6	6500	3900	6500	0
0.2	6750	1350	6500	12500
Total		6500		25000

Standard Deviation of Project A = (Variance of Project A)^1/2

=158.11

Coefficient of variation for Project A (CV A)= Standard Deviation of project A / Mean of Project A

= 158.11/6500 = 0.024

b) Risk adjusted NPV of projects

NPV of Project A = Expected Cashflow of Project A//(1+Risk Adjusted Rate)

=6500/(1+10%)

=6500 /(1.1)

=5909.10

NPV of Project B = Expected Cashflow of Project B /(1+Risk Adjusted Rate)

=7300/(1+13%)

=7300 /(1.13)

=6460.18

Based on the Risk Adjsuted rate, NPV of Project B is higher. Hence Project B will be chosen.

c) If Project B's Cashflow were negatively correlated with Firm's other Cashflow, then first an assessment has to be made regarding the Firm's Cash flow and duration of the project. IF the Firm's Cash flow is expected to be low for the duration of the Project, then Project B should be selected and if the Firm's Cash flow is expected to be strong, then Project B should not be selected. In case of it is expected that Firm will be experiencing negative cash flow, Project B would be a good diversification for the company. In this case assuming that Firm's Cashflow is expected to be strong, I would not select Project B.

d) If Project B's Cashflow were negatively correlated with GDP, then first an assessment has to be made regarding the GDP growth projections and duration of the project. IF the GDP is expected to be negative for the duration of the Project, then Project B should be selected and if the GDP growth is expected to be positive, then Project B should not be selected. In this case assuming that GDP growth is expected to be strong, I would not select Project B.