Question

B.) Based on the risk-adjusted NPVs, which project should BPC choose? Project A or B? 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? Would it make Project B more or less appealing? D.) 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? Would it make project B more or less appealing?

The Butler-Perkins Company (BPC) must decide between two mutually exclusive projects. Each costs $6,500 and has an expected life of 3 years. Annual project cash flows begin 1 year after the initial investment and are subject to the following probability distributions: Project A Project B Probability Cash Flows Probability Cash Flows 0.2 $6,000 0.2 $0 0.6 $6,500 0.6 $6,500 0.2 $7,000 0.2 $19,000 BPC has decided to evaluate the riskier project at 11% 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: $ Project B: $ Project B's standard deviation (CB) is $6,185.47 and its coefficient of variation (CVB) is 0.80. What are the values of (CA) and (CVA)? Round your answers to two decimal places. 0A = $ CVA =

Answer 1

a. Project A's expected annual cash flow= 0.2*6000+0.6*6500+0.2*7000=$6500

Project B's expected annual cash flow= 0.2*0+0.6*6500+0.2*19000=$7700

Standard deviation of A=sqrt of (0.2*(6000-6500)^2+0.6*(6500-6500)+0.2*(7000-6500)^2)=$316.22

Coefficient of variation of A= 316.22/6500=0.0486

B. As the Coefficient of variation is lower for A, BPC should choose Project A

This will not change, the decision and Project A will still be more attractive than B.

Relationship with GDP also will not change the decision as we have considered all such probability in the cash flow determination.