Question

The San Diego LLC is considering a three-year project, Project A, involving an initial investment of $80 million and the following cash inflows and probabilities: Year o Year 1 Year 2 Year 3 Probability Cash Flow Probability Cash Flow Probe o ($ mil.) (Smil) Probability Cash Flow 0.2 60 0.3 70 50 0.4 4 60 0.1 0.2 Initial Investment $80 mil. Discount Rate 8% Describe your answer for each question in complete sentences, whenever it is necessary. Show all of your calculations and processes for the following point a. Describe and calculate Project A's expected net present value (ENPV) and standard deviation (SD), assuming the discount rate (or risk-free interest rate to be 8%. What is the decision rule in terms of ENPV? What will be San Diego LLC's decision regarding this project? Describe your answer. b. The company is also considering another three-year project, Project B, which has an ENPV of $32 million and standard deviation of $10.5 million. Projec A and B are mutually exclusive. Which of the two projects would you prefer if you do not consider the risk factor? Explain. c. Describe the coefficient of variation (CV) and the standard deviation (SD) in connection with risk attitudes and decision making. If you now also consider your risk-aversion attitude, as the CEO of the San Diego LLC will you make a different decision between Project A and Project B? Why or why not?

Answer 1

a)Expected value in year 1=0.2*50+0.3*40+0.4*30+0.1*20=10+12+12+2=36.

Discounted value from 1st year=36/1.08=33.33

Expected value in year 2

=6+10+4+6=26.

Discounted year 2 value=26/1.08²=22.3

Expected value in year 3=21+16+5+8=50/1.08³=39.7

Total return = 39.7+22.3+33.3=95.3

Initial investment=80.

Therefore expected net present value=15.3.

The decision rule is that if ENPV is greater than 0, then one should invest in the project, else no. Therefore San Diego LLC will take up the project.

b)If only the expected return factor is considered and not the risk factor, then definitely project B as the net expected present value is higher(32>15.3).

C)Risk is the standard deviation of the expected return and coefficient of variation is standard deviation/mean. A risk averse individual would go with the less risky investment for a given return or higher return for a given risk.So, depending on situations, one might choose project A or B.