Your company asked you to evaluate two potential projects. These projects are active for 10 years and have no salvage life. Both have the same upfront costs, but the revenue stream from each of the projects is subject to variation, so risk is involved.
You are given the following information:
Firm's cost of capital: 10%
Each project will require three years of investment before revenues are generated.
The following cost distribution is given:
| |
Probability of Outcome |
Year 1 Investment Costs |
Year 2 Investment Costs |
Year 3 Investment Costs |
Expected Annual Revenues in Year 4 |
Expected Rate of Increase in Annual Revenues |
| Project 1 |
|
|
|
|
|
|
| Outcome A |
20% |
$1,000 |
$2,000 |
$1,000 |
500 |
2% |
| Outcome B |
40% |
$1,000 |
$2,000 |
$1,000 |
650 |
3% |
| Outcome C |
40% |
$1,000 |
$2,000 |
$1,000 |
850 |
4% |
| Project 2 |
|
|
|
|
|
|
| Outcome A |
10% |
$1,000 |
$2,000 |
$1,000 |
675 |
2% |
| Outcome B |
50% |
$1,000 |
$2,000 |
$1,000 |
700 |
2.40% |
| Outcome C |
40% |
$1,000 |
$2,000 |
$1,000 |
725 |
2.80% |
In a new worksheet in Excel, answer the following:
1. What is the expected value of the NPV for each of the projects?
2. What is the standard deviation of the NPV for each of the projects?
3. What is the coefficient of variation of the NPV for each of the projects?
4. Which project has a higher expected return? Which has more risk?
5. Which one would you recommend to your company? How does its attitude toward risk affect your answer?