Two projects have the following expected net present values and standard devia-

ID: 2382682 • Letter: T

Question

Two projects have the following expected net present values and standard devia- tions of net present values:

Project Expected Net Present Value Standard Deviation

A $50,000 $20,000

B $10,000 $7,000

a. Using the standard deviation criterion, which project is riskier?

b. Using the coefficient of variation criterion, which project is riskier?

c. Which criterion do you think is appropriate to use in this case? Why?

If standard deviation (SD) is taken for evaluating projects, higher SD of the project would be riskier.

Higher risk indicates greater variability. Therefore, investment in the project may not give returns as expected.

Answer: Project A is riskier.

Coefficient of variation of A = SD of A / Expected NPV of A = $20,000 / $50,000 = 0.4

Coefficient of variation of B = SD of B / Expected NPV of B = $7,000 / $10,000 = 0.7

The grater coefficient of variation indicates higher risk.

Answer: Project B is riskier.

Coefficient of variation is considered to be the best measure of variability when the expected returns on two alternatives are not the same.

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