Thanks P12-12-Risk classes and RADR Moses Manufacturing is attempting to select
ID: 2635346 • Letter: T
Question
Thanks
P12-12-Risk classes and RADR Moses Manufacturing is attempting to select the best of three mutually exclusive projects, X, Y, and Z. Although all the projects have 5-year lives, they possess different degrees of risk. Project X is class V, the highest risk class; project Y is II, the below average risk class; and project Z is class III, the average risk class. The basic cash flow data for each project and risk class and risk adjustment discount rates (RADRs) used by the firm are shown in the following tables.
Project X Project Y Project Z
Initial investment (CFg) -$180,000 -$235,000 -$310,000
Year (t) Cash inflows (CFt)
1 $80,000 $50,000 $90,000
2 $70,000 $60,000 $90,000
3 60,000 70,000 90,000
4 60,000 80,000 90,000
5 60,000 90,000 90,000
Risk Classes and RADRs
Risk class Descriptions Risk-adjusted discount rate (RADR)
I Lowest risk 10%
II Below-average risk 13
III Average risk 15
IV Above average risk 19
V Highest risk 22
a) Find the risk adjusted NPV for each project.
b) Which project if any, would you recommend that the firm undertake?
Explanation / Answer
(1)
NPV for Project X @dicount rate 22%
= -180,000 + 80,000/1.22 + 70,000/1.22^2 + 60,000/1.22^3 + 60,000/1.22^4 + 60,000/1.22^5
= 14,930.45
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NPV for Project Y @dicount rate 13%
= -235,000 + 50,000/1.13 + 60,000/1.13^2 + 70,000/1.13^3 + 80,000/1.13^4 + 90,000/1.13^5
= 2,663.99
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NPV for Project Z @dicount rate 15%
= -310,000 + 90,000/1.15 + 90,000/1.15^2 + 90,000/1.15^3 + 90,000/1.15^4 + 90,000/1.15^5
= -8,306.04
(b)
Project X is recommended as it has the highest NPV
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