You are considering two mutually exclusive projects. The expected values for eac
ID: 2648639 • Letter: Y
Question
You are considering two mutually exclusive projects. The expected values for each project's end-of-year cash flows are:
Year
Project A
Project B
0
-$1,000,000
-$1,000,000
1
550,000
500,000
2
700,000
680,000
3
600,000
700,000
4
500,000
800,000
You have decided to evaluate these projects using the certainty equivalent method. The certainty equivalent coefficients for each project's cash flows are given below:
Year
Project A
Project B
0
1.00
1.00
1
0.95
0.90
2
0.85
0.70
3
0.80
0.60
4
0.75
0.55a) Given that the required rate of return is 8.5% p.a. and risk-free rate of return is 6% p.a., what is the NPV of each project?
b) Briefly discuss and justify which project, if any, should be preferred.
c) In practice, what factors are likely to influence the selection of the certainty equivalent coefficients for each project's expected cash flows?
Year
Project A
Project B
0
-$1,000,000
-$1,000,000
1
550,000
500,000
2
700,000
680,000
3
600,000
700,000
4
500,000
800,000
Explanation / Answer
Formula A B C D E = A*C F = B*D G = 1/(1+r)^t E*G F*G Certainity Equivalent Coefficients Risk Adjusted Cash Flow Present Value Factor Present Value Year Project A Project B Project A Project B Project A Project B Project A Project B 0 ($1,000,000) ($1,000,000) 1 1 ($1,000,000) ($1,000,000) 1.00 ($1,000,000) ($1,000,000) 1 $550,000 $500,000 0.95 0.9 $522,500 $450,000 0.92 $481,567 $414,747 2 $700,000 $680,000 0.85 0.7 $595,000 $476,000 0.85 $505,426 $404,341 3 $600,000 $700,000 0.8 0.6 $480,000 $420,000 0.78 $375,796 $328,821 4 $500,000 $800,000 0.75 0.55 $375,000 $440,000 0.72 $270,590 $317,493 NPV $633,379 $465,401 Both Projects give positive Cash Flow, However NPV of Project A is higher than B, Hence A should be selected
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