P12-4 Basic scenario analysis Murdock Paints is in the process of evaluating two
ID: 2651209 • Letter: P
Question
P12-4 Basic scenario analysis Murdock Paints is in the process of evaluating two mutually exclusive additions to its processing capacity. The firm?s financial analysts have developed pessimistic, most likely, and optimistic estimates of the annual cash inflows associated with each project. These estimates are shown in the following table. a. Determine the range of annual cash inflows for each of the two projects. b. Assume that the firm's cost of capital is 10% and that both projects have 20-year lives. Construct a table similar to this one for the NPVs for each project. Include the range of NPVs for each project. c. Do parts a and b provide consistent views of the two projects? Explain. d. Which project do you recommend? Why?Explanation / Answer
a.Determine the range of annual cash inflows for each of the two projects. Range = Highest value - Lowest value Cash inflows Outcome Project A Project B Pessimistic 200 900 Most likely 1,000 1,000 Optimistic 1,800 1,100 Range = 1,600 200 b.Assume that the firm’ s cost of capital is 10% and that both projects have 20-year lives. Construct a table similar to this for the NPVs for each project. Include the range of NPVs for each project. Calculation of NPV for different outcomes: Project A: Pessimistic: Most likely: Optimistic: Rate = 10% Rate = 10% Rate = 10% Nper = 20 Nper = 20 Nper = 20 PMT = -200 PMT = -1,000 PMT = -1,800 PV =? PV =? PV =? PV = $1,702.71 PV = $8,513.56 PV = $15,324.41 Cash outflow = -8,000 Cash outflow = -8,000 Cash outflow = -8,000 NPV = ($6,297.29) NPV = $513.56 NPV = $7,324.41 Project B: Pessimistic: Most likely: Optimistic: Rate = 10% Rate = 10% Rate = 10% Nper = 20 Nper = 20 Nper = 20 PMT = -900 PMT = -1,000 PMT = -1,100 PV =? PV =? PV =? PV = $7,662.21 PV = $8,513.56 PV = $9,364.92 Cash outflow = -8,000 Cash outflow = -8,000 Cash outflow = -8,000 NPV = ($337.79) NPV = $513.56 NPV = $1,364.92 NPVs of project A and Project B under different outcomes: NPVs Outcome Project A Project B Pessimistic ($6,297.29) ($337.79) Most likely 513.56 513.56 Optimistic 7,324.41 1,364.92 Range = 13,622 1,703 c.Do parts a and b provide consistent views of the two projects? Explain. Yes both the projects provide consistent view as the initial investment and the years of the project are same. From the above we notice that project A is riskier than project B aas the range is high for project A. d.Which project do you recommend? Why? The decision depends upon the investors risk aversion. If the company is interested to earn higher returns and willing to take up greater risk, then the company should select Project A as the NPV is higher than B. If the company is risk averse then select project B as the range or deviation is less.
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