10-15. (Risk-adjusted discount rates and risk classes) The G. Wolfe Corporation
ID: 2670501 • Letter: 1
Question
10-15. (Risk-adjusted discount rates and risk classes) The G. Wolfe Corporation is examining two capital-budgeting projects with 5-year lives. The first, project A, is a replacement project; the second, project B, is a project unrelated to current operations. The G. Wolfe Corporation uses the risk-adjusted discount rate method and groups projects according to purpose, and then it uses a required rate of return or discount rate that has been preassigned to that purpose or risk class. The expected cash flows for these projects are given here:
PROJECT A PROJECT B
Initial investment $250,000 $400,000
Cash inflows:
Year 1 $130,000 $135,000
Year 2 40,000 135,000
Year 3 50,000 135,000
Year 4 90,000 135,000
Year 5 130,000 135,000
The purpose/risk classes and preassigned required rates of return are as follows:
PURPOSE REQUIRED RATE OF RETURN
Replacement decision 12%
Modification or expansion of existing product line 15%
Project unrelated to current operations 18%
Research and development operations 20%
Determine each project’s risk-adjusted net present value.
Explanation / Answer
10-15. (Risk-adjusted discount rates and risk classes) The G. Wolfe Corporation is examining two capital-budgeting projects with 5-year lives. The first, project A, is a replacement project; the second, project B, is a project unrelated to current operations. The G. Wolfe Corporation uses the risk-adjusted discount rate method and groups projects according to purpose, and then it uses a required rate of return or discount rate that has been preassigned to that purpose or risk class. The expected cash flows for these projects are given here:
PROJECT A PROJECT B
Initial investment $250,000 $400,000
Cash inflows:
Year 1 $130,000 $135,000
Year 2 40,000 135,000
Year 3 50,000 135,000
Year 4 90,000 135,000
Year 5 130,000 135,000
The purpose/risk classes and preassigned required rates of return are as follows:
PURPOSE REQUIRED RATE OF RETURN
Replacement decision 12%
Modification or expansion of existing product line 15%
Project unrelated to current operations 18%
Research and development operations 20%
Determine each project’s risk-adjusted net present value.
NPV a
=30,000 (.893) + 40,000(.797) + 50,000(.712) + 90,000(.636) + 130,000(.567) - 250,000
=26,790 + 31,880 + 35,600 + 57,240 + 73,710 -250,000
= - $24,780 ---------ANSWER
NPV b
= 135,000(3.127) - 400,000
= 422,145 - 400,000
= $22,145 ---------ANSWER
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