Project A generates $5,000.00 in revenue two years from today and costs $4,000.0

Question

Project A generates $5,000.00 in revenue two years from today and costs $4,000.00. Project B generates $4,000.00 (50% probability) or $6,000.00 (50% probability) one year from today and costs $4,500.00. Assuming a discount rate of 12% for both projects, which project does a risk averse manager prefer?

a. Project A

b. Project B

c. Neither project

d. Cannot be determined

A cash flow is expected to be $500.00 (50% probability) or $1,000.00 (50% probability) next year. Assuming the cash flow next year is $500.00, the cash flow the following year is $400.00 (60% probability) or $600.00 (40% probability). Assuming the cash flow next year is $1,000.00, the cash flow the following year is $1,200.00 (80% probability) or $2,000.00 (20%) probability. What is the probability of a $1,200.00 cash flow two years from today? a. 40%

b. 30%

c. 20%

d. 10%

Explanation / Answer

NPV at Project A = 5000 / (1.12)2   - 4000 = -14

NPV at Project B = ( 4000*50% + 6000*50% ) / (1.12) - 4500 = -36

A risk averse manager should choose project A.

Probablity of a 1200 cash flow in year 2 = 0.5 * 0.8 = 40%

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