G. Cinquetti Corporation (GCC), uses a cost of capital of 10 percent to evaluate

Question

G. Cinquetti Corporation (GCC), uses a cost of capital of 10 percent to evaluate average-risk projects, and it adds or subtracts 3 percentage points to evaluate projects of more or less risk. The company uses coefficient of variation (CV) to measure riskiness of the projects. Currently, two mutually exclusive projects are under consideration by GCC. Both have a cost of $400,000 and will last 4 years. Project A has a coefficient variable (CV) of 2.30 and will produce annual end of year cash flows of $71,104. Project B, with CV 1.70 will produce cash flows of $146,411 at the end of Years 3 and 4 only. Which project Cinquetti Corporation should accept. Please show you calculations and write a paragraph of 4 lines to explain your approach to solve this problem. GCC classifies a project of average-risk, if project’s CV is 2.00. Show your work step by step. Please be clean and neat. Explain, in words, the approach that you have used to solve this problem in 5 lines. Hint: Topic of this homework is “Capital Budgeting and Uncertainty” and note that as projects become riskier firms adjust cost of capital to reflect risk.

Explanation / Answer

CV for Average risk 2 CV for Project A 2.3 CV for Project B 1.7 Discount rate for project A 13% Discount rate for project B 7% Project A Year Cash flows PV @ 13% Present value 0 -400000 1 -400000.00 1 71104 0.885 62923.89 2 71104 0.783 55684.86 3 71104 0.693 49278.64 4 71104 0.613 43609.41 Net Present value -188503.19 Project B Year Cash flows PV @ 7% Present value 0 -400000 1 -400000.00 1 0.935 0.00 2 0.873 0.00 3 146411 0.816 119514.99 4 146411 0.763 111696.25 Net Present value -168788.76 Interpretation :- It is been seen that NPV for both the project is negetive, so the firm should not opt for any of the project. If one project has to be selected, then firm may go for Project B, as loss is lesser than project A.

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