Country Wallpapers is considering investing in one of three mutually exclusive?
ID: 1170800 • Letter: C
Question
Country Wallpapers is considering investing in one of three mutually exclusive? projects, E,? F, and G. The? firm's cost of? capital r, is 15.2% and the risk free rate, RF?, is 10.2%. The firm has gathered the following basic cash flow and risk index data for each project:
Project (j)
E
F
G
Initial Investment (CF0)
$15,600
$11,000
$19,300
Year (t)
Cash Flows
1
$6,400
$5,700
$4,100
2
6,400
3,500
6,800
3
6,400
4,600
8,000
4
6,400
1,500
12,200
Risk index (RI)
1.77
1.02
0.55
Find the net present value? (NPV?) of each project using the? firm's cost of capital. Which project is preferred in this? situation?
The firm uses the following equation to determine the? risk-adjusted discount? rate, RADRj?, for each project j ?:
j=RF+RIj×r?RF
where RF ?= risk-free rate of? return, RIj ?= risk index for project j ?, and r ?= cost of capital.
c. Use the RADR for each project to determine its ?risk-adjusted NPV. Which project is preferable in this? situation?
d. Compare and discuss your findings in parts ?(a?) and ?(c?).??Which project do you recommend that the firm? accept?
Project (j)
E
F
G
Initial Investment (CF0)
$15,600
$11,000
$19,300
Year (t)
Cash Flows
1
$6,400
$5,700
$4,100
2
6,400
3,500
6,800
3
6,400
4,600
8,000
4
6,400
1,500
12,200
Risk index (RI)
1.77
1.02
0.55
Explanation / Answer
Discount rate = 15.2 %
j=RF+RIj×(r?RF )
There are 3 different discount rates for 3 project
Project E Disount rate = RF+RIj×r?RF = 10.2% + 1.77 * ( 15.2 - 10.2%) = 0.1905 or 19.05%
Project F Disount rate = RF+RIj×r?RF = 10.2% + 1.02 * ( 15.2 - 10.2%) = 0.1503 or 15.30%
Project G Disount rate = RF+RIj×r?RF = 10.2% + 0.55 * ( 15.2 - 10.2%) = 0.1295 or 12.95%
As a result Project G should be selected as its risk adjusted NPV 0f 2,707.35 is highest
Best of Luck. God Bless
Project (j) E F G Initial Investment (CF0) $15,600 $11,000 $19,300 Year 1 $6,400 $5,700 $4,100 2 6,400 3,500 6,800 3 6,400 4,600 8,000 4 6,400 1,500 12,200 Risk index (RI) 1.77 1.02 0.55 Initial Discount rate 15.20% 15.20% 15.20% Risk adjusted Discount rate 19.05% 15.30% 12.95% a) NPV using Excel function= NPV(Dicount rate , Cash Flows)- Initial Investment $2,598.19 $445.78 $1,542.82 Based on NPV Project E should be selected as it has highest NPV b) Risk Adjusted NPV $1,270.75 $426.14 $2,707.55 Project G should be selected as it has highest Risk adjusted NPV c) In case a) NPV of E is maximum whereas in case b) NPV of G is maximum Comparing both the methods risk adjusted method is more accurate has higher discount rate should be applied to risky projectsAs a result Project G should be selected as its risk adjusted NPV 0f 2,707.35 is highest
Best of Luck. God Bless