Heywood Diagnostic Enterprises is evaluating a project with the following net ca
ID: 2360501 • Letter: H
Question
Heywood Diagnostic Enterprises is evaluating a project with the following net cash flows and probabilities: Year Prob=0.2 Prob=0.6 Prob=0.2 0 -$100,000 -$100,000 -$100,000 1 $20,000 $30,000 $40,000 2 $20,000 $30,000 $40,000 3 $20,000 $30,000 $40,000 4 $20,000 $30,000 $40,000 5 $30,000 $40,000 $50,000 The Year 5 values include salvage value. Heywood's corporate cost of capital is 10 percent. a. What is the project's expected (i.e., base case) NPV assuming average risk? (Hint: The base case net cash flows are the expected cash flows in each year.) b. What are the project's most likely, worst, and best case NPVs? c. What is the project's expected NPV on the basis of the scenario analysis? d. What is the project's standard deviation of NPV? e. Assume that Heywood's managers judge the project to have higher-than-average risk. Furthermore, the company's policy is to adjust the corporate cost of capital up or down by 3 percentage points to account for differential risk. Is the project financially attractive?Explanation / Answer
a. First you need to find the expected cash flow in each year years 1 - 4 are the same cash flows so they'll all be (0.2)(20) + (0.6)(30) + (0.2)(40) = 30 year 5 (0.2)(30) + (0.6)(40) + (0.2)(50) =40 So the expected NPV is -100 + 30/1.1 + 30/1.1^2 + 30/1.1^3 + 30/1.1^4 + 40/1.1^5 =19.932 or 19932 b. worst case NPV = -17975 most likely NPV = 19932 best case NPV = 57840 (see solution for c) c. The first thing you want to do is calculate the NPV for each state. State A -100 + 20/1.1 + 20/1.1^2 + 20/1.1^3 + 20/1.1^4 + 30/1.1^5 = -17.975 or -17975 State B -100 + 30/1.1 + 30/1.1^2 + 30/1.1^3 + 30/1.1^4 + 40/1.1^5 =19.932 or 19932 State C -100 + 40/1.1 + 40/1.1^2 + 40/1.1^3 + 40/1.1^4 + 50/1.1^5 =57.840 or 57840 Now we want to find the expected NPV weighted for the probability of each scenario so: (-17975)*(0.2) + (19932)*(0.6) + (57840)*(0.2) =19932.2 d. Using excel or a similar spreadsheet software, you plug in the three numbers -17975, 19932, and 57840 to get SDEV = 37907.5 e. all you do here is increase the discount rate 10% by 3% now you recalculate the NPVs State A -100 + 20/1.13 + 20/1.13^2 + 20/1.13^3 + 20/1.13^4 + 30/1.13^5 = -24.227 or -24227 State B -100 + 30/1.13 + 30/1.13^2 + 30/1.13^3 + 30/1.13^4 + 40/1.13^5 =10.944 or 10944 State C -100 + 40/1.13 + 40/1.13^2 + 40/1.13^3 + 40/1.13^4 + 50/1.13^5 =46.116 or 46116 so: (-24227)*(0.2) + (10944)*(0.6) + (46116)*(0.2) =10944.2 Since the new adjusted NPV is still positive the project is financially attractive.