Both projects are acceptable. Please see the correct answer for a complete explanation.
Project S has the greater relative risk because it has more variation in the probable cash flows. Therefore, the hurdle rate for Project S will be 16% and the hurdle rate for Project R will be 12%. This can be solved by calculating the NPV for each project, using the expected value for its annual net future cash flows and discounting each one's expected annual cash flow at its hurdle rate. If a project’s NPV is positive, it is acceptable. The expected value for Project R's annual cash flows is (.10 × $75,000) + (.80 × $95,000) + (.10 × $115,000) = $95,000. The PV of an annuity factor for 12% for 10 years is 5.650. Therefore, the present value of the future cash inflows is $95,000 × 5.650 = $536,750. $536,750 minus the initial cash outlay of $500,000 equals an NPV of $36,750. The expected value for Project S's annual cash flows is (.25 × $70,000) + (.50 × $110,000) + (.25 × $150,000) = $110,000. The PV of an annuity factor for 16% for 10 years is 4.833. Therefore, the present value of the future cash inflows is $110,000 × 4.833 = $531,630. $531,630 minus the initial cash outlay of $500,000 equals an NPV of $31,630. Since both NPVs are positive, both projects are acceptable.
Both projects are acceptable. Please see the correct answer for a complete explanation.
This answer could result from using 16% as the discount rate for Project R and 12% as the discount rate for Project S. Project S has more risk than Project R because it has more variation in the probable cash flows. Therefore, Project R's cash flows should be discounted at 14% and Project S's cash flows should be discounted at 16%.
|
Ironside has decided that the project with the greatest relative risk should meet a hurdle rate of 16% and the project with less risk should meet a hurdle rate of 12%. Given these parameters, which of the following actions should be recommended for Ironside to undertake?