Fin 450 Module 2 Problems

FIN 450 MODULE 2 PROBLEMS
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Breakeven cash inflows and risk Blair Gasses and Chemicals is a supplier of
highly purified to semiconductors manufactures. A large chip producer has
asked Blair to build a new gas production facility close to an existing
semiconductor plant. Once the new gas plant is in place, Blair will be the
excusive supplier for that semiconductor fabrication plant for the subsequent 5
years. Blair is considering one of two plant designs. The firsts standard
plant which will cost $40 million to build. The custom will allow Blair to produce
their highly specialized gases that are required for and emerging
semiconductor manufacturing process. Blair estimates that its clients will order
$10 million of product per year if the traditional plant is constructed, but if the
customized is put in place, Blair expects to sell $15 million worth of products
annually to it clients. Blair has enough money to build either type of plant, and
in the absence of risk difference, accepts the project with the highest NPV.
The cost of capital is 12%.
A)Find the NPV for each project. Are the projects acceptable?
B) Find the breakeven cash inflow for the project.
C) The firm has estimated the probabilities of achieving various ranges of
cash inflow for the two projects as shown in the following table. What is the
probability that each project will achieve the breakeven cash inflow found in
part b?
Probability of achieving
Cash inflow in given range
Range of cash inflow ($ millions)
Standard Plant
Custom Plant
$0 to $5
0%
5%
$5 to $8
10
10
$8 to 11
60
15
$11 to 14
25
25
$14 to 17
20
$17 to 20
15
Above $20
10
d) Which project is more risky? Which project has the potentially higher NPV?
Discuss the risk-return trade-offs of the two projects.
e). If the firm wishes to minimize losses (that is, NPV < $0), which project
would you recommend? Which would you recommend if the goal were to
achieve a higher NPV?
P12-4
Basic scenario Murdock Paints is in the process of evaluating two mutually
exclusive additions to the process capacity. The firms financial analyses
have developed pessimistic, most likely and optimistic estimates of an annual
cash inflows associated with cash projects. The estimates are shown in the
following table.
Project-A
Initial investments (CFo)

Outcome
-$8,000
Project-B
-$8,000
Annual cash flow (CF)
Pessimistic
$200
$900
Most Likely
1,000
1,000
Optimistic
1,800
1,000
a). Determine the range of annual cash inflows for cash of the two operations
b). Assume that the firms cost of capital is10% and that both projects have 20year lives. Construct a table similar to this one for the NPVs for each project.
Include the range of NPVs for each project.
c) Do parts a, and b provide consistent views of the two projects? Explain.
d) Which project do you recommend? Why?
P12-8
Risk adjustment discount rates; Basic Country Wallpaper is considering
investing in one of three mutually exclusive projects, E, F, and G. The firms
cost of capital, r is 15%, and the risk free rate is R, is10%. The firm has
gathered the basic cash flow and risk index data for each project as shown in
the following table.
Projects r
E
Initial investment (CFo)
-$15,000
-$11,000
-$19,000
Cash inflows (CFt)

Years (t)
1
$6,000
$6,000
$4,000
6,000
4,000
6,000
6,000
5,000
8,000
6,000
2,000
12,000
Risk index (R1t)
1.8
1.00
0.60
a). Find the net present value (NPV) of each project using the firms cost of
capital.
Which project is preferred in this situation?
b). The used the following equation ton determine the risk-adjusted discount
rate RADR, for each project j:
RADR j= Rf + [ RIj x (r Rf) ]
P12-12
Risk classes and RADR Moses Manufacturing is attempting to select the best
of three mutually exclusive projects, X, Y, and Z. Although all the projects have
5-year lives, they possess different degrees of risk. Project X is class V, the
highest risk class; project Y is II, the below average risk class; and project Z is
class III, the average risk class. The basic cash flow data for each project and
risk class and risk adjustment discount rates (RADRs) used by the firm are
shown in the following tables.
Project X
Project Y
Initial investment (CFg)

Year (t)
Project Z
-$180,000
-$235,000
-$310,000
Cash inflows (CFt)
$80,000
$50,000
$90,000
$70,000
$60,000
$90,000
60,000
70,000
90,000
60,000
80,000
90,000
60,000
90,000
90,000
Risk Classes and RADRs

Risk class
Descriptions
Risk-adjusted discount
Lowest risk
10%
rate (RADR)
I
II
Below-average risk
III
Average risk
IV
Above average risk
13
15
19
Highest risk
22
a) Find the risk adjusted NPV for each project.

b) Which project if any, would you recommend that the firm undertake?
P12-14
Unequal lives; ANPV approach Portland Products is considering the purchase
of one of three manually exclusive projects for increasing production efficiency.
The firm planes to use a 14% cost of capital to evaluate these equal risk
projects. The initial investment and annual cash inflows over the life of each
project are shown in the following table.
Project X
Project Y
Initial investment (CFo)
Project Z
-$78,000
Year (f)
-$52,000
-$66,000
Cash inflows (CFt)
$17,000
$28,000
25,000
38,000
$15,000
$15,000
33,000
$15,000
$41,000
$15,000
$15,000
$15,000
$15,000
$15,000
a) Calculate the NPV for each project over its life. Rank the project in
descending order on the basis of NVP
b) Use the annualized net present value (ANPV) approach to evaluate and
rank the projects in descending order on the basis of ANPV.
c)Compare and contrast your findings in parts a and b. Which project would
you recommend?
P12-18
Capital rationing; IRR and NPV Valley Corporation is attempting to select the
best of a group of independent projects competing for the firms fixed capital
budget of $4.5 million. The firms recognize that any unused portion of this
budget will less then 15% cost of capital, thereby resulting in a present value
of inflows, that that is less than the initial investment. The firm has
summarized in the following table, the key data to be used in selecting the
best group of projects.
Projects
Initial investments
IRR
-$5,000,000
17%
-800,000
18
-2,000,000
19
Present value of inflows at 15%

$5,400,000
1,100,000
2,300,000
-1,500,000
16
1,600,000
-800,000
22
900,000
-2,500,000
23
3,000,000
-1,200,000
20
1,300,000
a) Use the internal rate of return (IRR) to select the best group of projects.
b) Use the net present value (NPV) approach to select the best group of
projects.
c) Compare, contrast, and discuss your findings in parts a and b.
d) Which project should the firm implement? Why?

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FIN 450 MODULE 2 PROBLEMS

Range of cash inflow ($ millions)

Initial investments (CFo)

Annual cash flow (CF)

Initial investment (CFo)

Cash inflows (CFt)

Risk index (R1t)

Initial investment (CFg)

Cash inflows (CFt)

Risk Classes and RADRs

Above average risk

a) Find the risk adjusted NPV for each project.

Initial investment (CFo)

Cash inflows (CFt)

Present value of inflows at 15%

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