Chapter 13: Risk and Capital Budgeting

Chapter 13 Risk and Capital Budgeting

Discussion Questions
13-1. If corporate managers are risk-averse, does this mean they will not take risks? Explain. Risk-averse corporate managers are not unwilling to take risks, but will require a higher return from risky investments. There must be a premium or additional compensation for risk taking. 13-2. Discuss the concept of risk and how it might be measured. Risk may be defined in terms of the variability of outcomes from a given investment. The greater the variability, the greater the risk. Risk may be measured in terms of the coefficient of variation, in which we divide the standard deviation (or measure of dispersion) by the mean. We also may measure risk in terms of beta, in which we determine the volatility of returns on an individual stock relative to a stock market index. 13-3. When is the coefficient of variation a better measure of risk than the standard deviation? The standard deviation is an absolute measure of dispersion while the coefficient of variation is a relative measure and allows us to relate the standard deviation to the mean. The coefficient of variation is a better measure of dispersion when we wish to consider the relative size of the standard deviation or compare two or more investments of different size. 13-4. Explain how the concept of risk can be incorporated into the capital budgeting process. Risk may be introduced into the capital budgeting process by requiring higher returns for risky investments. One method of achieving this is to use higher discount rates for riskier investments. This risk-adjusted discount rate approach specifies different discount rates for different risk categories as measured by the coefficient of variation or some other factor. Other methods, such as the certainty equivalent approach, also may be used.

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13-5.

If risk is to be analyzed in a qualitative way, place the following investment decisions in order from the lowest risk to the highest risk: New equipment. New market. Repair of old machinery. New product in a foreign market. New product in a related market. Addition to a new product line. Referring to Table 13-3, the following order would be correct: repair old machinery (c) new equipment (a) addition to normal product line (f) new product in related market (e) completely new market (b) new product in foreign market (d)

13-6.

Assume a company, correlated with the economy, is evaluating six projects, of which two are positively correlated with the economy, two are negatively correlated, and two are not correlated with it at all. Which two projects would you select to minimize the companys overall risk? In order to minimize risk, the firm that is positively correlated with the economy should select the two projects that are negatively correlated with the economy.

13-7.

Assume a firm has several hundred possible investments and that it wants to analyze the risk-return trade-off for portfolios of 20 projects. How should it proceed with the evaluation? The firm should attempt to construct a chart showing the risk-return characteristics for every possible set of 20. By using a procedure similar to that indicated in Figure 13-11, the best risk-return trade-offs or efficient frontier can be determined. We then can decide where we wish to be along this line.

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13-8.

Explain the effect of the risk-return trade-off on the market value of common stock. High profits alone will not necessarily lead to a high market value for common stock. To the extent large or unnecessary risks are taken, a higher discount rate and lower valuation may be assigned to our stock. Only by attempting to match the appropriate levels for risk and return can we hope to maximize our overall value in the market.

13-9.

What is the purpose of using simulation analysis? Simulation is one way of dealing with the uncertainty involved in forecasting the outcomes of capital budgeting projects or other types of decisions. A Monte Carlo simulation model uses random variables for inputs. By programming the computer to randomly select inputs from probability distributions, the outcomes generated by a simulation are distributed about a mean and instead of generating one return or net present value, a range of outcomes with standard deviations are provided.

Chapter 13 Problems
1. Risk Averse (LO2) Assume you are risk averse and have the following three choices. Which project will you select? Compute the coefficient of variation for each. Expected Value $1,800 2,000 1,500 Standard Deviation $900 1,400 500

A B C

13-1. Solution: V= A. B. C. $900 / $1,800 = .50 1,400 / 2,000 = .70 $500 / $1,500 = .33

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Based on the coefficient of variation, you should select Project C as it is the least risky.
2. Expected value and standard deviation (LO1) Lowe Technology Corp. is evaluating the introduction of a new product. The possible levels of unit sales and the probabilities of their occurrence are given: Possible Market Reaction Low response........................................... Moderate response................................... High response.......................................... Very high response.................................. a. b. Sales in Units 20 40 65 80 Probabilities .10 .20 .40 .30

What is the expected value of unit sales for the new product? What is the standard deviation of unit sales?

13-2. Solution: Lowe Technology Corp a. D 20 40 65 80 D = DP P .10 .20 .40 .30 DP 2 8 26 24 60 = D

b.

D D 2P

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D 20 40 65 80

D 60 60 60 60

(D D) 40 20 +5 +20

(D D)2 1,600 400 25 400

P .10 .20 .40 .30

(D D)2 P 160 80 10 120 370

370 = 19.24 =
3. Expected value and standard deviation (LO1) Northern Wind Power, a new age energy company, is considering the introduction of a product intended to use wind as an energy producing device. The possible level of unit sales and the probability of their occurrence are given. Acceptance Potential Low Moderate Strong Very Strong a. b. Sales in Units 50 70 90 130 Probabilities .10 .40 .20 .30

What is the expected value of unit sales for the new product? What is the standard deviation of unit sales?

13-3. Solution: Northern Wind Power a. D 50 70 90 140 D = DP P .10 .40 .20 .30 DP 2 28 18 42 90

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b. D 50 70 90 140 D 90 90 90 90

(D D)

P P .10 .40 .20 .30 (D D) 2 P 160 160 0 750 1070

(D D) 40 20 0 +50

(D D) 2 1,600 400 0 2,500

4.

Coefficient of variation (LO1) Shack Homebuilders, Limited, is evaluating a new promotional campaign that could increase home sales. Possible outcomes and probabilities of the outcomes are shown below. Compute the coefficient of variation. Possible Outcomes Ineffective campaign................... Normal response.......................... Extremely effective..................... Additional Sales in Units 40 60 140 Probabilities .20 .50 .30

1070 = 32.71 =

Solution: Shack Homebuilders, Limited Coefficient of variation (V) = standard deviation/expected value. D = DP D P DP 40 .20 8 60 .50 30 140 .30 42 80= D

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=
D 40 60 140 D 80 80 80

(D D)
(D D) 40 20 +60

P P .20 .50 .30 (D D) 2 P 320 200 1,080 1,600

(D D) 2 1,600 400 3,600

5.

Coefficient of variation (LO1) Sam Sung is evaluating a new advertising program that could increase electronics sales. Possible outcomes and probabilities of the outcomes are shown below. Compute the coefficient of variation. Possible Outcomes Ineffective campaign................ Normal response....................... Extremely effective.................. Additional Sales in Units 80 124 340 Probabilities .20 .50 .30

1, 600 = 40 = 40 V= = .50 80

13-5. Solution: Sam Sung Coefficient of variation (V) = standard deviation/expected value. D = DP D 80 124 340 P .20 .50 .30 DP 16 62 102 180 = D
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=
D 80 124 340 D 180 180 180

(D D)

P P .20 .50 .30 (D D) 2 P 2,000 1,568 7,680 11,248

(D D) 100 56 +160

(D D) 2 10,000 3,136 25,600

11, 248 = 106.06 = V=

6.

106.06 = .589 180

Coefficient of variation (LO1) Possible outcomes for three investment alternatives and their probabilities of occurrence are given below. Alternative 1 Outcomes Probability 50 .2 80 .4 120 .4 Alternative 2 Outcomes Probability 90 .3 160 .5 200 .2 Alternative 3 Outcomes Probability 80 .4 200 .5 400 .1

Failure.......... Acceptable.... Successful.....

Rank the three alternatives in terms of risk from lowest to highest (compute the coefficient of variation).

13-6. Solution: Alternative 1 D P = DP $50 0.2 $10 80 0.4 32 120 0.4 48

D = $90

Alternative 2 D P = P $90 0.3 $27 160 0.5 80 200 0.2 40

D

Alternative 3 D P = DP $80 0.4 $32 200 0.5 100 400 0.1 40

D = $172

= D $147

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Standard Deviation Alternative 1 D $ 50 80 120 D $90 90 90 (D D) $40 10 +30 (D D) 2 $1,600 100 900 P .2 .4 .4 (D D) 2 P $320 40 360 $720

720 = $26.83 = 13-6. (Continued) Alternative 2 $ 90 160 200 $147 147 147 $57 +13 +53 $3,249 169 2,809 .3 .5 .2 $ 974.70 84.50 561.80 $1,621.00

1,621 = $40.26 = Alternative 3 $ 80 200 400 $172 172 172 $92 +28 +228 $ 8,464 784 51,984 .4 .5 .1 $3,385.60 392.00 5,198.40 $8,976.00

8,976 = $94.74 = Rank by Coefficient of Variation Coefficient of variation (V) = standard deviation/expected value V
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Alternative 2

40.26 = .274 147 26.83 = .298 90 94.74 = .551 172

Alternative 1

Alternative 3
7.

Coefficient of variation (LO1) Five investment alternatives have the following returns and standard deviations of returns. Alternatives A .................................................. B .................................................. C .................................................. D .................................................. E .................................................. Returns: Expected Value $ 1,200 800 5,000 1,000 60,000 Standard Deviation $ 300 600 450 430 13,200

Using the coefficient of variation, rank the five alternatives from the lowest risk to the highest risk.

13-7. Solution: Coefficient of variation (V) = standard deviation/mean return Ranking from lowest to highest C (.09) E (.22) A (.25) D (.43) B (.75)

A B C D E

300/1,200 = .25 600/800 = .75 450/5,000 = .09 430/1,000 = .43 13,200/60,000 = .22
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8.

Coefficient of variation (LO1) Five investment alternatives have the following returns and standard deviations of returns. Alternative A .................................................. B .................................................. C .................................................. D .................................................. E .................................................. Returns: Expected Value $ 1,000 3,000 3,000 5,000 10,000 Standard Deviation $ 590 600 750 2,300 800

Using the coefficient of variation, rank the five alternatives from lowest risk to highest risk.

13-8. Solution: Coefficient of variation (V) = standard deviation/expected value Ranking from lowest to highest E (.08) B (.20) C (.25) D (.46) A (.59)

A B C D E
9.

$590/$1,000 = .59 $600/$3,000 = .20 $750/$3,000 = .25 $2,300/$5,000 = .46 $800/$10,000 = .08

Coefficient of variation (LO1) In problem 8, if you were to choose between Alternatives B and C only, would you need to use the coefficient of variation? Why?

13-9. Solution: You would not need to use the coefficient of variation. Since B and C have the same expected value, they can be evaluated based solely on their standard deviations of return. C has a larger standard deviation and so is riskier than B for the same expected return.

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10.

Coefficient of variation and time (LO1) Sensor Technology wishes to determine its coefficient of variation as a company over time. The firm projects the following data (in millions of dollars): Year 1 ............................................ 3 ............................................ 6 ............................................ 9 ............................................ a. b. Profits: Expected Value $ 90 120 150 200 Standard Deviation $ 31 52 83 146

Compute the coefficient of variation (V) for each time period. Does the risk (V) appear to be increasing over a period of time? If so, why might this be the case?

13-10. Solution: Sensor Technology a. Profits: Standard Coefficient Year Expected Value Deviation of Variation 1 90 31 .34 3 120 52 .43 6 150 83 .55 9 200 146 .73 b. Yes, the risk appears to be increasing over time. This may be related to the inability to make forecasts far into the future. There is more uncertainty.
11. Risk-averse (LO2) Tim Trepid is highly risk-averse while Mike Macho actually enjoys taking a risk. a. Which one of the four investments should Tim choose? Compute coefficients of variation to help you in your choice. Standard Returns: Deviation Investments Expected Value
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Buy stocks............................. Buy bonds.............................. Buy commodity futures.........

$ 8,800 7,000 16,900

$ 5,600 2,060 22,100

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Buy options........................... b.

11,600

12,400

Which one of the four investments should Mike choose?

13-11. Solution: Coefficient of variation (V) = standard deviation/expected value. Buy stocks Buy bonds Buy commodity futures Buy options $5,600/8,800 = .636 $2,060/7,000 = .294 $22,100/16,900 = 1.308 $12,400/11,600 = 1.069

a. Tim should buy the bonds because bonds have the lowest coefficient of variation. b. Mike should buy the commodity futures because they have the highest coefficient of variation.
12. Risk-averse (LO2) Wildcat Oil Company was set up to take large risks and is willing to take the greatest risk possible. Richmond Construction Company is more typical of the average corporation and is risk-averse. a. b. Which of the following four projects should Wildcat Oil Company choose? Compute the coefficients of variation to help you make your decision. Which one of the four projects should Richmond Construction Company choose based on the same criteria of using the coefficient of variation? Returns: Expected Value $262,000 674,000 88,000 125,000 Standard Deviation $138,000 403,000 108,000 207,000

Projects A .................................................. B .................................................. C .................................................. D ..................................................

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13-12. Solution:

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Chapter 13: Risk and Capital Budgeting

Wildcat Oil Company and Richmond Construction Company Coefficient of variation (V) = standard deviation/expected value Project A Project B Project C Project D $138,000 / 262,000 = .527 $403,000 / 674,000 = .598 $108,000 / 88,000 = 1.227 $207,000 / 125,000 = 1.656

a. Wildcat Oil Company should choose Project D because it has the largest coefficient of variation. b. Richmond Construction Company should choose Project A because it has the smallest coefficient of variation.
13. Coefficient of variation and investment decision (LO1) Kyles Shoe Stores, Inc., is considering opening an additional suburban outlet. An aftertax expected cash flow of $100 per week is anticipated from two stores that are being evaluated. Both stores have positive net present values. Which store site would you select based on the distribution of these cash flows? Use the coefficient of variation as your measure of risk. Site A Probability .2 .3 .3 .2 Cash Flows 50 100 110 135 Probability .1 .2 .4 .2 .1 Site B Cash Flows 20 50 100 150 180

13-13. Solution: Kyles Shoe Stores, Inc. Standard Deviations of Sites A and B Site A

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D $ 50 100 110 135

D $100 100 100 100

(D D) $50 0 +10 +35

(D D) 2 $2,500 0 100 1,225

P .2 .3 .3 .2

(D D) 2 P $500 0 30 245 $775

13-13. (Continued) Site B D $ 20 50 100 150 180 D $100 100 100 100 100

775 = $27.84 = A

(D D) $80 50 0 +50 +80

(D D) 2 $6,400 2,500 0 2,500 6,400

P .1 .2 .4 .2 .1

(D D) 2 P $ 640 500 0 500 640 $2,280

2, 280 = $47.75 = B VA = VB = $27.84/$100 = .2784 $47.75/$100 = .4775

Site A is the preferred site since it has the smallest coefficient of variation. Because both alternatives have the same expected value, the standard deviation alone would have been enough for a decision. A will be just as profitable as B but with less risk.

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Chapter 13: Risk and Capital Budgeting

14.

Risk-adjusted discount rate (LO3) Micro Systems is evaluating a $50,000 project with the following cash flows. Year 1 .......................... 2 .......................... 3 .......................... 4 .......................... 5 .......................... Cash Flows $ 9,000 12,000 18,000 16,000 24,000

The coefficient of variation for the project is .726. Based on the following table of risk-adjusted discount rates, should the project be undertaken? Select the appropriate discount rate and then compute the net present value. Coefficient Discount of Variation Rate 0 .25.................... 6% .26 .50.................... 8 .51 .75.................... 12 .76 1.00.................. 16 1.01 1.25................. 20

13-14. Solution: Micro Systems Year 1 2 3 4 5 Inflows PVIF @ 12% $ 9,000 .893 12,000 .797 18,000 .712 16,000 .636 24,000 .567 PV of Inflows Investment NPV PV $ 8,037 9,564 12,816 10,176 13,608 $54,201 50,000 $ 4,201

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Based on the positive net present value, the project should be undertaken.

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15.

Risk-adjusted discount rate (LO3) Payne Medical Labs is evaluating two new products to introduce into the marketplace. Product 1 (a new form of plaster cast) is relatively low in risk for this business and will carry a 10 percent discount rate. Product 2 (a knee joint support brace) has a less predictable outcome and will require a higher discount rate of 15 percent. Either investment will require an initial capital outlay of $90,000. The inflows from projected business over the next five years are given below. Which product should be selected using net present value analysis? Years 1 .......................... 2 .......................... 3 .......................... 4 .......................... 5 .......................... Product 1 $25,000 30,000 38,000 31,000 19,000 Product 2 $16,000 22,000 34,000 29,000 70,000

13-15. Solution: Payne Medical Labs Product 1 PVIF @ Year Inflows 10% 1 $25,000 .909 2 30,000 .826 3 38,000 .751 4 31,000 .683 5 19,000 .621 PV of Inflows Investment NPV Select Method 1 The instructor may wish to point out that Product 2 has higher undiscounted total cash flows than Product 1 (the numbers are
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Product 2 PVIF @ 15% .870 .756 .658 .572 .497

PV Year Inflows $ 22,725 1 $16,000 24,780 2 22,000 28,538 3 34,000 21,173 4 29,000 11,799 5 70,000 $109,015 90,000 $ 19,015

PV $ 13,920 16,632 22,372 16,588 34,790 $104,302 90,000 $ 14,302

Chapter 13: Risk and Capital Budgeting

$171,000 versus $143,000), but has a lower NPV because of the higher discount rate.

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16.

Discount rate and timing (LO1) Fill in the table below from Appendix B. Does a high discount rate have a greater or lesser effect on long-term inflows compared to recent ones? Years 1 .................................. 10 .................................. 20 .................................. Discount Rate 6% 18% _______ _______ _______ _______ _______ _______

13-16. Solution: Discount Rate Years 1 10 20 6% .943 .558 .312 18% .847 .191 .037

The impact of a high discount rate is much greater on long-term value. For example, after the first year, the high discount rate value produces an answer that is 89.8% of the low discount rate (.847/.943). However, after the 20th year, the high discount rate value is only 11.90% of the low discount rate (.037/.312).
17. Expected value with net present value (LO1) Debbys Dance Studios is considering the purchase of new sound equipment that will enhance the popularity of its aerobics dancing. The equipment will cost $25,000. Debby is not sure how many members the new equipment will attract, but she estimates that her increased annual cash flows for each of the next five years will have the following probability distribution. Debbys cost of capital is 11 percent. Cash Flow $3,600 ............................................ 5,000 ............................................ 7,400 ............................................ 9,800 ............................................ Probability .2 .3 .4 .1

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a. b. c.

What is the expected value of the cash flow? The value you compute will apply to each of the five years. What is the expected net present value? Should Debby buy the new equipment?

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13-17. Solution: Debbys Dance Studios a. Expected Cash Flow Cash Flow $3,600 5,000 7,400 9,800 b. Net Present Value P .2 .3 .4 .1 $ 720 1,500 2,960 980 $6,160 (Appendix D)

$6,160 3.696 (PVIFA @ 11%, n = 5) = $22,767 Present Value of inflows 25,000 Present Value of outflows $(2,233) Net Present Value c. Debby should not buy this new equipment because the net present value is negative.
18. Deferred cash flows and risk-adjusted discount rate Highland Mining and Minerals Co. is considering the purchase of two gold mines. Only one investment will be made. The Australian gold mine will cost $1,600,000 and will produce $300,000 per year in years 5 through 15 and $500,000 per year in years 16 through 25. The U.S. gold mine will cost $2,000,000 and will produce $250,000 per year for the next 25 years. The cost of capital is 10 percent. a. Which investment should be made? (Note: In looking up present value factors for this problem, you need to work with the concept of a deferred annuity for the Australian mine. The returns in years 5 through 15 actually represent 11 years; the returns in years 16 through 25 represent 10 years.) If the Australian mine justifies an extra 5 percent premium over the normal cost of capital because of its riskiness and relative uncertainty of cash flows, does the investment decision change?

b.

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13-18. Solution: Highland Mining and Minerals Co. a. Calculate the net present value for each project. The Australian Mine Years 515 1625 Cash Flow n Factor PVIFA@10% (7.606 3.170) (9.077 7.606) Present Value $1,330,800 $ 735,500 $2,066,300 $1,600,000 $ 466,300

$300,000 (15 4) $500,000 (25 15)

Present Value of inflows Present Value of outflows Net Present Value 13-18. (Continued) The U.S. Mine Years 125 Cash Flow $250,000 n Factor (25) PVIFA@10% 9.077

Present Value $2,269,250 $2,269,250 $2,000,000 $ 269,250

Present Value of inflows Present Value of outflows Net Present Value

Select the Australian Mine. While both mines have a positive net present value, the Australian mine adds more value to the company for with a smaller investment.

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b. Recalculate the net present value of the Australian Mine at a 15 percent discount rate. Present Years Cash Flow n Factor PVIFA @ 15% Value 515 $300,000 (15 4) (5.847 2.855) $ 897,600 1625 $500,000 (25 15) (6.464 5.847) $ 308,500 Present Value of inflows Present Value of outflows Net Present Value $1,206,100 $1,600,000 $ (393,900)

Now the decision should be made to reject the purchase of the Australian Mine and purchase the U.S. Mine.
19. Coefficient of variation and investment decision (LO1) Mr. Sam Golff desires to invest a portion of his assets in rental property. He has narrowed his choices down to two apartment complexes, Palmer Heights and Crenshaw Village. After conferring with the present owners, Mr. Golff has developed the following estimates of the cash flows for these properties. Palmer Heights Yearly Aftertax Cash Inflow (in thousands) Probability $10 .1 .................................. 15 .2 .................................. 30 .4 .................................. 45 .2 .................................. 50 .1 .................................. a. b. c. Crenshaw Village Yearly Aftertax Cash Inflow (in thousands) $15................ 20................ 30................ 40................

Probability .2 .3 .4 .1

Find the expected cash flow from each apartment complex. What is the coefficient of variation for each apartment complex? Which apartment complex has more risk?

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13-19. Solution:

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Chapter 13: Risk and Capital Budgeting

Mr. Sam Golff D = DP Palmer Heights D P DP 10 .1 $1.0 15 .2 3.0 30 .4 12.0 45 .2 9.0 50 .1 5.0 Expected Cash $30.0 Flow (thousands) 13-19. (Continued) b. First find the standard deviation and then the coefficient of variation. V= D Palmer Heights D $10 15 30 45 50 D $30 30 30 30 30 (D D) $20 15 0 +15 +20 (D D) 2 $400 225 0 225 400 P .10 .20 .40 .20 .10 (D D) 2 P 40 45 0 45 40 170 D 15 20 30 40 Crenshaw Village P DP .2 $ 3.0 .3 6.0 .4 12.0 .1 4.0

Expected Cash $25.0 Flow (thousands)

170 = $13.04 (thousands) =

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V= $13.04/$30 = .435 Crenshaw Village D $15 20 30 40 D $25 25 25 25 (D D) $10 5 +5 +15 (D D) 2 $100 25 25 225 P .20 .30 .40 .10 (D D) 2 P 20.0 7.5 10.0 22.5 $60.0

60 = $7.75 (thousands) = V=$7.75/$25=.310 c. Based on the coefficient of variation, Palmer Heights has more risk (.435 vs. .310).
20. Risk-adjusted discount rate (LO3) Referring to problem 19, Mr. Golff is likely to hold the complex of his choice for 25 years, and will use this time period for decision-making purposes. Either apartment complex can be acquired for $200,000. Mr. Golff uses a riskadjusted discount rate when considering investments. His scale is related to the coefficient of variation. Coefficient of Variation 0 0.20................................ 0.21 0.40................................ 0.41 0.60................................ Over 0.90................................ a. b. Discount Rate 5% 9 13 16

(cost of capital)

Compute the risk-adjusted net present values for Palmer Heights and Crenshaw Village. You can get the coefficient of correlation and cash flow figures (in thousands) from the previous problem. Which investment should Mr. Golff accept if the two investments are mutually exclusive? If the investments are not mutually exclusive and no capital rationing is involved, how would your decision be affected?

13-20. Solution:

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Mr. Sam Golff (Continued)

a. Risk-adjusted net present value

Palmer Heights Crenshaw Village With V = .435, With V = .310, discount rate = 13% discount rate = 9% Expected Cash Flow $ 30,000 $ 25,000 IFPVA (n = 25) 7.330 9.823 Present Value of Inflows $219,900 $245,575 Present Value of Outflows 200,000 $200,000 Net Present Value $ 19,900 $ 45,575 13-20. (Continued) b. If these two investments are mutually exclusive, he should accept Crenshaw Village because it has a higher net present value. If the investments are non-mutually exclusive and no capital rationing is involved, they both should be undertaken.
21. Decision-tree analysis (LO4) Allisons Dresswear Manufacturers is preparing a strategy for the fall season. One alternative is to expand its traditional ensemble of wool sweaters. A second option would be to enter the cashmere sweater market with a new line of highquality designer label products. The marketing department has determined that the wool and cashmere sweater lines offer the following probability of outcomes and related cash flows.

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Expand Wool Sweaters Line Expected Sales Fantastic.................... Moderate.................... Low............................ Present Value of Cash Flows from Sales $180,000 130,000 85,000

Probability .2 .6 .2

Enter Cashmere Sweaters Line Present Value of Cash Flows Probability from Sales .4 $300,000 .2 230,000 .4 0

The initial cost to expand the wool sweater line is $110,000. To enter the cashmere sweater line the initial cost in designs, inventory, and equipment is $125,000. a. Diagram a complete decision tree of possible outcomes similar to Figure 138. Note that you are dealing with thousands of dollars rather than millions. Take the analysis all the way through the process of computing expected NPV (last column for each investment). b. Given the analysis in part a, would you automatically make the investment indicated?

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13-21. Solution: Allisons Dresswear Manufacturers a. (1) Expected Sales Fantastic Moderate Low (2) (3) Present Value of cash flows from sales $180,000 130,00 0 85,00 0 (4) (5) NPV (3) (4) $70,000 20,000 (25,000) Expected NPV Enter Cashmere Sweaters Fantastic Moderate Low .4 .2 .4 $300,000 230,000 0 $125,000 125,000 125,000 $175,000 105,000 (125,000) Expected NPV (6) Expected NPV (2) (5) $14,000 12,000 (5,000) $21,000 $70,000 21,000 (50,000) $41,000

Expand Wool Sweaters

Probability .2 .6 .2

Initial cost $110,000 110,000 110,000

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b. The indicated investment, based on the expected NPV, is in the Cashmere sweater line. However, there is more risk in this alternative so further analysis may be necessary. It is not an automatic decision.

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22.

Probability analysis with a normal curve distribution (LO4) When returns from a project can be assumed to be normally distributed, such as those shown in Figure 136 on page ___ (represented by a symmetrical, bell-shaped curve), the areas under the curve can be determined from statistical tables based on standard deviations. For example, 68.26 percent of the distribution will fall within one standard deviation of the expected value ( D 1). Similarly 95.44 percent will fall within two standard deviations ( D 2), and so on. An abbreviated table of areas under the normal curve is shown here. Number of s from Expected Value 0.5 ...................................... 1.0 ...................................... 1.5 ...................................... 1.96 ...................................... 2.0 ...................................... + or 0.1915 0.3413 0.4332 0.4750 0.4772 + and 0.3830 0.6826 0.8664 0.9500 0.9544

Assume Project A has an expected value of $30,000 and a standard deviation () of $6,000. a. b. c. d. e. What is the probability that the outcome will be between $24,000 and $36,000? What is the probability that the outcome will be between $21,000 and $39,000? What is the probability that the outcome will be at least $18,000? What is the probability that the outcome will be less than $41,760? What is the probability that the outcome will be less than $27,000 or greater than $39,000?

13-22. Solution: a. expected value = $30,000, = $6,000 $24,000 > $30,000 < $36,000 expected value 1 .6826 b. $21,000 > $30,000 < $39,000 expected value 1.5 .8664

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13-22. (Continued) c. at least $18,000

$18,000 .4772 $18, 000 $30, 000 $12, 000 = = 2 $6,000 $6, 000 .5000 .9772 Distribution under the curve
d.

Less than $41,760

$41,760 $41, 760 $30, 000 $11, 760 = = 1.96 $6, 000 $6, 000

.4750 .5000 .9750 Distribution under the curve

13-37

13-22. (Continued) e. Less than $27,000 or greater than $39,000

$27,000

$39,000 Area

$27,000 $30,000 $3,000 = = .5 .1915 .5000 .1915 = .3085 $6,000 $6,000 $39,000 $30,000 $9,000 .0668 = = 1.5 .4332 .5000 .4332 = $6,000 $6,000 .3753 Distribution under the curve is .3753
23. Increasing risk over time (LO1) The Oklahoma Pipeline Company projects the following pattern of inflows from an investment. The inflows are spread over time to reflect delayed benefits. Each year is independent of the others. Year 1 Cash Inflow 65 .................... 80 .................... 95 .................... Probability .20 .60 .20 Year 5 Cash Inflow 50....... 80....... 110....... Probability .25 .50 .25 Year 10 Cash Inflow Probability 40 .30 ................... 80 .40 ................... 120 .30 ...................

The expected value for all three years is $80. a. Compute the standard deviation for each of the three years. b. Diagram the expected values and standard deviations for each of the three years in a manner similar to Figure 136. c. Assuming 6 percent and 12 percent discount rates, complete the table below for present value factors. PVIF 6% .943 PVIF 12% .893

Year 1 ....................

Difference .050

13-38

5 .................... 10 ....................

________ ________

________ ________

________ ________

13-39

d. e.

Is the increasing risk over time, as diagrammed in part b, consistent with the larger differences in PVIFs over time as computed in part c? Assume the initial investment is $135. What is the net present value of the investment at a 12 percent discount rate? Should the investment be accepted?

13-23. Solution: Oklahoma Pipeline Company a. Standard deviationyear 1 D $65 80 95 D 80 80 80 (D D) 15 0 +15 (D D) 2 225 0 225 P .20 .60 .20 (D D) 2 P 45 0 45 90

90 = 9.49 = Standard deviationyear 5 D 50 80 110 D 80 80 80

(D D) 30 0 +30 (D D) 2 900 0 900

P .25 .50 .25

(D D) 2 P 225 0 225 450

450 = 21.21 =

13-40

13-23. (Continued) Standard deviationyear 10 D 40 80 120 D 80 80 80 (D D) 40 0 +40 (D D) 2 1,600 0 1,600 P .30 .40 .30 (D D) 2 P 480 0 480 960

960 = $30.98 = b. Risk over time

D o l l a r s

E x p e c t e d C a s h f l o w ( $ 8 0 )

r .

5 T

y i m

r . e

r .

c. Year 1 5 10 (1) PVIF 6% .943 .747 .558 (2) PVIF 12% .893 .567 .322 (3) PVIF Difference .050 .180 .236

13-41

13-23. (Continued) d. Yes. The larger risk over time is consistent with the larger differences in the present value interest factors (IFPV) over time. In effect, future uncertainty is being penalized by a lower present value interest factor (IFPV). This is one of the consequences of using progressively higher discount rates to penalize for risk. Year 1 5 10 Inflow PVIF (12%) $80 .893 80 .567 80 .322 PV of inflows Investment NPV PV $ 71.4 $ 45.4 $ 25.8 $142.6 $135.0 $ 7.6

e. Accept the investment.

13-42

24.

Portfolio effect of a merger (LO5) Treynor Pie Co. is a food company specializing in high-calorie snack foods. It is seeking to diversify its food business and lower its risks. It is examining three companiesa gourmet restaurant chain, a baby food company and a nutritional products firm. Each of these companies can be bought at the same multiple of earnings. The following represents information about all the companies. Correlation with Treynor Company Pie Company Treynor Pie Company............. + 1.0 Gourmet restaurant.................. + .6 Baby food company................ + .2 Nutritional products company.................................. .7 a. b. Expected Earnings ($ millions) $8 6 4 5 Standard Deviation in Earnings ($ millions) $2.0 1.2 1.8 3.4

Sales ($ millions) $100 60 50 70

Using the last two columns, compute the coefficient of variation for each of the four companies. Which company is the least risky? Which company is the most risky? Discuss which of the acquisition candidates is most likely to reduce Treynor Pie Companys risk? Explain why.

13-24. Solution: Treynor Pie Co. a. Coefficient of variation (V) = standard deviation expected value

Treynor Pie Co. Gourmet Restaurant Baby Food Nutritional Products

(millions) $2/$8 $1.2/$6 $1.8/$4 $3.4/$5

= .25 = .20 = .45 = .68

The Gourmet Restaurant chain is the least risky with a coefficient of variation of .20, while the nutritional products firm has the highest risk with a coefficient of variation of .68

13-43

13-24. (Continued)
b.

Because the nutritional products firm is highly negatively correlated (.7) with Treynor Pie Co., it is most likely to reduce risk. It would appear that the demand for high calorie snack foods moves in the opposite direction as the demand for nutritional items. Thus, Treynor Pie Co. would reduce its risk to the largest extent by acquiring the company with the highest coefficient of variation (.68) as computed in part a. This would appear to represent a paradox, but it is not. It simply reflects the fact that the interaction between two companies is much more important than the individual risk of the companies.

25.

Portfolio effect of a merger (LO5) Transoceanic Airlines is examining a resort motel chain to add to its operation. Prior to the acquisition, the normal expected outcomes for the firm are as follows: Outcomes ($ millions) $30 50 70

Recession............................. Normal economy................. Strong economy...................

Probability .30 .40 .30

After the acquisition, the expected outcomes for the firm would be: Outcomes ($ millions) $ 10 50 100

Recession............................. Normal economy................. Strong economy...................

Probability .30 .40 .30

13-44

a.

Compute the expected value, standard deviation, and coefficient of variation before the acquisition. After the acquisition, these values are as follows: Expected value........................................ Standard deviation................................... Coefficient of variation........................... 53.0 ($ millions) 34.9 ($ millions) .658

b. c. d.

Comment on whether this acquisition appears desirable to you. Do you think the firms stock price is likely to go up as a result of this acquisition? If the firm were interested in reducing its risk exposure, which of the following three industries would you advise it to consider for an acquisition? Briefly comment on your answer. (1) Major travel agency (2) Oil company (3) Gambling casino

Solution: Transoceanic Airlines D $30 50 70 D = DP P PD .30 9 .40 20 .30 21 $50 ($ million)

(D D)

13-45

13-25. (Continued) D $30 50 70 D 50 50 50 (D D) 20 0 +20 (D D) 2 400 0 400 P .30 .40 .30 (D D) 2 P 120 0 120 240

240 = $15.5 ($million) V = $15.5/$50 = .310 b. No, it does not appear to be desirable. Although the expected value is $3 million higher, the coefficient of variation is more than twice as high (.658 vs. .310). The slightly added return probably does not adequately compensate for the added risk. c. Probably not. There may be a higher discount rate applied to the firms earnings to compensate for the additional risk. The stock price may actually go down. d. The oil company may provide the best diversification benefits. The performance of oil companies and airlines tend to go in opposite directions. If oil prices are high, oil companies benefit, but airlines are hurt. The opposite effect is true when oil prices are low. A major travel agency or gambling casino would probably not provide much in the way of risk reduction benefits. They are both closely associated with entertainment and travel.

13-46

26.

Efficient frontier (LO5) Ms. Sharp is looking at a number of different types of investments for her portfolio. She identifies eight possible investments. (a).................. (b).................. (c).................. (d).................. a. Return 11% 11 13 13 Risk 2% 2.5 3.0 4.2 (e).................. (f)................... (g).................. (h).................. Return 14% 16 15 18 Risk 5.0% 5.0 5.8 7.0

Graph the data in a manner similar to Figure 1311. Use the axes below for your data.

b. c. d.

Draw a curved line representing the efficient frontier. What two objectives do points on the efficient frontier satisfy? Is there one point on the efficient frontier that is best for all investors?

13-47

13-26. Solution: Ms. Sharp a., b.

18

17

16

Return

15

14

13

12

11

10 0 1 2 3 4 5 6 7 8

Risk (percent)

c. Achieve the highest possible return for a given risk level. Allow the lowest possible risk at a given return level. d. No. Each investor must assess his or her own preferences about their risk and return trade-off.

13-48

27.

Certainty equivalent approach (LO1) Sheila Goodman recently received her MBA from the Harvard Business School. She has joined the family business, Goodman Software Products, Inc., as vice-president of finance. She believes in adjusting projects for risk. Her father is somewhat skeptical but agrees to go along with her. Her approach is somewhat different than the risk-adjusted discount rate approach, but achieves the same objective. She suggests that the inflows for each year of a project be adjusted downward for lack of certainty and then be discounted back at a risk-free rate. The theory is that the adjustment penalty makes the inflows the equivalent of risk-less inflows, and therefore a risk-free rate is justified. A table showing the possible coefficient of variation for an inflow and the associated adjustment factor is shown below: Coefficient of Variation 0 .25.................. .26 .50.................. .51 .75.................. .76 1.00................ 1.011.25................ Adjustment Factor .90 .80 .70 .60 .50

Assume a $150,000 project provides the following inflows with the associated coefficients of variation for each year. Year 1 ............................. 2 ............................. 3 ............................. 4 ............................. 5 ............................. a. Fill in the table below: Year 1 ......................... 2 ......................... 3 ......................... 4 ......................... Inflow $30,000 50,000 70,000 55,000 Coefficient of Variation .12 .22 .46 .78 Adjustment Factor ___________ _ ___________ _ ___________ _ ___________ _ Adjusted Inflow ___________ _ ___________ _ ___________ _ ___________ _ Inflow $30,000 50,000 70,000 55,000 60,000 Coefficient of Variation .12 .22 .46 .78 1.06

13-49

5 ......................... b.

60,000

1.06

___________ _

___________ _

If the risk-free rate is 5 percent, should this $150,000 project be accepted? Compute the net present value of the adjusted inflows.

13-50

13-27. Solution: Goodman Software Products a. Year 1 2 3 4 5 b. Adjusted Inflows Coefficient Adjustment Adjusted Inflow of Variation Factor Inflow $30,00 .12 .90 $27,000 0 50,000 .22 .90 45,000 70,000 .46 .80 56,000 55,000 .78 .60 33,000 60,000 1.06 .50 30,000 Net Present Value Present Value $ 25,704 40,815 43,384 27,154 23,520 $165,577 150,000 $ 15,577

Adjusted PVIF Year Inflow at 5% 1 $27,000 .952 2 45,000 .907 3 56,000 .864 4 33,000 .823 5 30,000 .784 Present value of adjusted inflows Present value of outflows Net present value

Based on the positive net present value of $15,577, the project should be accepted.

13-51

COMPREHENSIVE PROBLEMS
Comprehensive Problem 1. Gibson Appliance Co. (portfolio effect of a merger) (LO5) Gibson Appliance Co. is a very stable billion-dollar company with a sales growth of about 7 percent per year in good or bad economic conditions. Because of this stability (a coefficient of correlation with the economy of +.4, and a standard deviation of sales of about 5 percent from the mean), Mr. Hoover, the vice-president of finance, thinks the company could absorb a small risky company that could add quite a bit of return without increasing the companys risk very much. He is trying to decide which of the two companies he will buy, using the figures below. Gibsons cost of capital is 12 percent. Genetic Technology Co. (cost $80 million) Cash Flow for 10 Years ($ millions) Probability $2 .2 8 .3 16 .2 25 .2 40 .1 a. b. c. d. e. f. g. Silicon Microchip Co. (cost $80 million) Cash Flow for 10 Years ($ millions) Probability $5 .2 7 .2 18 .3 24 .3

What is the expected cash flow from both companies? Which company has the lower coefficient of variation? Compute the net present value of each company. Which company would you pick, based on the net present values? Would you change your mind if you added the risk dimensions to the problem? Explain. What if Genetic Technology Co. had a coefficient of correlation with the economy of .2 and Silicon Microchip Co. had one of +.5? Which of these companies would give you the best portfolio effects for risk reduction? What might be the effect of the acquisitions on the market value of Gibson Appliance Co.s stock?

13-52

CP 13-1

Solution: Portfolio Effect of a Merger Gibson Appliance Co.

a. Genetic Technology Co. D P DP $2 .2 .4 8 .3 2.4 16 .2 3.2 25 .2 5.0 40 .1 4.0 Expected Value of Cash Flows $15.0 (million)

D $5 7 18 24

Silicon Microchip Co. P DP .2 1.0 .2 1.4 .3 5.4 .3 7.2 $15.0 (million)

Expected Value of Cash Flows

b. Coefficient of variation for Genetic Technology Co. D $2 8 16 25 40 D $15 15 15 15 15 (D D) $13 7 +1 +10 +25 (D D) 2 $169 49 1 100 625 P .2 .3 .2 .2 .1 (D D) 2 P $33.8 14.7 .2 20.0 62.5 $131.2

131.2 = $11.45 (million) = Coefficient of variation = $11.45/$15 = .764 (million)

13-53

CP 13-1. (Continued) Coefficient of variation for Silicon Microchip Co. D $5 7 18 24 D $15 15 15 15 (D D) $103 8 +3 +9 (D D) 2 $100 64 9 81 P .2 .2 .3 .3 (D D) 2 P $20.0 12.8 2.7 24.3 $59.8

59.8 = $7.73 (million) = Coefficient of variation = $7.73/$15 = .515 Silicon Microchip has a lower coefficient of variation, .515 < .764. c. For both companies the annual expected value is $15 million for 10 years. The cost is $80 million for either company. Gibson has a cost of capital of 12%. $15 million PVIFA (n=10, i=12%) (Appendix D) $15 5.650 = $84.750 PV of inflows 80.000 PV of outflows $ 4.750 Net Present Value (million) d. Based on present values, you could pick either company. e. The only way one will win out over the other is if risk factors are considered. Since Genetic Technology Co. has the higher coefficient of variation, we would select the lower risk companySilicon Microchip. If Gibson Appliance Co. uses risk-adjusted cost of capital concepts, it would use a higher cost of capital for the cash flows generated by Genetic Technology Co. and this would reduce its NPV.
13-54

f.

Since Gibson Appliance Co. has a correlation coefficient with the economy of +.4, the selection of Genetic Technology Co. would offer the most risk reduction because its correlation coefficient with the economy is .2.

g. Because Gibson Appliance Co. is a stable billion-dollar company, this investment of $80 million would probably not have a great impact on the stock price in the short run. There could be some positive movement in the stock price if investors perceive less risk from portfolio diversification. This would be particularly true for a merger with Genetic Technology Co. You can use this question to discuss risk-return trade-offs and market reactions.
Comprehensive Problem 2. Kennedy Trucking Company (investment decision based on probability analysis) (LO1) Five years ago, Kennedy Trucking Company was considering the purchase of 60 new diesel trucks that were 15 percent more fuel-efficient than the ones the firm is now using. Mr. Hoffman, the president, had found that the company uses an average of 10 million gallons of diesel fuel per year at a price of $1.25 per gallon. If he can cut fuel consumption by 15 percent, he will save $1,875,000 per year (1,500,000 gallons times $1.25). Mr. Hoffman assumed that the price of diesel fuel is an external market force that he cannot control and that any increased costs of fuel will be passed on to the shipper through higher rates endorsed by the Interstate Commerce Commission. If this is true, then fuel efficiency would save more money as the price of diesel fuel rises (at $1.35 per gallon, he would save $2,025,000 in total if he buys the new trucks). Mr. Hoffman has come up with two possible forecasts shown beloweach of which he feels has about a 50 percent chance of coming true. Under assumption number 1, diesel prices will stay relatively low; under assumption number 2, diesel prices will rise considerably. Sixty new trucks will cost Kennedy Trucking $5 million. Under a special provision from the Interstate Commerce Commission, the allowable depreciation will be 25 percent in year 1, 38 percent in year 2, and 37 percent in year 3. The firm has a tax rate of 40 percent and a cost of capital of 10 percent. a. First compute the yearly expected price of diesel fuel for both assumption 1 (relatively low prices) and assumption 2 (high prices) from the forecasts below. Forecast for assumption 1 (low fuel prices):

13-55

Probability (same for each year)

Price of Diesel Fuel per Gallon Year 1 Year 2 Year 3 $ .90 1.10 1.20 1.45 1.55 $1.00 1.10 1.30 1.45 1.60

.1 $ .80 .2 1.00 .3 1.10 .2 1.30 .2 1.40 Forecast for assumption 2 (high fuel prices): Probability (same For each year) .1 .3 .4 .2 b. c. d. e. f.

Price of Diesel Fuel per Gallon Year 1 Year 2 Year 3 $1.20 1.30 1.80 2.20 $1.50 1.70 2.30 2.50 $1.70 2.00 2.50 2.80

What will be the dollar savings in diesel expenses each year for assumption 1 and for assumption 2? Find the increased cash flow after taxes for both forecasts. Compute the net present value of the truck purchases for each fuel forecast assumption and the combined net present value (that is, weigh the NPV by .5). If you were Mr. Hoffman, would you go ahead with this capital investment? How sensitive to fuel prices is this capital investment?

CP 13-2

Solution: Investment Decision Based on Probability Analysis Kennedy Trucking Company

a. Assumption One:

13-56

Probability .1 .2 .3 .2 .2

Yr.1 D DP $0.8 .08 0 1.00 .20 1.10 1.30 1.40 .33 .26 .28 $1.15/gallon

Yr.2 D $0.9 0 1.10 1.20 1.45 1.55 DP .09 .22 .36 .29 .31 $1.27/gallon

Yr.3 D $1.0 0 1.1 0 1.3 0 1.4 5 1.6 0 DP .10 .22 .39 .29 .32 $1.32/gallon

Expected value Assumption Two: Probability D .1 $1.20 .3 1.30 .4 1.80 .2 2.20 Expected value

Yr.1 Yr.2 Yr.3 DP D DP D DP .12 $1.50 .15 $1.70 .17 .39 1.70 .51 2.00 .60 .72 2.30 .92 2.50 1.00 .44 2.50 .50 2.80 .56 $1.67/gallon $2.08/gallon $2.33/gallon

13-CP 2. (Continued) b. Assumption One: #of Gals. Without Efficiency =

13-57

Yr.

Expected Cost/gal.

Cost

% Savings with Efficiency

Total $ Saved

1 2 3

$1.15 1.27 1.32

10 million

$11,500,00 0 12,700,00 0 13,200,00 0

15%

$1,725,00 0 1,905,000 1,980,000

Assumption Two:

13-58

Yr. 1 2 3

Expected Cost/gal. $1.67 2.08 2.33

#of Gals. without Efficiency = 10 million

Cost $16,700,00 0 20,800,00 0 23,300,00 0

% Savings with Efficiency 15%

Total $ Saved $2,505,000 3,120,000 3,495,000

c. First compute annual depreciation: Then proceed to the analysis. Year 1 Year 2 Year 3 25% $5 mil. = 1.25 mil. 38% $5 mil. = 1.90 mil. 37% $5 mil. = 1.85 mil.

Total saved equals increase in EBDT

13-CP 2. (Continued) Assumption One: Increase in EBDT Depreciation Increase in EBT Taxes 40 percent Increase in EAT + Depreciation Increased Cash Flow Year 1 $1,725,000 1,250,000 475,000 190,000 285,000 1,250,000 $1,535,000 Year 2 $1,905,000 1,900,000 5,000 2,000 3,000 1,900,000 $1,903,000 Year 3 $1,980,000 1,850,000 130,000 52,000 78,000 1,850,000 $1,928,000

13-59

Assumption Two:

13-60

Increase in EBDT - Depreciation Increase in EBT - Taxes 40 percent Increase in EAT + Depreciation Increased Cash Flow 13-CP 2. (Continued) d. Present Value Assumption One: Year 1 2 3

Year 1 Year 2 Year 3 $2,505,000 $3,120,000 $3,495,000 1,250,000 1,900,000 1,850,000 1,255,000 1,220,000 1,645,000 502,000 488,000 658,000 753,000 732,000 987,000 1,250,000 1,900,000 1,850,000 $2,003,000 $2,632,000 $2,837,000

Cash Flow PVIF @ 10% $1,535,000 .909 1,903,000 .826 1,928,000 .751 PV of inflows PV of outflows NPV

Present Value $1,395,315 1,571,878 1,447,928 $4,415,121 5,000,000 $ (584,879)

Assumption Two: Year 1 2 3 Cash Flow PVIF @ 10% $2,003,000 .909 2,632,000 .826 2,837,000 .751 PV of inflows PV of outflows NPV Present Value $1,820,727 2,174,032 2,130,587 $6,125,346 5,000,000 $1,125,346

13-61

Combined NPV: Outcome Assumption One Assumption Two Expected Outcome NPV 584,879 1,125,346 Probability .5 292,440 .5 562.673 $270,233

e. YesThe combined expected value of the outcomes is positive. f. Quite sensitive when that many gallons are used per year.

13-62