Risk classes and RADR Moses Manufacturing is attempting to select the best of th
ID: 1170826 • Letter: R
Question
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 differing degrees of risk Project X is in class V, the highest-risk class; project Y is in class II, the below-average-risk class; and project Z is in class IlI, the average-risk class. The basic cash flow data for each project and the risk classes risk-adjusted discount rates (RADRs) used by the firm are shown in the following tables a. Find the risk-adjusted NPV for each project. b. Which project, if any, would you recommend that the firm undertake? Data Table Click on the icon located on the top-right corner of the data table below in order to copy its contents into a spreadsheet.) Project X Initial investment (CFo $175,000 Project Y $238,000 Cash inflows (CF) S57,000 66,000 73,000 85,000 98,000 Project Z $309,000 Year (t) $78,000 68,000 60,000 61,000 61,000 $90,000 90,000 90,000 90,000 90,000 Risk Classes and RADRs Risk Class Description Risk adjusted discount rate (RADR) 10.2% 13.3 15.1 18.9 22.0 Lowest risk Average risk Above-average risk Highest riskExplanation / Answer
NPV is the present value of all cashflows associated with the project, discounted by their risk adjusted rate of return to PV.
Risk adjusted NPV for projects is calculated as:
Project X
Discounted Cashflow
CF0
(175,000)
= -175000/(1 +0.22)^0
(175,000.00)
CF1
78,000
= 78000/(1 +0.22)^1
63,934.43
CF2
68,000
= 68000/(1 +0.22)^2
45,686.64
CF3
60,000
= 60000/(1 +0.22)^3
33,042.41
CF4
61,000
= 61000/(1 +0.22)^4
27,535.34
CF5
61,000
= 61000/(1 +0.22)^5
22,569.95
Class
V
Sum of Discounted CFs
17,768.78
RADR
22%
For Project X, Risk adjusted NPV = $17,768.78
Project Y
Discounted Cashflow
CF0
(238,000)
= -238000/(1 +0.133)^0
(238,000.00)
CF1
57,000
= 57000/(1 +0.133)^1
50,308.91
CF2
66,000
= 66000/(1 +0.133)^2
51,414.32
CF3
73,000
= 73000/(1 +0.133)^3
50,191.84
CF4
85,000
= 85000/(1 +0.133)^4
51,582.13
CF5
98,000
= 98000/(1 +0.133)^5
52,489.99
Class
II
Sum of Discounted CFs
17,987.20
RADR
13.30%
For Project Y, Risk adjusted NPV = $17,987.20
Project Z
Discounted Cashflow
CF0
(309,000)
= -309000/(1 +0.151)^0
(309,000.00)
CF1
90,000
= 90000/(1 +0.151)^0
78,192.88
CF2
90,000
= 90000/(1 +0.151)^0
67,934.73
CF3
90,000
= 90000/(1 +0.151)^0
59,022.36
CF4
90,000
= 90000/(1 +0.151)^0
51,279.20
CF5
90,000
= 90000/(1 +0.151)^0
44,551.87
Class
III
Sum of Discounted CFs
(8,018.98)
RADR
15.10%
For Project Z, Risk adjusted NPV = - $8,018.98
b. With Positive and maximum risk adjusted NPV, select Project Y.
Project X would be the second preference and can be accepted.
Avoid project Z, since it has a negative NPV.
Project X
Discounted Cashflow
CF0
(175,000)
= -175000/(1 +0.22)^0
(175,000.00)
CF1
78,000
= 78000/(1 +0.22)^1
63,934.43
CF2
68,000
= 68000/(1 +0.22)^2
45,686.64
CF3
60,000
= 60000/(1 +0.22)^3
33,042.41
CF4
61,000
= 61000/(1 +0.22)^4
27,535.34
CF5
61,000
= 61000/(1 +0.22)^5
22,569.95
Class
V
Sum of Discounted CFs
17,768.78
RADR
22%
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