Thompson Industries is considering undertaking a new project with a one-year lif

Question

Thompson Industries is considering undertaking a new project with a one-year life with the following expected return scenarios.

The company currently has no debt, but is considering borrowing $870,000 on a short-term basis to help finance its purchase of the project. The company will owe $900,000, including principal and interest, in one year. There is 60% chance a boom will occur, and only 40% chance a bust will occur.

Part 2: Case Analysis

1)  Calculate the expected value of the high- and low-risk projects to Thompson Industry

Scenario 1 HIGH-RISK PROJECT Scenario 2 LOW-RISK PROJECT Cash flow (boom) $1,500,000 $1,000,000 Cash flow (bust) $400,000 $500,000

Explanation / Answer

1)

Excepted value of High risk project = (1,500,000 x 0.60) + (400,000 x 0.40)

                                                                       =$1,060,000

Excepted value of low risk project = (1,000,000 x 0.60) + (500,000 x 0.40)

                                                                       =$800,000

Since High risk project has higher expected cash flow, they would choose high risk project.

2) Expected value of high risk project =1060,000

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