The Slumber Corp. is considering two mutually exclusive mattress assemblers. Bot

Question

The Slumber Corp. is considering two mutually exclusive mattress assemblers. Both require an initial outlay of $75,000 and will operate for five years. The probability distributions associated with each assembler for years 1 through 5 are given below:

Cash Flow Years 1-5
Assembler A Assembler B
Probability Cash Flow Probability Cash Flow
.20 $30,000 .20 $18,000
.60 45,000 .60 54,000
.20 60,000 .20 90,000

Since assembler B is the riskier of the two, management has decided to apply a required rate of return of 18 percent to its evaluation but only a 12 percent required rate of return to assembler A.

a. Determine the expected value of each assembler's cash
flows.
b. Determine each assembler's risk-adjusted net present
value.

Explanation / Answer

Expected cash flow per year for A = 0.2*30000+0.6*45000+0.2*60000 = 45000 ($) Expected cash flow per year for B = 0.2*18000+0.6*54000+0.2*90000 = 54000 ($) a) Expected PV of cash flows of A = 45000*((1+0.12)^5 - 1)/(0.12*(1+0.12) =255248.33 ($) (ANSWER) Expected PV of cash flows of B = 54000*((1+0.18)^5 - 1)/(0.18*(1+0.18) =327396.04 ($) (ANSWER) b) NPV of A = 255248.33 - 75000 = 180248.33 ($) (ANSWER) NPV of B = 327396.04 - 75000 = 252396.04 ($) (ANSWER)

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