3. Montrose Manufacturing is considering two potential investments. Each project

Question

3. Montrose Manufacturing is considering two potential investments. Each project will cost $70,000 and have an expected life of five
years. The CFO has estimated the probability distributions for each project's cash flows as shown in the following table.

Probability         Potential Cash Flows

                          Project 1                       Project 2
25%                   12,000                          10,000
50%                    27,000                          30,000
25%                   36,000                           46,000

The company believes that the probability distributions apply to each year of the five years of the projects' lives. Montrose Manufacturing
uses the risk-adjusted discount rate technique to evaluate potential investments.
As a guide for assigning the risk premiums, the CFO has put together the following table based on the coefficient of variation.

Coefficient of Variation      Risk Premium
0.00                                  -1.50%
0.20                                    0%
0.30                                     1%
0.40                                    1.50%
0.50                                     2.50%

a. Calculate the expected cash flows, standard deviation, and coefficient of variation for each project.
b. If the firm's WACC for average risk projects is 10%, what is the appropriate risk-adjusted discount rate for each project? Use the
VLookup function to calculate the project WACC.
c. Using the appropriate discount rates, calculate the payback period, discounted payback period, NPV, PI, IRR, and MIRR for each
project.
d. If the projects are mutually exclusive, which should be accepted? What if they are independent?

Explanation / Answer

a.

Coefficient of variation = standard deviation/return = 8616.843/ 25500 = 0.34467

Coefficient of variation = standard deviation/return = 12767.14533/ 29000 = 0.44024

b)

Project 1

CV = .34467

Risk premium = interpolation between 4 and 3 % for the value of .34467

= 1 + ((0.34467 - 0.3)/(0.4 -0.3) * (1.5 - 1) = 1.22335

Risk adjusted WACC = WACC for average risk project + risk premium = 10 + 1.22335 = 11.22335%

Project 2

CV = .44024

Risk premium = interpolation between 4 and 5 % for the value of .44024

= 1.5 + ((0.44024 - 0.4)/(0.5 -0.4) * (2.5 - 1.5) = 1.9024

Risk adjusted WACC = WACC for average risk project + risk premium = 10 + 1.9024= 11.9024%

Please ask remaining questions seperately

Project 1 Scenario Probability Cash flow =rate of Cashflow * probability Actual Cashflow -expected Cashflow(A) (A)^2* probability Scenario 1 0.25 12000 3000 -13500 45562500 Scenario 2 0.5 27000 13500 1500 1125000 Scenario 3 0.25 36000 9000 10500 27562500 Expected Cashflow = sum of weighted Cashflow = 25500 Sum= 74250000 Standard deviation= Standard deviation of stock A =(sum)^(1/2) 8616.84397

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