Question 8 (Capital Budgeting) A construction company is considering whether to

Question

Question 8 (Capital Budgeting) A construction company is considering whether to invest in project A or B. Project A is expected to generate a cash flow of $200 million for each of the next two years and $60 million for the third year. The risk free interest rate is 5%, the expected return on market portfolio is 10%, and project A’s beta is 1. Project B is a safer project and generates a constant cash flow of $120 million for each of the next three years. Project A and B’s cash flows during their lifetime are summarized below:

(a) Calculate the certainty equivalent of year-2 cash flows for projects A and B. What are the deductions for risk?

(b) Calculate the present value of each project

Year Forecasted Cash Flows for Project A ($ millions) Cash Flows for Project B ($ millions) 1 200 120 2 200 120 3 60 120

Explanation / Answer

a. Risk premium = Rm-Rf = 10-5 = 5%

Certainity equivalent cash flow = Expected cash flow / (1+Risk premium)

Project A = 200 million / (1.05) = $190476190.48

Project B = 120 million / (1.05) = $114285714.29

b. Discount rate = Rf + Beta x Risk premium

= 5 + 1x 5

= 10%

Present value of project A = 200(1.736) + 60(0.751) = $392.26 million

Present value of project B = 120 (2.487) = $298.44 million

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