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(Risk- adjusted discount rates and risk classes) The G. Wolfe Corporation is exa

ID: 2765997 • Letter: #

Question

(Risk- adjusted discount rates and risk classes) The G. Wolfe Corporation is examining two capital-budgeting projects with 5-year lives. The firs, project A, is a replacement project; the second, project B, is a project unrelated to current operations. The G. Wolfe Corporation uses the risk-adjusted discount rate method and groups projects according to purpose, and then it uses a required rate of return or discount rate that has been preassigned to that purpose, and then it users a required rate of return or discount rate that has been preassigned to that purpose or risk class. The expected cash flows for these projects are given here:

Project A

Project B

Initial investment

-$250,000

-$400,000

Cash inflows:

Year 1

$130,000

$135,000

Year 2

40,000

135,000

Year 3

50,000

135,000

Year 4

90,000

135,000

Year 5

130,000

135,000

The purpose/risk classes and preassigned required rates of return are as follows:

Purpose

Required rate of return

Replacement decision

12%

Modification or expansion of existing product line

15

Project unrelated to current operations

18

Research and development operations

20

Determine each project’s risk-adjusted net present value.

Project A

Project B

Initial investment

-$250,000

-$400,000

Cash inflows:

Year 1

$130,000

$135,000

Year 2

40,000

135,000

Year 3

50,000

135,000

Year 4

90,000

135,000

Year 5

130,000

135,000

Explanation / Answer

G.Wolfe Corporation All Amounts in $ For Project A, the required rate of return as per the table is 12% For Project B, the required rate of return as per the table is 18% Given the information pertaining to the cash inflows and outflows, and the rate of return The risk adjusted Net Present Value for Project A will be $ 41,665.67 The risk adjusted Net Present Value for Project B will be $ 18,786.52