The ACME Umbrella Company is deciding between two different umbrella factories.
ID: 2813284 • Letter: T
Question
The ACME Umbrella Company is deciding between two different umbrella factories. Both factories will cost $500,000 to get started. However, the cash flows for each factory will depend on whether the next five years are rainier than average or sunnier than average. Factory A will have cash flows of $130,000 per year for the next five years if the weather is sunnier than average. But if it is rainier than average the cash flows will be $150,000 per year for the next five years. Factory B will have cash flows of $100,000 per year for the next five years if it is sunnier than average, but if it is rainier than average it will have cash flows of $200,000 per year. ACME has a cost of capital of 9%. Based on this information, calculate the following:
Calculate the NPV for both factories and for both scenarios (rainy versus sunny). What is the range of NPV for each factory based on your scenario analysis?
Based on your answer to a) above, do you think ACME should use the same discount rate of 9% for each factory? Or should they use a risk-adjusted discount rate (RADR)? If so, which factory should have a higher RADR? Explain your answer with references to the background readings.
Explanation / Answer
Soln : Step 1 : Consider it is as rainy weather
Factory A
Factory B
In case if weather is sunny :
Factory A:
Factory B
We can see here in case of weather is rainy than average, B would make the better project to invest in as NPV is way higher
While on other side if it gets sunny, the NPV of B has gone to a very heavy negative figure, while the A is still maintaining positive cash flows
a) As per the above, ACME should use RADR i,e, risk adjusted discount rate which means risk free rate + risk premium.
HIgher the risk , higher the risk premium and hence the RADR of the same is also gets higher. In this case it seems to be hiher RADR for factory B, as there is higher risk of lossing money in case if things go south i.e. sunny and if it is rainy , the project returns are also on very higher side.
Year,t 0 1 2 3 4 5 Initial cost -500000 Cash flows,C 150000.00 150000.00 150000.00 150000.00 150000.00 discount rate,d 0.09 0.09 0.09 0.09 0.09 Discount factor,f = 1/(1+d)^t 0.92 0.84 0.77 0.71 0.65 PV -500000 137614.68 126252.00 115827.52 106263.78 97489.71 NPV 83447.69Related Questions
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