BPC Inc. must decide between two mutually exclusive projects. Each costs $6,750 and has an expected life of 3 years. Annual project cash flows begin 1 year after the initial investment, and are subject to the following probability distributions:
PROJECT A PROJECT B
Probability Cash Flows Probability Cash Flows
0.2 $6,000 0.2 $ 0
0.6 $6,750 0.6 $6,750
0.2 $7,500 0.2 $18,000
BPC has decided to evaluate the riskier project at 12 percent and the less-risky project at 10 percent.
a) What is each project's expected annual cash flow? Project B's standard deviation
is $5,798 and its coefficient of variation (CV) is 0.76. What are the values of standard deviation of project A and the CV of project A?
b) Based on their risk-adjusted NPVs, which project should BPC choose?
c) If you knew that Project B's cash flows were negatively correlated with the firm's
other cash flow, whereas Project A's flows were positively correlated, how might
this affect the decision? If Project B's cash flows were negatively correlated with
gross domestic product (GDP), while A's flows were positively correlated, would
that influence your risk assessment?
a) Expected annual cash flow for project A = 6000*0.2+6750*0.6+7500*0.2=6750
Expected annual cash flow for project B = 0*0.2+6750*0.6+18000*0.2=7650
Standard deviation of project A = ((6000-6750)^2*0.2+(6750-6750)^2*0.6+(7500-6750)^2*0.2)^0.5
Standard deviation of project B = ((0-7650)^2*0.2+(6750-7650)^2*0.6+(18000-7650)^2*0.2)^0.5
CV for project A = Standard deviation of project A / Expected annual cash flow for project ...
The solution discusses and compares the projects for BPC Inc.