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Evaluating NPV Using Coefficient of Variation

____ 8. After taking into account all of the relevant cash flows from the previous question, the company's CFO has estimated the project's NPV and has also put together the following scenario analysis:

Scenario Prob. of Scenario Occurring Expected NPV
County taxes increased 25% $ 5 million
County taxes unchanged 50 8 million
County taxes decreased 25 10 million

On the basis of the numbers calculated above, the CFO estimates that the standard deviation of the project's NPV is 2.06. The company typically calculates a project's coefficient of variation (CV) and uses this information to assess the project's risk. Here is the scale that Bruener uses to evaluate project risk:

Range for Coefficient Risk Project's
of Variation (CV) Assessment WACC

CV > 0.3 High risk 12%
0.2<CV<0.3 Average risk 10
CV < 0.2 Low risk 8

On the basis of this scenario analysis, which of the following statements is most correct?
a. The project's expected NPV is $7.75 million.
b. The project would be classified as an average-risk project.
c. If the project were classified as a high-risk project, the company should go back and recalculate the project's NPV using the higher cost of capital estimate.
d. Statements a and b are correct.
e. All of the statements above are correct.

Solution Preview

The correct answer is "e. All of the statements above are correct." Here is why:

The expected net present value of the project is ($5,000,000*.25) ...

Solution Summary

____ 8. After taking into account all of the relevant cash flows from the previous question, the company's CFO has estimated the project's NPV and has also put together the following scenario analysis:

Scenario Prob. of Scenario Occurring Expected NPV
County taxes increased 25% $ 5 million
County taxes unchanged 50 8 million
County taxes decreased 25 10 million

On the basis of the numbers calculated above, the CFO estimates that the standard deviation of the project's NPV is 2.06. The company typically calculates a project's coefficient of variation (CV) and uses this information to assess the project's risk. Here is the scale that Bruener uses to evaluate project risk:

Range for Coefficient Risk Project's
of Variation (CV) Assessment WACC

CV > 0.3 High risk 12%
0.2<CV<0.3 Average risk 10
CV < 0.2 Low risk 8

On the basis of this scenario analysis, which of the following statements is most correct?
a. The project's expected NPV is $7.75 million.
b. The project would be classified as an average-risk project.
c. If the project were classified as a high-risk project, the company should go back and recalculate the project's NPV using the higher cost of capital estimate.
d. Statements a and b are correct.
e. All of the statements above are correct.

$2.19