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Finance: Use of Net Present Value (NPV) to Evaluate Projects

Scenario 1:
The manager of Merton Medical Clinic are analyzing a proposed project. The project's most likely NPV is $120,000, by the following NPV distribution, there is considerable risk involved:

Probability NPV
0.05 ($700,000)
0.20 (250,000)
0.50 120,000
0.20 200,000
0.05 300,000

a. What are the project's expected NPV and standard deviation of NPV?
b. Should the base case analysis use the most likely NPV or the expected NPV? Explain your answer.

Scenario 2:
Heywood Diagnostic Enterprise is evaluating a project with the following net cash flows and probabilities:

Year Prob = 0.2 Prob = 0.6 Prob = 0.2
1 ($100,000) ($100,000) ($100,000)
2 20,000 30,000 40,000
3 20,000 30,000 40,000
4 20,000 30,000 40,000
5 30,000 40,000 50,000

The Year 5 values include salvage value. Heywood's corporate cost of capital is 10%.

a. What is the project's expected (i.e., base case) NPV assuming average risk? (Hint: The base case net cash flows are the expected cash flows in each year.)

b. What are the project's most likely, worst, and best case NPV's?

c. What is the project's expected NPV on the basis of the scenario analysis?

d. What is the project's standard deviation of NPV?

e. Assume that Heywood's managers judge the project to have a lower than average risk. Furthermore, the company's policy is to adjust the corporate cost of capital up or down by 3 percentage points to account for differential risk. Is the project financially attractive?

Solution Summary

The expert uses the net present value to evaluate projects.