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Incorporation of Risk into the Decision-Making Process

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Your company has asked you to analyze two mutually exclusive projects for the coming year. Project A will have an initial outlay of $7,200. Project B will cost $6,800. Both projects will last for three years.

On the basis of the information regarding the risk involved in the two projects, you came up with the following probability distributions for the projects:

Project A Project B
Probability Net Cash Flows ($) Probability Net Cash Flows ($)
0.3 8,100 0.3 500
0.5 9,100 0.5 8,100
0.2 10,500 0.2 16,500

To evaluate the two projects, you decide to use the company's weighted average cost of capital (WACC) for the less risky project (11 percent) and the WACC plus two points (13 percent) for the more risky project.

- What is the expected value for each project? What does this value represent?
- What is the coefficient of variation for each project? What information does this measure provide to you and to the company?
- Which project has the most risk? Why?
- What is the risk-adjusted NPV for each project? What do these measures tell you and the company?
- Which project would you recommend to management, and how would you justify your selection?
- If these two projects were not mutually exclusive, would you select both? Why or why not?

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Solution provided by:
Lokesh Jain, MSc
Education
  • BEng (Hons) , Birla Institute of Technology and Science, India
  • MSc (Hons) , Birla Institute of Technology and Science, India
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