The managers of Merton Clinic are analyzing a proposed project. The project’s most likely NPV is $120,000 but as evidence by the following NPV distribution, there is considerable risk involved;
a. What are the projects 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.
2. Heywood Diagnostic Enterprise is evaluating a project with the following net cash flows and probabilities
Year Pro=0.2 Pro=0.6 Pro=0.2
0 ($100,000) ($100,000) ($100,000)
1 20,000 30,000 40,000
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 percent
a. What is the projects expected (i.e. base case) NPV assuming average risk? ( Hint: The base net cash flows are the expected cash flows in each year)
b. What are the project’s most likely, worst and best cases NPVs?
c. What is the projects’ expected NPV on the basis of the scenario analysis?
d. What is the projects standard deviation of NPV?
e. Assume that Heywood’s managers judge the project to have lowered that average risk. Furthermore, the company’s policy is to adjust the corporate cost of capital up or down by 3 percentage point to account for differential risk. Is the project financially attractive?
3. Consider the project contained in problem 14.7 in chapter 14.
a. Perform a sensitivity analysis to see how NPV is affected by changes in the number of procedures per day, average collection amount. And salvage value.
b. Conduct a scenario analysis. Supposed that the hospital’s staff concluded that the three most uncertain variables were numbers of procedures’ per day, average collection amount and the equipment’s salvage value. Furthermore the following data were developed;
Scenario Probability Number of Average Collection Equipment
Procedures Salvage Value
Worst 0.25 10 $60 $100,000
Most Likely 0.50 15 80 200,000
Best 0.25 20 100 300,000
c. Finally, assume that California Health Center’s average project has a coefficient of variation of NPV in the range of 1.0-2.0 (Hint; the coefficient of variation is defined as the standard deviation of NPV divided by the expected NPV) The hospital adjusts for risk by adding or subtracting 3 percentage points to it’s 10 percent corporate cost of capital. After adjusting for differential risk, is the project still profitable?
d. What type of risk was measured and accounted for in parts b and c? Should this be of concern to the hospital’s manager?
4. The managers of United Medtronic’s are evaluating the following four projects for the coming budget period. The firms corporate cost of capital is 14 percent.
Project Cost IRR
A $15,000 17%
B 15,000 16
C 12,000 15
D 20,000 13
What is the firm’s optimal capital budget?
Now supposed Medtronic’s managers want to consider differential risk in the capital budgeting process. Project A has average risk, B has below average risk, C has above average risk, and D has average risk. What is the firm’s optimal capital budget when differential risk is considered? ( Hint: the firms managers lower the IRR of high risk project by 3 percentage points and raise the IRR of low risk projects by the same amount)
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