CHAPTER 11

Capital Budgeting
and Risk Analysis
CHAPTER ORIENTATION
The focus of this chapter will be on how to adjust for the riskiness of a given project or
combination of projects.

CHAPTER OUTLINE

I. Risk and the investment decision

A. Up to this point we have treated the expected cash flows resulting from an
investment proposal as being known with perfect certainty. We will now
introduce risk.
B. The riskiness of an investment project is defined as the variability of its cash
flows from the expected cash flow.
II. What measure of risk is relevant in capital budgeting.
A. In capital budgeting, a project can be looked at on three levels.
1. First, there is the project standing alone risk, which is a project’s risk
ignoring the fact that much of this risk will be diversified away as the
project is combined with the firm’s other projects and assets.
2. Second, we have the project’s contribution-to-firm risk, which is the
amount of risk that the project contributes to the firm as a whole; this
measure considers the fact that some of the project’s risk will be
diversified away as the project is combined with the firm’s other
projects and assets, but ignores the effects of diversification of the
firm’s shareholders.
3. Finally, there is systematic risk, which is the risk of the project from
the viewpoint of a well-diversified shareholder; this measure
considers the fact that some of a project’s risk will be diversified
away as the project is combined with the firm’s other projects, and, in
addition, some of the remaining risk will be diversified away by
shareholders as they combine this stock with other stocks in their
portfolio.

275
 B. Because of bankruptcy costs and the practical difficulties involved in
measuring a project’s level of systematic risk, we will give consideration to
the project’s contribution-to-firm risk and the project’s systematic risk.
III. Methods for incorporating risk into capital budgeting
A. The certainty equivalent approach involves a direct attempt to allow the
decision maker to incorporate his or her utility function into the analysis.
1. In effect, a riskless set of cash flows is substituted for the original set
of cash flows between which the financial manager is indifferent.
2. To simplify calculations certainty equivalent coefficients ( t's) are
defined as the ratio of the certain outcome to the risky outcome
between which the financial manager is indifferent.
3. Mathematically, certainty equivalent coefficients can be defined as
follows:
certain cash flow t
t =
risky cash flow t
4. The appropriate certainty equivalent coefficient is multiplied by the
original cash flow (which is the risky cash flow) with this product
being equal to the equivalent certain cash flow.
5. Once risk is taken out of the cash flows, those cash flows are
discounted back to present at the risk-free rate of interest and the
project's net present value or profitability index is determined.
6. If the internal rate of return is calculated, it is then compared with the
risk-free rate of interest rather than the firm's required rate of return.
7. Mathematically, the certainty equivalent can be summarized as
follows:
n
 t ACFt
NPV =  (1  i F ) t
- IO
t 1

where t = the certainty equivalent coefficient for time

period t
ACFt = the annual after-tax expected cash flow in time
period t
IO = the initial cash outlay
n = the project's expected life
iF = the risk-free interest rate

276
 B. The use of the risk-adjusted discount rate is based on the concept that
investors demand higher returns for more risky projects.
1. If the risk associated with the investment is greater than the risk
involved in a typical endeavor, then the discount rate is adjusted
upward to compensate for this risk.
2. The expected cash flows are then discounted back to present at the
risk-adjusted discount rate. Then the normal capital budgeting criteria
are applied, except in the case of the internal rate of return, in which
case the hurdle rate to which the project's internal rate of return is
compared now becomes the risk-adjusted discount rate.
3. Expressed mathematically the net present value using the risk-
adjusted discount rate becomes
n
ACFt
NPV =  (1  i*) t
- IO
t 1

where ACFt = the annual after-tax cash flow in time period t

IO = the initial outlay
i* = the risk-adjusted discount rate
n = the project's expected life
IV. Methods for measuring a project's systematic risk
A. Theoretically, we know that systematic risk is the "priced" risk, and thus, the
risk that affects the stock's market price and thus the appropriate risk with
which to be concerned. However, if there are bankruptcy costs (which are
assumed away by the CAPM), if there are undiversified shareholders who are
concerned with more than just systematic risk, if there are factors that affect
a security's price beyond what the CAPM suggests, or if we are unable to
confidently measure the project's systematic risk, then the project's individual
risk carries relevance. Moreover, in general, a project's individual risk is
highly correlated with the project's systematic risk, making it a reasonable
proxy to use.
B. In spite of problems in confidently measuring an individual firm's level of
systematic risk, if the project appears to be a typical one for the firm, then
using the CAPM to determine the appropriate risk return tradeoffs and then
judging the project against them may be a warranted approach.
C. If the project is not a typical project, we are without historical data and must
either estimate the beta using accounting data or use the pure-play method for
estimating beta.
1. Using historical accounting data to substitute for historical price data
in estimating systematic risk: To estimate a project's beta using
accounting data we need only run a time series regression of the

277
 division's return on assets on the market index. The regression
coefficient from this equation would be the project's accounting beta
and serves as an approximation for the project's true beta.
2. The pure play method for estimating a project's beta: The pure play
method attempts to find a publicly traded firm in the same industry as
the capital-budgeting project. Once the proxy or pure-play firm is
identified, its systematic risk is determined and then used as a proxy
for the project's systematic risk.
V. Additional approaches for dealing with risk in capital budgeting
A. A simulation imitates the performance of the project being evaluated by
randomly selecting observations from each of the distributions that affect the
outcome of the project, combining those observations to determine the final
output of the final project, and continuing with this process until a
representative record of the project's probable outcome is assembled.
1. The firm's management then examines the resultant probability
distribution, and if management considers enough of the distribution
lies above the normal cutoff criterion, it will accept the project.
2. The use of a simulation approach to analyze investment proposals
offers two major advantages:
a. The financial managers are able to examine and base their
decisions on the whole range of possible outcomes rather than
just point estimates.
b. They can undertake subsequent sensitivity analysis of the
project.
B. A probability tree is a graphical exposition of the sequence of possible
outcomes; it presents the decision maker with a schematic representation of
the problem in which all possible outcomes are graphically displayed.
VI. Other sources and measures of risk
A. Many times, especially with the introduction of a new product, the cash flows
experienced in early years affect the size of the cash flows experienced in
later years. This is called time dependence of cash flows, and it has the effect
of increasing the riskiness of the project over time.

ANSWERS TO
END-OF-CHAPTER QUESTIONS
11-1. The payback period method is frequently used as a rough risk screening device to
eliminate projects whose returns do not materialize until later years. In this way, the
earliest returns are emphasized, which in all likelihood have less uncertainty
surrounding them.

278
11-2. The use of the risk-adjusted discount rate assumes that risk increases over time.
When using the risk-adjusted discount rate method, we are adjusting downward the
value of future cash flows that occur later in the future more severely than earlier
ones. This assumption can be justified because flows that are expected further out in
the future are more difficult to forecast and less certain than are flows that are
expected in the near future.
11-3. The primary difference between the certainty equivalent approach and the risk-
adjusted discount rate approach is where the adjustment for risk is incorporated into
the calculations. The certainty equivalent approach penalizes or adjust downwards
the value of the expected annual after-tax cash flows, while the risk-adjusted
discount rate leaves the cash flows at their expected value and adjusts the required
rate of return, i, upwards to compensate for added risk. In either case the net present
value of the project is being adjusted downwards to compensate for additional risk.
An additional difference between these methods is that the risk-adjusted discount
rate assumes that risk increases over time and that cash flows occurring later in the
future should be more severely penalized. The certainty equivalent method, on the
other hand, allows each cash flow to be treated individually.
11-4. A probability tree is a graphical exposition of the sequence of possible outcomes,
presenting the decision maker with a schematic representation of the problem in
which all possible outcomes are graphically displayed. Moreover, the computations
and results of the computations are shown directly on the tree, so that the
information can be easily understood. Thus the probability tree allows the manager
to quickly visualize the possible future events, their probabilities, and outcomes. In
addition, the calculation of the expected net present value and enumeration of the
distribution should aid the financial manager in his decision-making process.
11-5. The idea behind simulation is to imitate the performance of the project being
evaluated. This is done by randomly selecting observations from each of the
distributions that affect the outcome of the project, combining each of those
observations and determining the final outcome of the project, and continuing with
this process until a representative record of the project's probable outcome is
assembled. In effect, the output from a simulation is a probability distribution of net
present values or internal rates of return for the project. The decision maker then
bases his decision on the full range of possible outcomes.
11-6. The time dependence of cash flows refers to the fact that, many times, cash flows in
later periods are dependent upon the cash flows experienced in earlier periods. For
example, if a new product is introduced and the initial public reaction is poor,
resulting in low initial cash flows, then cash flows in future periods are likely to be
low also. Examples include the introduction of any new products, for example, the
Edsel on the negative side, and hopefully this book on the positive side.

279
 SOLUTIONS TO
END-OF-CHAPTER PROBLEMS

Solutions to Problem Set A

N
11-1A. (a) X =  Xi P(Xi)
i 1

XA = $4,000 (0.15) + $5,000 (0.70) + $6,000 (0.15)

= $600 + $3,500 + $900

= $5,000

XB = $2,000 (0.15) + $6,000 (0.70) + $10,000 (0.15)

= $300 + $4,200 + $1,500

= $6,000

N ACFt
(b) NPV =  - I0
t 1 (1  i*) t

NPVA = $5,000 (3.605) - $10,000

= $18,025 - $10,000

= $8,025

NPVB = $6,000 (3.352) - $10,000

= $20,112 - $10,000

= $10,112

(c) One might also consider the potential diversification effect associated with
these projects. If the project's cash flow patterns are cyclically divergent
from those of the company, the overall risk of the company may be
significantly reduced.

280
 N
11-2A. (a) X =  Xi P(Xi)
i 1

XA = $35,000 (0.10) + $40,000 (0.40) + $45,000 (0.40)

+ $50,000 (0.10)
= $3,500 + $16,000 + $18,000 + $5,000
= $42,500
XB = $10,000 (0.10) + $30,000 (0.20) + $45,000 (0.40)
+ $60,000 (0.20) + $80,000 (0.10)
= $1,000 + $6,000 + $18,000 + $12,000 + $8,000
= $45,000

N ACFt
(b) NPV =  - IO
t 1 (1  i*) t
NPVA = $42,500 (3.605) - $100,000
= $153,212.50 - $100,000
= $53,212.50
NPVB = $45,000 (3.517) - $100,000
= $158,265 - $100,000
= $58,265
(c) One might also consider the potential diversification effect associated with
these projects. If the project's cash flow patterns are cyclically divergent
from those of the company, the overall risk of the company may be
significantly reduced.
11-3A.
Project A:
(A) (B) (A x B)
Present Value
Expected (Expected Factor at Present
Year Cash Flow t Cash Flow ) • (t) 5% Value
0 -$1,000,000 1.00 -$1,000,000 1.000 -$1,000,000
1 500,000 .95 475,000 .952 452,200
2 700,000 .90 630,000 .907 571,410
3 600,000 .80 480,000 .864 414,720
4 500,000 .70 350,000 .823 288,050
NPVA = $ 726,380

281
 Project B:
(A) (B) (A x B)
Present Value

Expected (Expected Factor at Present

Year Cash Flow t Cash Flow ) • (t) 5% Value
0 -$1,000,000 1.00 -$1,000,000 1.000 -$1,000,000
1 500,000 .90 450,000 .952 428,400
2 600,000 .70 420,000 .907 380,940
3 700,000 .60 420,000 .864 362,880
4 800,000 .50 400,000 .823 329,200
NPVB = $ 501,420

Thus, project A should be selected, as it has a higher NPV.

11-4A.
(A) (B) (A x B)
Present Value

Expected (Expected Factor at Present

Year Cash Flow t Cash Flow ) • (t) 7% Value
0 -$90,000 1.00 -$90,000 1.000 -$90,000
1 25,000 0.95 23,750 .935 22,206
2 30,000 0.90 27,000 .873 23,571
3 30,000 0.83 24,900 .816 20,318
4 25,000 0.75 18,750 .763 14,306
5 20,000 0.65 13,000 .713 9,269
NPV = $ -330

Thus, this project should not be accepted because it has a negative NPV.

11-5A.
N ACFt
NPVA =  - I0
t 1 (1  i*) t
= $30,000 (.893) + $40,000(.797) + $50,000(.712)
+ $90,000(.636) + $130,000(.567) - $250,000
= $26,790 + $31,880 + $35,600 + $57,240 + $73,710 - $250,000
= - $24,780
N ACF
NPVB =  - I0
t 1 (1  i*) t
= $135,000(3.127) - $400,000
= $422,145 - $400,000

282
= $22,145

283
11-6A.
Project A:

(A) (B) (A x B)
Present Value
Expected (Expected Factor at Present
Year Cash Flow t Cash Flow ) • (t) 6% Value
0 -$ 50,000 1.00 -$ 50,000 1.000 -$ 50,000.00
1 15,000 .95 14,250 .943 13,437.75
2 15,000 .85 12,750 .890 11,347.50
3 15,000 .80 12,000 .840 10,080.00
4 45,000 .70 31,500 .792 24,948.00
NPVA = $ 9,813.25

Project B:

(A) (B) (A x B)
Present Value
Expected (Expected Factor at Present
Year Cash Flow t Cash Flow ) • (t) 6% Value
0 -$ 50,000 1.00 -$ 50,000 1.000 -$ 50,000.00
1 20,000 .90 18,000 .943 16,974.00
2 25,000 .85 21,250 .890 18,912.50
3 25,000 .80 20,000 .840 16,800.00
4 30,000 .75 22,500 .792 17,820.00
NPVB = $ 20,506.50

Thus project B should be selected, as it has a higher NPV

284
 Internal Rate

11-7A. (a –c)
of Return for Joint
0 Year 1 Year 2 Years each Branch Probability (A)(B)

$300,000 -12.95% 0.18 -2.33%

p = 0.3

p = 0.6 $700,000 10.92% 0.36 3.93%

$700,000
P = 0.1
$1,100,000 29.25% 0.06 1.76%
p = 0.6

p = 0.2 $400,000 3.15% 0.06 0.19%

p = 0.5
$700,000 19.61% 0.15 2.94%
284

p=
- 0.3
p = 0.2

$850,000
$1,000,000 33.33% 0.06 2.00%]
p = 0.1

$1,300,000 45.36% 0.03 1.36%

p = 0.1

p = 0.1 $600,000 23.74% 0.01 0.24%

p= $900,000 37.77% 0.05 1.89%

$1,000,000 0.5
p = 0.4
$1,100,000 46.08% 0.04 1.84%
1.00
Expected internal rate of return = 13.82%
d. The range of possible IRR’s from –12.95% to 46.08%
 Internal Rate

11-8A. (a –c)
of Return for Joint
0 Year 1 Year 2 Years each Branch Probability (A)(B)

p = 0.5 $230,000 130.25% 0.09 11.72%

p = 0.5
$180,000 124.68% 0.09 11.22%
$200,000
p=
0.3
p = 0.5 $205,000 121.09% 0.15 18.16%
p = 0.5
p = 0.5
$175,000 $155,000 114.96% 0.15 17.24%
285

p= $100,000
p = 0.2
p = 0.5 $180,000 111.30% 0.06 6.68%
$-100,000
p = 0.5
$150,000 $130,000 104.46% 0.06 6.27%]

p = 0.4 p= p = 1.0
0.6 $10,000 -42.44% 0.24 -10.19%
$10,000
p = 1.0
$10,000 $0 -90.007% 0.16 -14.40%
p = 0.4
$0 1.00
Expected internal rate of return = 46.70%
SOLUTIONS TO INTEGRATIVE PROBLEM

1. First there is the project standing alone risk, which is a project's risk ignoring the
fact that much of this risk will be diversified away as the project is combined with
the firm's other projects and assets. Second, we have the project's contribution-to-
firm risk, which is the amount of risk that the project contributes to the firm as a
whole; this measure considers the fact that some of the project's risk will be
diversified away as the project is combined with the firm's other projects and assets,
but ignores the effects of diversification of the firm's shareholders. Finally, there is
systematic risk, which is the risk of the project from the viewpoint of a well
diversified shareholder; this measure considers the fact that some of a project's risk
will be diversified away as the project is combined with the firm's other projects,
and, in addition, some of the remaining risk will be diversified away by the
shareholders as they combine this stock with other stocks in their portfolio.
2. According to the CAPM, systematic risk is the only relevant risk for capital
budgeting purposes; however, reality complicates this somewhat. In many instances
a firm will have undiversified shareholders; for them the relevant measure of risk is
the project's contribution to firm risk. The possibility of bankruptcy also affects our
view of what measure of risk is relevant. Because the project's contribution to firm
risk can affect the possibility of bankruptcy, this may be an appropriate measure of
risk since there are costs associated with bankruptcy.
3. The primary difference between the certainty equivalent approach and the risk-
adjusted discount rate approach is where the adjustment for risk is incorporated into
the calculations. The certainty equivalent approach penalizes or adjusted downwards
the value of the expected annual after-tax cash flows, while the risk-adjusted
discount rate leaves the cash flows at their expected value and adjusts the required
rate of return, i, upwards to compensate for added risk. In either case the net present
value of the project is being adjusted downwards to compensate for additional risk.
An additional difference between these methods is that the risk-adjusted discount
rate assumes that risk increases over time and that cash flows occurring later in the
future should be more severely penalized. The certainty equivalent method, on the
other hand, allows each cash flow to be treated individually.
4. A probability tree is a graphical exposition of the sequence of possible outcomes,
presenting the decision maker with a schematic representation of the problem in
which all possible outcomes are graphically displayed. Moreover, the computations
and results of the computations are shown directly on the tree, so that the
information can be easily understood. Thus the probability tree allows the manager
to quickly visualize the possible future events, their probabilities, and outcomes. In
addition, the calculation of the expected net present value and enumeration of the
distribution should aid the financial manager in his decision-making process.
5. The idea behind simulation is to imitate the performance of the project being
evaluated. This is done by randomly selecting observations from each of the
distributions that affect the outcome of the project, combining each of those

286
 observations and determining the final outcome of the project, and continuing with
this process until a representative record of the project's probable outcome is
assembled. In effect, the output from a simulation is a probability distribution of net
present values or internal rates of return for the project. The decision maker then
bases his decision on the full range of possible outcomes.
6. Sensitivity analysis involves determining how the distribution of possible net present
values or internal rates of return for a particular project is affected by a change in
one particular input variable. This is done by changing the value of one input
variable while holding all other input variables constant.
7. The time dependence of cash flows refers to the fact that, many times, cash flows in
later periods are dependent upon the cash flows experienced in earlier periods. For
example, if a new product is introduced and the initial public reaction is poor,
resulting in low initial cash flows, then cash flows in future periods are likely to be
low also. Examples include the introduction of any new products, for example, the
Edsel on the negative side, and hopefully this book on the positive side.

8. Project A:

(A) (B) (A x B)
Present Value

Expected (Expected Factor at Present

Year Cash Flow t Cash Flow ) • (t) 7% Value
0 -$150,000 1.00 -$150,000 1.000 -$150,000
1 40,000 .90 36,000 .935 33,660
2 40,000 .85 34,000 .873 29,682
3 40,000 .80 32,000 .816 26,112
4 100,000 .70 70,000 .763 53,410
NPVA = - $ 7,136

Project B:

(A) (B) (A x B)
Present Value
Expected (Expected Factor at Present
Year Cash Flow t Cash Flow ) • (t) 7% Value
0 -$200,000 1.00 -$200,000 1.000 -$200,000
1 50,000 .95 47,500 .935 44,413
2 60,000 .85 51,000 .873 44,523
3 60,000 .80 48,000 .816 39,168
4 50,000 .75 37,500 .763 28,613
NPVB = - $ 43,283

Thus, neither project should be selected, as they both have negative NPVs..

287
 Internal Rate
of Return for Joint

Part 9
0 Year 1 Year 2 Years each Branch Probability (A)(B)

$200,000 -12.09% 0.12 -1.45%

p = 0.3
p = 0.7
$300,000 0.00% 0.28 0.00%
$300,000

p=
0.4 p = 0.2 $250,000 0.00% 0.08 0.00%

p = 0.5
p = 0.4 $450,000 20.55% 0.20 4.11%
288

-$600,000
p = 0.3
$350,000
$650,000 37.26% 0.12 4.47%

p = 0.2 $300,000 17.54% 0.04 0.70%]

p = 0.2

$500,000 36.19% 0.10 3.62%

p =0.5

$700,000 51.84% 0.04 2.07%

p = 0.2
$450,000
p=
0.1 $1,000,000 71.94% 0.02 1.44%
1.00

Expected internal rate of return = 14.96%

Solutions to Problem Set B
N
11-1B. (a) X =  Xi P(Xi)
i 1

X A = $5,000 (0.20) + $6,000 (0.60) + $7,000 (0.20)

= $1,000 + $3,600 + $1,400

= $6,000

X B = $3,000 (0.20) + $7,000 (0.60) + $11,000 (0.20)

= $600 + $4,200 + $2,200

= $7,000

N ACFt
(b) NPV =  - I0
t 1 (1  i*) t

NPVA = $6,000 (3.517) - $10,000

= $21,102 - $10,000

= $11,102

NPVB = $7,000 (3.127) - $10,000

= $21,889 - $10,000

= $11,889

(c) One might also consider the potential diversification effect associated with
these projects. If the project's cash flow patterns are cyclically divergent
from those of the company, the overall risk of the company may be
significantly reduced.

289
 N
11-2B. (a) X =  Xi P(Xi)
i 1

X A = $40,000 (0.10) + $45,000 (0.40)

+ $50,000 (0.40) + $55,000 (0.10)

= $4,000 + $18,000 + $20,000 + $5,500

= $47,500

X B = $20,000 (0.10) + $40,000 (0.20)

+ $55,000 (0.40) + $70,000 (0.20) + $90,000 (0.10)

= $2,000 + $8,000 + $22,000 + $14,000 + $9,000

= $55,000

N ACFt
(b) NPV =  - I0
t 1 (1  i*) t

NPVA = $47,500 (3.696) - $125,000

= $175,560 - $125,000

= $50,560

NPVB = $55,000 (3.517) - $125,000

= $193,435 - $125,000

= $68,435

(c) One might also consider the potential diversification effect associated with
these projects. If the project's cash flow patterns are cyclically divergent
from those of the company, the overall risk of the company may be
significantly reduced.

290
11-3B.
Project A:

(A) (B) (A x B)
Present Value

Expected (Expected Factor at Present

Year Cash Flow t Cash Flow ) x (t) 5% Value
0 -$1,000,000 1.00 -$1,000,000 1.000 -$1,000,000
1 600,000 .90 540,000 .952 514,080
2 750,000 .90 675,000 .907 612,225
3 600,000 .75 450,000 .864 388,800
4 550,000 .65 357,500 .823 294,222.50
NPVA = $ 809,327.50

Project B:

(A) (B) (A x B)
Present Value
Expected (Expected Factor at Present
Year Cash Flow t Cash Flow ) x (t) 5% Value
0 -$1,000,000 1.00 -$1,000,000 1.000 -$1,000,000
1 600,000 .95 570,000 .952 542,640
2 650,000 .75 487,500 .907 442,162.50
3 700,000 .60 420,000 .864 362,880
4 750,000 .60 450,000 .823 370,350
NPVB = $ 718,032.50

Thus, project A should be selected, as it has a higher NPV.

11-4B.
(A) (B) (A x B)
Present Value
Expected (Expected Factor at Present
Year Cash Flow t Cash Flow ) .( t) 8% Value
0 -$100,000 1.00 -$100,000 1.000 -$100,000
1 30,000 0.95 28,500 .926 26,391
2 25,000 0.90 22,500 .857 19,283
3 30,000 0.83 24,900 .794 19,771
4 20,000 0.75 15,000 .735 11,025
5 25,000 0.65 16,250 .681 11,066
NPV = -$ 12,465

Thus, this project should not be accepted because it has a negative NPV.

291
11-5B.
N ACFt
NPVA =  - IO
t 1 (1  i*) t
= $30,000 (.885) + $40,000(.783) + $50,000(.693)
+ $80,000(.613) + $120,000(.543) - $300,000
= $26,550 + $31,320 + $34,650 + $49,040
+ $65,160 - $300,000
= - $93,280
N ACF
NPVB =  - IO
t 1 (1  i*) t
= $130,000(3.127) - $450,000
= $406,510 - $450,000
= -$43,490

11-6B.
Project A:
(A) (B) (A x B)
Present Value
Expected (Expected Factor at Present
Year Cash Flow t Cash Flow ) x (t) 7% Value
0 -$ 75,000 1.00 -$ 75,000 1.000 -$ 75,000.00
1 20,000 .95 19,000 .935 17,765.00
2 20,000 .85 17,000 .873 14,841.00
3 15,000 .80 12,000 .816 9,792.00
4 50,000 .70 35,000 .763 26,705.00
NPVA = ($ 5,897.00)

Project B:
(A) (B) (A x B)
Present Value
Expected (Expected Factor at Present
Year Cash Flow t Cash Flow ) x (t) 7% Value
0 -$ 75,000 1.00 -$ 75,000 1.000 -$ 75,000.00
1 25,000 .95 23,750 .935 22,206.25
2 30,000 .85 25,500 .873 22,261.50
3 30,000 .80 24,000 .816 19,584.00
4 25,000 .75 18,750 .763 14,306.25
NPVB = $ 3,358.00

Thus project B should be selected, as it has a higher NPV.

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 Internal Rate

11-7B. (a –c)
of Return for Joint
0 Year 1 Year 2 Years each Branch Probability (A)(B)

$300,000 -15.12% 0.06 -0.9072%

p = 0.1

$700,000 7.69% 0.30 2.3070%

p = 0.5
$750,000
p = 0.4 $1,100,000 25.25% 0.24 6.0600%

p = 0.6
$400,000 0.00% 0.06 0.0000%
p = 0.2

p = 0.5 $700,000 15.75% 0.15 2.3625%

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p=
-$900,000 0.3
p = 0.2
$900,000 24.73% 0.06 1.4838%]

p = 0.1
$1,300,000 40.44% 0.03 1.2132%
p = 0.1

$600,000 46.82% 0.03 1.4046%

p = 0.3

p=
0.6 $900,000 58.94% 0.06 3.5364%

$1,500,000
p = 0.1 $1,100,000 66.27% 0.01 0.6627%
1.00
Expected internal rate of return = 18.1230%
(d) The range of possible IRR’s from -15.12% to 66.27
 Internal Rate

11-8B. (a –c)
of Return for Joint
0 Year 1 Year 2 Years each Branch Probability (A)(B)

p = 0.5 $255,000 115/83% .105 12.16227%

p = 0.5
$225,000 $205,000 110.76% .105 11.6298%
p=
0.3
p = 0.5 $210,000 101.15% .175 17.7013%
p = 0.5
p = 0.5
$160,000 95.18% .175 16.6565%
p = 0.7 $180,000
p = 0.2
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$100,000 p = 0.5
$170,000 86.57% .070 6.0599%
$-120,000
p = 0.5

$140,000 $120,000 79.42% .070 5.5594%]

p = 1.0
p = 0.3 p=
0.6 $10,000 -46.70% .180 -8.4060%
$10,000
p=
$10,000 $0 -91.67% .120 -11.0004%
p = 0.4

$0 1.00
Expected internal rate of return = 50.3627%
(d) The range of possible IRR’s from –91.67% to 115.83%
MADE IN THE U. S. A., DUMPED IN BRAZIL, AFRICA, . . .
(Ethics in Capital Budgeting)

OBJECTIVE: To force the student to recognize the role ethical behavior plays in all
areas of Finance.

DEGREE OF DIFFICULTY: Easy

Case Solution:

With ethics cases there are no right or wrong answers - just opinions. Try to bring out
as many opinions as possible without being judgmental. In this case the question centers
around what to do when a product is no longer sellable.

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