# Question

Problem 13-35 contained the details of a new-project capital budgeting evaluation being conducted by Argile textiles. Although inflation was considered in the initial analysis, the riskiness of the project was not taken into account. Argile’s required rate of return is 10 percent. You have been asked to answer the following questions:

a. Assume that you are confident about the estimates of all variables that affect the project’s cash flows except unit sales. If product acceptance is poor, sales would be only 85,000 units per year, whereas a strong consumer response would produce sales of 130,000 units per year. In either case, cash costs would amount to 60 percent of revenues. You believe that there is a 25 percent chance of poor acceptance, a 25 percent chance of excellent acceptance, and a 50 percent chance of average acceptance (the base case).

(1) What is the worst case NPV? The best case NPV?

(2) Use the worst, most likely (base), and best case NPVs and probabilities of occurrence to find the project’s expected NPV, standard deviation (NPV), and coefficient of variation (CVNPV).

b. (1) Assume that Argile’s average project has a coefficient of variation (CVNPV) in the range 2.0 - 3.0. Would the silk/wool blend fabric project be classified as high risk, average risk, or low risk? What type of risk is being measured here?

(2) Based on common sense, how highly correlated do you think the project would be to the firm’s other assets? (Give a correlation coefficient, or range of coefficients, based on your judgment.)

(3) How would this correlation coefficient and the previously calculated combine to affect the project’s contribution to corporate (within-firm) risk? Explain.

c. (1) Argile typically adds or subtracts three percentage points to the overall required rate of return to adjust for risk. Given this fact, should Argile accept the project?

(2) What subjective risk factors should be considered before the final decision is made?

d. Assume that the risk-free rate is 5 percent, the market risk premium is 7 percent, and the new project’s beta is 1.2. What is the project’s required rate of return on equity based on the CAPM?

a. Assume that you are confident about the estimates of all variables that affect the project’s cash flows except unit sales. If product acceptance is poor, sales would be only 85,000 units per year, whereas a strong consumer response would produce sales of 130,000 units per year. In either case, cash costs would amount to 60 percent of revenues. You believe that there is a 25 percent chance of poor acceptance, a 25 percent chance of excellent acceptance, and a 50 percent chance of average acceptance (the base case).

(1) What is the worst case NPV? The best case NPV?

(2) Use the worst, most likely (base), and best case NPVs and probabilities of occurrence to find the project’s expected NPV, standard deviation (NPV), and coefficient of variation (CVNPV).

b. (1) Assume that Argile’s average project has a coefficient of variation (CVNPV) in the range 2.0 - 3.0. Would the silk/wool blend fabric project be classified as high risk, average risk, or low risk? What type of risk is being measured here?

(2) Based on common sense, how highly correlated do you think the project would be to the firm’s other assets? (Give a correlation coefficient, or range of coefficients, based on your judgment.)

(3) How would this correlation coefficient and the previously calculated combine to affect the project’s contribution to corporate (within-firm) risk? Explain.

c. (1) Argile typically adds or subtracts three percentage points to the overall required rate of return to adjust for risk. Given this fact, should Argile accept the project?

(2) What subjective risk factors should be considered before the final decision is made?

d. Assume that the risk-free rate is 5 percent, the market risk premium is 7 percent, and the new project’s beta is 1.2. What is the project’s required rate of return on equity based on the CAPM?

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