Question

The Central Perk Coffee House, Inc., is engaged in an aggressive store refurbishing program and is contemplating expansion of its in-store banking facilities. This investment project is to be evaluated using the certainty equivalent adjustment factor method and the risk-adjusted discount rate method. If the project has a positive value when both methods are employed, the project will be undertaken. The project will not be undertaken if either evaluation method suggests that the investment will fail to increase the value of the firm. Expected cash flow after tax (CFAT) values over the five-year life of the investment project and relevant certainty equivalent adjustment factor information are as follows:

.:.
At the present time, an 8 percent annual rate of return can be obtained on short-term U.S. government securities; the company uses this rate as an estimate of the risk-free rate of return.
A. Use the 8 percent risk-free rate to calculate the present value of the investment project.
B. Using this present value as a basis, use the certainty equivalent adjustment factor information given previously to determine the risk-adjusted present value of the project.
C. Use an alternative risk-adjusted discount rate method of project valuation on the assumption that a 15 percent rate of return is appropriate in light of the level of risk undertaken.
D. Compare and contrast your answers to parts B and C. Should the investment be made?



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  • CreatedFebruary 13, 2015
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