In the book Foundations of Financial Management (7th ed.), Stanley B. Block and Geoffrey A. Hirt discuss a semiconductor firm that is considering two choices: (l) expanding the production of semiconductors for sale to end users or (2) entering the highly competitive home computer market. The cost of both projects is $60 million, but the net present value of the cash flows from sales and the risks are different.
Figure 5.3 gives a tree diagram of the project choices. The tree diagram gives a probability distribution of expected sales for each project. It also gives the present value of cash flows from sales and the net present value (NPV = present value of cash flow from sales minus initial cost) corresponding to each sales alternative. Note that figures in parentheses denote losses.
a. For each project choice, calculate the expected net present value.
b. For each project choice, calculate the variance and standard deviation of the net present value.
c. Calculate the coefficient of variation for each project choice. See Exercise 5.14d for a discussion of the coefficient of variation.
d. Which project has the higher expected net present value?
e. Which project carries the least risk? Explain.
f. In your opinion, which project should be undertaken? Justify your answer.
In exercise 5.14d
Investment AInvestment B
μ = $6,000..................................μ = $600
σ = $600....................................σ = $190