Chapter 15 Questions:

1. a. Why is risk analysis so important to the capital budgeting process? b. Describe the three types of project risk. Under what situation is each of the types most relevant to the capital budgeting decision? c. Which type of risk is easiest to measure in practice? d. Are the three types of project risk usually highly correlated? Explain your answer. e. Why is the correlation among project risk measures important? (5 points each; 25 points total)

Chapter 15 Problem:

Heywood Diagnostic Enterprises is evaluating a project with the following net cash flows and probabilities (Prob.):

10% 10% 10%

Year Prob=0.2 Prob=0.6 Prob=0.2 E(Value)

0 -100000 -100000 -100000 -100000

1 20000 30000 40000 30000

2 20000 30000 40000 30000

3 20000 30000 40000 30000

4 20000 30000 40000 30000

5 30000 40000 50000 40000

The Year 5 values include salvage value. Heywood's corporate cost of capital is 10 percent. a. What is the project's expected (i.e., base case) NPV assuming average risk? (Hint: The base case net cash flows are the expected cash flows in each year.) b. What are the project's most likely, worst-case, and best-case NPVs? c. What is the project's expected NPV on the basis of the scenario analysis? d. What is the project's standard deviation of NPV? e. Assume that Heywood's managers judge the pr oject to have lower-than-average risk. Furthermore, the company's policy is to adjust the corporate cost of capital up or down by 3 percentage points to account for differential risk. Is the project financially attractive?