PROJECT RISK ANALYSIS.
The Butter- Perkins Company (BPC) must decide between two mutually exclusive projects. Each costs $6,750 and has an expected life of 3 years. Annual project cash flows begin 1 year after the initial investment and are subject to the following probability distributions:
PROJECT A
Probability Cash Flows
0.2 $6,000
0.6 6,750
0.2 7,500
PROJECT B
Probability Cash Flows
0.2 $ 0
0.6 6,750
0.2 18,000
BPC has decided to evaluate the riskier project at 12% and the less-risky project at 10%.
a. What is each project's expected annual cash flow? Project B's standard deviation is $5,798, and its coefficient of variation is 0.76. What are the values of Project A's standard deviation and coefficient of variation of Project A?
b. Based on the risk-adjusted NPV's, which project should BPC choose?
c. If you knew that Project B's cash flows were negatively correlated with the firm's other cash flows whereas Project A's flows were positively correlated, how might this affect the decision? If Project B's cash flows were negatively correlated with gross domestic product (GDP), while A's flows were positively correlated, would that influence your risk assessment?