CHAPTER 11

Cash Flow Estimation and

Risk Analysis

1
 CASH FLOW ESTIMATION
Why? Business Application
Importance in Project Determine Value : Based
Valuation on accurate CF
Effects on Firm Valuation Projections
Relevance of CF over Acctg New vs. Replacement
Income Projects
Incremental CF Basis Relevant CFs
Depreciation & Tax
Effects
Inflation & Risk

2
CASH FLOW ESTIMATION
Why? Business Application
Techniques to Manage CFs
Sensitivity Analysis
Scenario Analysis
Decision Tree Analysis
MonteCarlo Simulation

3
Topics
Estimating cash flows:
Relevant cash flows
Working capital treatment
Risk analysis:
Sensitivity analysis
Scenario analysis
Simulation analysis
Real options
4
 The Big Picture:
Project Risk Analysis

Projects Cash
Flows (CFt)

CF1 CF2 CFN

NPV = + + + Initial cost
(1 + r )1 (1 + r)2 (1 + r) N

Market Projects
interest rates debt/equity capacity
Projects risk-adjusted
cost of capital
(r)
Market
risk aversion
Projects
business risk
 Capital Budgeting Analysis

What Long-Term projects (Capital

Investments) should our company
undertake in order to generate additional
return (Value ($$)) to the owners
(Stockholders)??
CFs are KEY, NOT Acctg Income!!
Consider Only Incremental CFs
Compare Outflows to acquire vs. inflows
generated by operating project.
If PV of inflows > PV of outflows, then
making $ and adding value.
Accept if project generates positive NPV
 TYPES OF PROJECTS
Expansion Replacement
Add New Equipment Swap out equipment
Increase in Op CFs Decrease in Operating Costs

8
Incremental Cash Flow for a
Project
Projects incremental cash flow is:

Corporate cash flow with the project

Minus
Corporate cash flow without the project.

9
 Type of Costs

Sunk Costs
Incremental Costs
Externalities
Opportunity Costs
Shipping and installation
Financing Costs
Taxes
10
Sunk Costs
Suppose $100,000 had been spent last year
to improve the production line site. Should
this cost be included in the analysis?

NO. This is a sunk cost. Focus on

incremental investment and operating cash
flows.

11
Incremental Costs
Suppose the plant space could be leased out
for $25,000 a year. Would this affect the
analysis?
Yes. Accepting the project means we will not
receive the $25,000. This is an opportunity
cost and it should be charged to the project.
A.T. opportunity cost = $25,000 (1 T) =
$15,000 annual cost.

12
Externalities
If new product line decreases sales of firms
other products by $50,000 per year, would
this affect the analysis?
Yes. The effects on the other projects CFs
are externalities.
Net CF loss per year on other lines would be
a cost to this project:: PIRACY
Externalities be positive if new projects are
complements to existing assets, negative if
substitutes.
13
Treatment of Financing Costs
Should you subtract interest expense or
dividends when calculating CF?
NO.
Project CFs discounted by cost of capital that is
rate of return required by all investors so should
discount total amount of cash flow available to all
investors.
They are part of the costs of capital. If subtracted
them from cash flows, would be double counting
capital costs.

14
Proposed Project Data
$200,000 cost + $10,000 shipping +
$30,000 installation.
Economic life = 4 years.
Salvage value = $25,000.
MACRS 3-year class.

Continued
15
Project Data (Continued)

Annual unit sales = 1,250.

Unit sales price = $200.
Unit costs = $100.
Net working capital:
NWCt = 12%(Salest+1)
Tax rate = 40%.
Project cost of capital = 10%.
16
What is an assets depreciable
basis?

Basis = Cost
+ Shipping
+ Installation
$240,000

17
Annual Depreciation Expense
(000s)
(Initial
Year % X = Deprec.
Basis)
1 0.33 $240 $79.2

2 0.45 108.0

3 0.15 36.0

4 0.07 16.8

18
 Annual Sales and Costs

Year 1 Year 2 Year 3 Year 4

Units 1,250 1,250 1,250 1,250

Unit Price $200 $206 $212.18 $218.55

Unit Cost $100 $103 $106.09 $109.27

Sales $250,000 $257,500 $265,225 $273,188

Costs $125,000 $128,750 $132,613 $136,588

19
Why is it important to include
inflation when estimating cash flows?
Nominal r > real r. The cost of capital,
r, includes a premium for inflation.
Nominal CF > real CF. This is because
nominal cash flows incorporate
inflation.
If you discount real CF with the higher
nominal r, then your NPV estimate is
too low.
Continued
20
Inflation (Continued)

Nominal CF should be discounted with

nominal r, and real CF should be
discounted with real r.
It is more realistic to find the nominal
CF (i.e., increase cash flow estimates
with inflation) than it is to reduce the
nominal r to a real r.

21
Operating Cash Flows
(Years 1 and 2)
Year 1 Year 2
Sales $250,000 $257,500
Costs 125,000 128,750
Deprec. 79,200 108,000
EBIT $ 45,800 $ 20,750
Taxes (40%) 18,320 8,300
EBIT(1 T) $ 27,480 $ 12,450
+ Deprec. 79,200 108,000
Net Op. CF $106,680 $120,450
22
Operating Cash Flows
(Years 3 and 4)
Year 3 Year 4
Sales $265,225 $273,188
Costs 132,613 136,588
Deprec. 36,000 16,800
EBIT $ 96,612 $119,800
Taxes (40%) 38,645 47,920
EBIT(1 T) $ 57,967 $ 71,880
+ Deprec. 36,000 16,800
Net Op. CF $ 93,967 $ 88,680
23
Cash Flows Due to Investments in Net
Working Capital (NWC)

CF Due to
NWC Investment
Sales (% of sales) in NWC
Year 0 $30,000 -$30,000
Year 1 $250,000 30,900 -900
Year 2 257,500 31,827 -927
Year 3 265,225 32,783 -956
Year 4 273,188 0 32,783

24
Salvage Cash Flow at t = 4
(000s)
Salvage Value $25
Book Value 0
Gain or loss $25
Tax on SV 10
Net Terminal CF $15

25
What if you terminate a project
before the asset is fully depreciated?
Basis = Original basis Accum. deprec.
Taxes are based on difference between
sales price and tax basis.

Cash flow = Sale Taxes

from sale proceeds paid

26
Example: If Sold After 3
Years for $25 ($ thousands)
Original basis = $240.
After 3 years, basis = $16.8 remaining.
Sales price = $25.
Gain or loss = $25 $16.8 = $8.2.
Tax on sale = 0.4($8.2) = $3.28.
Cash flow = $25 $3.28 = $21.72.

27
Example: If Sold After 3
Years for $10 ($ thousands)
Original basis = $240.
After 3 years, basis = $16.8 remaining.
Sales price = $10.
Gain or loss = $10 $16.8 = -$6.8.
Tax on sale = 0.4(-$6.8) = -$2.72.
Cash flow = $10 (-$2.72) = $12.72.
Sale at a loss provides a tax credit, so cash
flow is larger than sales price!
28
 Net Cash Flows for Years 1-2
Year 0 Year 1 Year 2
Init. Cost -$240,000 0 0
Op. CF 0 $106,680 $120,450
NWC CF -$30,000 -$900 -$927
Salvage CF 0 0 0
Net CF -$270,000 $105,780 $119,523

29
Net Cash Flows for Years 3-4
Year 3 Year 4
Init. Cost 0 0
Op. CF $93,967 $88,680
NWC CF -$956 $32,783
Salvage CF 0 $15,000
Net CF $93,011 $136,463

30
 Project Net CFs Time Line

0 1 2 3 4

(270,000) 105,780 119,523 93,011 136,463

Enter CFs in CFLO register and I/YR = 10.

NPV = $88,030.
IRR = 23.9%.
31
 What is the projects MIRR?

0 10%
1 2 3 4

(270,000) 105,780 119,523 93,011 136,463

102,312
144,623
140,793

(270,000) 524,191
MIRR = ?
32
Calculator Solution
Enter positive CFs in CFLO. Enter I/YR = 10.
Solve for NPV = $358,029.581.
Now use TVM keys: PV = -358,029.581,
N = 4, I/YR = 10; PMT = 0; Solve for FV =
524,191. (This is TV of inflows)
Use TVM keys: N = 4; FV = 524,191;
PV = -270,000; PMT= 0; Solve for I/YR =
18.0%.
MIRR = 18.0%.

33
 What is the projects payback?
($ thousands)

0 1 2 3 4

(270) 106 120 93 136

Cumulative:
(270) (164) (44) 49 185

Payback = 2 + $44/$93 = 2.5 years.

34
CF Estimation Practice Q1

35
 CF Estimation - Practice

a. Equipment purchase ($ 9,000,000)

NOWC investment (3,000,000)
Initial investment outlay ($12,000,000)

36
CF Estimation Practice Q2

37
 CF Estimation Practice Q2

Project cash flows: t = 1

Sales revenues $10,000,000
Operating costs 7,000,000
Depreciation 2,000,000
EBIT $ 1,000,000
Taxes (40%) 400,000
EBIT(1 T) $ 600,000
Add back depreciation 2,000,000
Project cash flow = EBIT(1 T) + DEP
$ 2,600,000

38
 CF Estimation Practice Q2

If the tax rate fell to 30%, the projects cash flow would
change to:
EBIT $1,000,000
Taxes (30%) 300,000
EBIT(1 T) $ 700,000
Add back depreciation 2,000,000
Project cash flow = EBIT(1 T) + DEP $2,700,000

39
CF Estimation Practice Q3

40
 CF Estimation Practice Q3
Equipments original cost $20,000,000
Depreciation (80%) 16,000,000
Book value $ 4,000,000

Gain on sale = $5,000,000 $4,000,000

= $1,000,000.

Tax on gain = $1,000,000(0.4) = $400,000.

AT salvage value = $5,000,000 $400,000

= $4,600,000.

41
CF Estimation Practice Q4

42
CF Estimation Practice Q5

43
 CF Estimation Practice Q5
First, solve for each projects NPV.

Project A: CF0 = -20000, CF1 = 6000, Nj = 6, I/YR = 10;

solve for NPV = $6,131.56.
Project B: CF0 = -12000, CF1 = 6000, Nj = 3, I/YR = 10;
solve for NPV = $2,921.11.

The appropriate EAAs are:

Project A: N = 6, I/YR = 10, PV = -6131.56, FV = 0; solve for
PMT = EAAA = $1,407.85.
Project B: N = 3, I/YR = 10, PV = -2921.11, FV = 0; solve for
PMT = EAAB = $1,174.62.

Choose Project A, whose EAA = $1,407.85.

44
CF Estimation Practice Q6

45
 CF Estimation Practice Q6

The applicable depreciation values are as follows for the two

scenarios:
Scenario 1 Scenario 2
Year (Straight-Line) (MACRS)
1 $200,000 $264,000
2 200,000 360,000
3 200,000 120,000
4 200,000 56,000

46
 CF Estimation Practice Q6
Ddepreciation T DDepreciation
Year Expense (2 1) Expense

1 $ 64,000 $25,600
2 160,000 64,000
3 -80,000 -32,000
4 -144,000 -57,600

Now to find the difference in NPV to be generated under

these scenarios, just enter the cash flows that represent
the benefit from depreciation expense and solve for net
present value based upon a WACC of 10%.

CF0 = 0; CF1 = 25600; CF2 = 64000; CF3 = -32000; CF4 = -

57600; and I/YR = 10. Solve for NPV = $12,781.64
47
CF Estimation Practice Q7

48
 CF Estimation Practice Q7

a. CF0 = -$178,000:
Initial investment outlay at t = 0:
Price ($140,000)
Modification (30,000)
CAPEX ($170,000)
DNOWC (8,000)
Initial investment outlay ($178,000)

49
Projects operating cash flows:
Year 1 Year 2 Year 3
Savings $50,000 $50,000 $50,000
Depreciation 56,100 76,500 25,500
EBIT ($ 6,100) ($26,500) $24,500
Taxes (40%) (2,440) (10,600) 9,800
EBIT(1 T) ($ 3,660) ($15,900) $14,700
Add Depreciation 56,100 76,500 25,500
EBIT(1 T) + DEP $52,440 $60,600 $40,200

Terminal cash flows at t = 3:

Salvage value $60,000
Tax on salvage value 19,240
AT salvage value $40,760
DNOWC = Recovery of NOWC 8,000

Project FCFs = EBIT(1 T) + DEP CAPEX DNOWC

$52,440 $60,600 $88,960
50
The project has an NPV of ($19,549). Thus, it should not be
accepted.

Year Cash Flows PV @ 12%

0 ($178,000) ($178,000)
1 52,440 46,821
2 60,600 48,310
3 88,960 63,320

NPV= ($ 19,549)

51
CF Estimation Practice Q8

52
 CF Estimation Practice Q8
First determine the net cash flow at t = 0:
Purchase price ($8,000)
Sale of old machine 2,500
Tax on sale of old machine (160)a
Change in net operating working capital (1,500)b
Total investment ($7,160)
A Themarket value is $2,500 $2,100 = $400 above the book value.
Thus, there is a $400 recapture of depreciation,
and Dauten would have to pay 0.40($400) = $160 in taxes.

b Thechange in net operating working capital is a

$2,000 increase in current assets minus a $500 increase in
accounts payable, which totals to $1,500.
53
 CF Estimation Practice Q8

Now, examine the annual cash inflows:

Sales increase $1,000
Cost decrease 1,500
Increase in pre-tax revenues $2,500

After-tax revenue increase:

$2,500(1 T) = $2,500(0.60)
= $1,500.

54
 CF Estimation Practice Q8
Depreciation:
Year 1 2 3 4 5 6
Newa $1,600 $2,560 $1,520 $960 $880 $480
Old 350 350 350 350 350 350
Change $1,250 $2,210 $1,170 $610 $530 $130
Depreciation tax savingsb $ 500 $ 884 $ 468 $244 $212 $ 52

55
 CF Estimation Practice Q8
Finally, place all the cash flows on a time line:
0 15% 1 2 3 4 5 6
| | | | | | |
Net investment (7,160)
After-tax revenue increase 1,500 1,500 1,500 1,500 1,500 1,500
Depreciation tax savings 500 884 468 244 212 52
NOWC recovery 1,500
Salvage value of new machine 800
Tax on salvage value of
new machine (320)
Opportunity cost of
old machine (300)
Project cash flows (7,160) 2,000 2,384 1,968 1,744 1,712 3,232

The net present value of this incremental cash flow stream, when discounted at 15%, is $921.36.
Thus, the replacement should be made.

56
CF Estimation Practice Q9

57
 CF Estimation Practice Q9

Using a financial calculator, input the following data:

CF0 = -190000; CF1-3 = 87000; I/YR = 14; and solve for
NPV190-3 = $11,982 (for 3 years).

Replacement Chain NPV (for 6 years) = 20,070

EAA190-3:

Using a financial calculator, input the following data:

N = 3; I/YR = 14; PV = -11982; and FV = 0.
Solve for PMT = EAA190-3 = $5,161.

58
 CF Estimation Practice Q9
Using a financial calculator, input the following data:
CF0 = -360000; CF1-6 = 98300; I/YR = 14; and

solve for NPV360-6 = $22,256 (for 6 years).

EAA360-6:
Using a financial calculator, input the following data:

N = 6; I/YR = 14; PV = -22256; and FV = 0.

Solve for PMT = EAA360-6 =
$5,723.

59
CF Estimation Practice Q10

60
 CF Estimation Practice Q10
Machine As simple NPV is calculated as follows: Enter
CF0 = -10 and CF1-4 = 4. Then enter I/YR = 10, and
press the NPV key to get NPVA = $2.679 million.

However, this does not consider the fact that the project
can be repeated again.
Enter these values into the cash flow register: CF0 = -
10; CF1-3 = 4; CF4 = -8; CF5-8 = 4.2.

Then enter I/YR = 10, and press the NPV key to get
extended NPVA = $3.58 million.

61
CF Estimation Practice Q10

Machine B:

Enter cash flows into the cash flow register, along with
the interest rate, and press the NPV key to get NPVB =
$3.672 $3.67 million.

Machine B is the better project and will increase the

company's value by $3.67 million, rather than the
$3.58 million created by Machine A.

62
CF Estimation Practice Q11

63
 CF Estimation Practice Q11
First, solve for each projects NPV.
Project X: CF0 = -100000, CF1 = 30000, CF2 = 50000, CF3 =
70000, I/YR = 12; solve for NPV = $16,470.0255.

Project Y: CF0 = -70000, CF1 = 30000, Nj = 4, CF2 = 10000,

I/YR = 12; solve for NPV = $26,794.749.

The appropriate EAAs are:

Project X: N = 3, I/YR = 12, PV = -16470.0255, FV = 0; solve
for PMT = EAAX = $6,857.28 $6,857.

Project Y: N = 5, I/YR = 12, PV = -26794.749, FV = 0; solve

for PMT = EAAY = $7,433.12 $7,433.
Choose Project Y. 64
CF Estimation Practice Q11

65
 CF Estimation Practice Q11
Old depreciation = $9,000 per year.

Book value = $90,000 5($9,000) = $45,000.

Gain = $55,000 $45,000 = $10,000.

Tax on book gain = $10,000(0.35) = $3,500.

Price ($150,000)
SV (old machine) 55,000
Tax effect (3,500)
Initial outlay ($ 98,500)

66
 CF Estimation Practice Q11

Change in
Year Percentage Basis Dep, New Dep, Old Depreciation
1 33% $150,000 $49,500 $9,000 $40,500
2 45 150,000 67,500 9,000 58,500
3 15 150,000 22,500 9,000 13,500
4 7 150,000 10,500 9,000 1,500
5 9,000 (9,000)

67
 CF Estimation Practice Q11
CFt = (DOperating expenses)(1 T) + (DDepreciation)(T).

CF1 = ($50,000)(0.65) + ($40,500)(0.35)

= $32,500 + $14,175 = $46,675.
CF2 = ($50,000)(0.65) + ($58,500)(0.35)
= $32,500 + $20,475 = $52,975.
CF3 = ($50,000)(0.65) + ($13,500)(0.35)
= $32,500 + $4,725 = $37,225.
CF4 = ($50,000)(0.65) + ($1,500)(0.35)
= $32,500 + $525 = $33,025.
CF5 = ($50,000)(0.65) + (-$9,000)(0.35)
= $32,500 $3,150 = $29,350.

68
 CF Estimation Practice Q11
0 1 2 3 4 5
16%
| | | | | |
Purchase (98,500)
Operating CFs 46,675 52,975 37,225 33,025 29,350
Opportunity cost (6,500)*
CFs (98,500) 46,675 52,975 37,225 33,025 22,850
*After-tax opportunity cost of not being able to sell old machine at end of its useful life. It is calculated as
$10,000(1 0.35) = $6,500.

CF0 = -98500; CF1 = 46675; CF2 = 52975; CF3 = 37225; CF4 =

33025; CF5 = 22850; I/YR = 16;

Solve for NPV = $34,073.20.

Therefore, the firm should replace the old machine.

69
What does risk mean in
capital budgeting?
Uncertainty about a projects future
profitability.
Measured by NPV, IRR, beta.
Will taking on the project increase the
firms and stockholders risk?

70
Is risk analysis based on historical
data or subjective judgment?
Can sometimes use historical data, but
generally cannot.
So risk analysis in capital budgeting is
usually based on subjective judgments.

71
What three types of risk are
relevant in capital budgeting?
Stand-alone risk
Corporate risk
Market (or beta) risk

72
Stand-Alone Risk
The projects risk if it were the firms
only asset and there were no
shareholders.
Ignores both firm and shareholder
diversification.
Measured by the or CV of NPV, IRR,
or MIRR.

73
Probability Density

Flatter distribution,
larger , larger
stand-alone risk.

0 E(NPV) NPV
74
Corporate Risk
Reflects the projects effect on corporate
earnings stability.
Considers firms other assets (diversification
within firm).
Depends on projects , and its correlation, ,
with returns on firms other assets.
Measured by the projects corporate beta.

75
 Project X is negatively correlated to
firms other assets, so has big
diversification benefits

Profitability If r = 1.0, no diversification

benefits. If r < 1.0, some
diversification benefits.
Project X

Total Firm
Rest of Firm

0 Years
76
Market Risk
Reflects the projects effect on a well-
diversified stock portfolio.
Takes account of stockholders other
assets.
Depends on projects and correlation
with the stock market.
Measured by the projects market beta.

77
How is each type of risk used?
Market risk is theoretically best in most
situations.
However, creditors, customers,
suppliers, and employees are more
affected by corporate risk.
Therefore, corporate risk is also
relevant.
Continued

78
 Stand-alone risk is easiest to measure,
more intuitive.
Core projects are highly correlated with
other assets, so stand-alone risk
generally reflects corporate risk.
If the project is highly correlated with
the economy, stand-alone risk also
reflects market risk.

79
What is sensitivity analysis?
Shows how changes in a variable such
as unit sales affect NPV or IRR.
Each variable is fixed except one.
Change this one variable to see the
effect on NPV or IRR.
Answers what if questions, e.g. What
if sales decline by 30%?

80
 Sensitivity Analysis
Change From Resulting NPV (000s)
Base level r Unit sales Salvage
-30% $113 $17 $85
-15% $100 $52 $86
0% $88 $88 $88
15% $76 $124 $90
30% $65 $159 $91

81
Sensitivity Graph
NPV
($ 000s)
Unit Sales

88 Salvage

-30 -20 -10 Base 10 20 30 (%)

82
Results of Sensitivity Analysis
Steeper sensitivity lines show greater
risk. Small changes result in large
declines in NPV.
Unit sales line is steeper than salvage
value or r, so for this project, should
worry most about accuracy of sales
forecast.

83
What are the weaknesses of
sensitivity analysis?
Does not reflect diversification.
Says nothing about the likelihood of
change in a variable, i.e. a steep sales
line is not a problem if sales wont fall.
Ignores relationships among variables.

84
Why is sensitivity analysis
useful?
Gives some idea of stand-alone risk.
Identifies dangerous variables.
Gives some breakeven information.

85
What is scenario analysis?
Examines several possible situations,
usually worst case, most likely case,
and best case.
Provides a range of possible outcomes.

86
Best scenario: 1,600 units @ $240
Worst scenario: 900 units @ $160
Scenario Probability NPV(000)
Best 0.25 $279
Base 0.50 88
Worst 0.25 -49
E(NPV) = $101.6
(NPV) = 116.6
CV(NPV) = (NPV)/E(NPV) = 1.15
87
Best scenario: 1,600 units @ $240
Worst scenario: 900 units @ $160

Scenario Probability NPV (1)* (2)

(1) (2)
Best 0.25 279 69.75
Base 0.5 88 44
Worse 0.25 -49 -12
Sum = Expected NPV = 101.75

88
 Best scenario: 1,600 units @ $240
Worst scenario: 900 units @ $160

Scenari Probabil NPV {(NPV Exp (3)*(1)

o ity (1) (2) NPV}^2
Best 0.25 279 31,417.56 7854.39
Base 0.5 88 189.06 94.53
Worse 0.25 -49 22,725.56 5681.39
Expected NPV = 101.75 Sum = Var 13,630.22
SD 116.74

89
Are there any problems with
scenario analysis?
Only considers a few possible out-
comes.
Assumes that inputs are perfectly
correlatedall bad values occur
together and all good values occur
together.
Focuses on stand-alone risk, although
subjective adjustments can be made.

90
Scenario Analysis Practice

91
 Scenario Analysis Practice
E(NPV)= 0.05(-$70) + 0.20(-$25) + 0.50($12) + 0.20($20) +
0.05($30)
= -$3.5 + -$5.0 + $6.0 + $4.0 + $1.5
= $3.0 million.

NPV = [0.05(-$70 $3)2 + 0.20(-$25 $3)2

+ 0.50($12 $3)2 + 0.20($20 $3)2 + 0.05($30 $3)2]

= $23.622 million.

CV = 23.622 / 3.0 = 7.8744

92
Scenario Analysis Practice

93
 Scenario Analysis Practice
Expected annual cash flows:
Project A: Probable
Probability Cash Flow= Cash Flow
0.2 $6,000 $1,200
0.6 6,750 4,050
0.2 7,500 1,500
Expected annual cash flow = $6,750

Project B: Probable
Probability Cash Flow = Cash Flow
0.2 $ 0 $ 0
0.6 6,750 4,050
0.2 18,000 3,600
Expected annual cash flow = $7,650
94
 Scenario Analysis Practice
Coefficient of variation:
Standard deviation NPV
CV
Expected value Expected NPV
Project A:

A (-$750) 2 (0.2) ($0) 2 (0.6) ($750) 2 (0.2) $474.34.

CVA = $474.34/$6,750 = 0.0703.

95
 Scenario Analysis Practice
Project B:

B (-$7,650) 2 (0.2) (-$900) 2 (0.6) ($10,350) 2 (0.2) $5,797.84.

CVB = $5,797.84/$7,650 = 0.7579.

96
 Scenario Analysis Practice
Project B is the riskier project because it has the greater
variability in its probable cash flows, whether measured by the
standard deviation or the coefficient of variation. Hence, Project
B is evaluated at the 12% cost of capital, while Project A
requires only a 10% cost of capital.

Using a financial calculator, input the appropriate expected

annual cash flows for Project A into the cash flow register, input
I/YR = 10, and solve for NPVA = $10,036.25.
Using a financial calculator, input the appropriate expected
annual cash flows for Project B into the cash flow register, input
I/YR = 12, and solve for NPVB = $11,624.01.

97