Assignment for Business Finance Mbs605 Essay

1908 Words Jul 29th, 2013 8 Pages
MBS605 Study questions Suggested solutions Workshop six: capital budgeting – risk analysis & capital rationing 1. Chapter 10 Review questions

10-9 Real Options are opportunities embedded in real assets that are part of the capital budgeting process. Managers have the option of implementing some of these opportunities to alter the cash flow and risk of a given project. Examples of real options include: Abandonment – the option to abandon or terminate a project prior to the end of its planned life. Flexibility - the ability to adopt a project that permits flexibility in the firm’s production process, such as to be able to reconfigure a machine to accept various types of inputs. Growth - the option to develop follow-on projects, expand
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Using a financial calculator the IRRs are: IRRX = 16.22% IRRY = 18.82%

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Both NPV and IRR favour selection of project Y. The NPV is larger by $79,140 ($428,840 – $349,700) and the IRR is 2.6% higher. 2. Plan X Year 1 2 3 4 5

CF

PVIF13%,n 0.885 0.783 0.693 0.613 0.543

PV $ 415,950 477,630 658,350 594,610 814,500 $2,961,040

$ 470,000 610,000 950,000 970,000 1,500,000

NPV = $2,961,040 – $2,700,000 = $261,040 Calculator solution: $261,105.40 Plan Y PV Year CF PVIF15%,n 1 2 3 4 5 $ 380,000 700,000 800,000 600,000 1,200,000 0.870 0.756 0.658 0.572 0.497 $ 330,600 529,200 526,400 343,200 596,400 $2,325,800

NPV = $2,325,800 – $2,100,000 = $225,800 Calculator solution: $225,412.37 The RADR NPV favours selection of project X. The RADR NPV is larger by $35,240 ($261,040 – $225,800).

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3. Plan X Y NPV 2 1

Rankings IRR 2 1 RADRs 1 2

Both NPV and IRR achieved the same relative rankings. However, making risk adjustments through RADRs caused the ranking to reverse from the non-risk adjusted results. The final choice would be to select Plan X since it ranks first using the risk-adjusted method. 4. Plan X Value of real options = 0.25 × $100,000 = $25,000 NPVstrategic = NPVtraditional + Value of real options NPVstrategic = $261,040 + $25,000 = $286,040 Plan Y Value of real options = 0.20 × $500,000 = $100,000 NPVstrategic = NPVtraditional + Value of real options NPVstrategic = $225,800 +

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