Question

Assume the following regarding a project.

a. A project has a capital investment of $15M in year zero.
b. Operating cost, sales revenue and associated probabilities as shown below.
Project year 1 2 3 4 5
(a) Operating cost ($M) if:
(i) Demand is weak 5 5 5 5 5
(ii) Demand is avg. 6 6 6 6 6
(iii)Demand id good 12 12 12 12 12
(b) Sales revenue ($M) if:
(i) Demand is weak 8 8 8 8 8
(ii) Demand is avg. 10 10 10 10 10
(iii)Demand id good 20 20 20 20 20
The probabilities associated with demand are as follows:
Demand Probability
(i) Demand is weak - 0.25
(ii) Demand is avg. - 0.45
(iii) Demand id good - 0.30
The residual value of fixed assets is $5M.
The cost of equity is 20% and loan can be obtained at 10%. The leverage factor is 60%.
Inflation rate is projected to be 6% over the appraisal life of the project.
(a) Compute the real discount rate.
(b) Calculate the Expected NPV for the project.
(c) Compute the Std. Dev. of the NPV and interpret the result.
(d) Compute the CV and interpret the result.

Answer 1

To compute the real discount rate, subtract the projected inflation rate from the cost of equity. To calculate the Expected NPV, multiply the operating cost for each demand scenario by its corresponding probability and sum the results.

Step-by-step explanation:

To compute the real discount rate, we need to subtract the projected inflation rate from the cost of equity. The formula to calculate the real discount rate is:

Real Discount Rate = Cost of Equity - Inflation Rate

In this case, the cost of equity is 20% and the inflation rate is 6%. So the real discount rate would be 14%.

To calculate the Expected NPV, we need to multiply the operating cost for each demand scenario by its corresponding probability and sum the results. Then, we subtract the capital investment and add the residual value of fixed assets. The formula to calculate the Expected NPV is:

Expected NPV = (Probability1 * NPV1) + (Probability2 * NPV2) + ... + (Probability n * NPVn)

Using the provided operating costs, sales revenue, and probabilities, we can calculate the Expected NPV.