risky project choice

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Dsylexic

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The Oneonta Chemical Company is evaluating two mutually exclusive pollution control systems. Since the company's revenue stream will not be affected by the choice of control systems, the projects are being evaluated by finding the PV of each set of costs. The firm's required rate of return is 13 percent, and it adds or subtracts 3 percentage points to adjust for project risk differences. System A is judged to be a high-risk project (it might end up costing much more to operate than is expected).

System A's risk-adjusted cost of capital is


a) 16 percent; since A is more risky, its cash flows should be discounted at a higher rate, because this correctly penalizes the project for its high risk.
b) 13 percent; the firms cost of capital should not be adjusted when evaluating outflow only projects.
c) somewhere between 10 percent and 16 percent, with the answer depending on the riskiness of the relevant inflows.
d) 10 percent; this might seem illogical at first, but it correctly adjusts for risk where outflows, rather than inflows, are being discounted.
e) indeterminate, or, more accurately, irrelevant, because for such projects we would simply select the process that meets the requirements with the lowest required investment.
 
16%, but I've never heard of "penalizing" yourself for taking a riskier project. I believe it is because shareholders require a higher rate of return for taking on additional risk.
 
I don't know what this is or where its coming from, but my guess would be E since it is (I forget the name) a regulatory task. Either way, I am pretty bored today and lurking.
 
I am going to go with D...discounting the outflows at a lower cost of capital would result in evaluating it at a higher cost which takes into account the added risk, my next guess would be E...but I think D is better.
 
How is it a regulatory task? Does the SEC mandate which projects the firm accepts and denies?
 
ca-cbv-cfa Wrote:
-------------------------------------------------------
> I am going to go with D...discounting the outflows
> at a lower cost of capital would result in
> evaluating it at a higher cost which takes into
> account the added risk, my next guess would be
> E...but I think D is better.


PV = Present Value not present cost. At some point the inflows will outweigh the outflows or the firm wouldn't even be considering the project.
 
mwvt9 Wrote:
-------------------------------------------------------
> Revenues are unaffected.....


exactly...thats why I am saying D. They will just choose the project that costs them the least after the costs are discounted by risk adjusted cost of capital. Alphabound good job with pv=present value not present cost, the prickishness is much appreciated.
 
Good point, I missed the second line about the unchanging revenue stream. I recant and go with D.
 
D is the right answer..tricky one if you get lost in the dense verbiage.

Correct answer: 10 percent; this might seem illogical at first, but it correctly adjusts for risk where outflows, rather than inflows, are being discounted.

Rationale:
k(A) = 13% - 3% = 10%. If the cash flows are cost only outflows, and the analyst wants to correctly reflect their risk, the discount rate should be adjusted downward (in this case by subtracting 3 percentage points) to make the discounted flows comparatively larger.
 
The question comes off as a little tricky, but at the end of the day the answer is A. While revs won't be affected, it doesn't matter as any PV (see NPV) calc is based off of incremental cash flows. Whether that be cash flows saved given the implemention of a new system or cash flows from undertaking a new revenue/incremental cash flow producing project. And, when it comes time to determine the WACC, this figure needs to be adjusted to reflect the degree of risk as it relates to the company's average risk investment. More risk means a higher hurdle rate (see WACC or MCC).
 
mwvt9 Wrote:
-------------------------------------------------------
> Makes sense, but kind of goofy wording if you ask
> me...


about that- did you guys feel that there were poorly worded /long winding questions on the Jun test?.perhaps its just something the test prep providers indulge in hopefully..

thanks
 
No. Not at all. CFAI test is very straightforward. Much less wordy than Schweser, but still very difficult.

It seemed like almost every question on the exam was two-part. If you take a practice exam from CFAI you will get a feel for them.

I did several Schweser practice exams and had some trouble with time due to the length of questions. I had plenty of time to finish the actual exam.



Edited 1 time(s). Last edit at Thursday, July 26, 2007 at 04:05PM by mwvt9.
 
ca-cbv-cfa Wrote:
-------------------------------------------------------
> I am going to go with D...discounting the outflows
> at a lower cost of capital would result in
> evaluating it at a higher cost which takes into
> account the added risk, my next guess would be
> E...but I think D is better.


It is a Project with some outflows and 0 inflows.


NPV = PV of Inflows- PV of outflows
in this case since there is 0 inflow

NPV = (-) PV of outflows= CashOutflow/rate of return

dont forget the negative sign here.
So basically discounting the outflows at a higher cost of capital would result in evaluating it to higher NPV.

My answer would be A.
Higher risk implies higher required rate of return i.e. 13+3

Having said that i would love to hear from the veterans. Where are joey and others?

Dsylexic what is the source of this question, more importantly the answer.
The question is interesting though.
 
Source of question and answer is the Allenresources testbank which I am using for my prep.
 
reema Wrote:
-------------------------------------------------------
> ca-cbv-cfa Wrote:
> --------------------------------------------------
> -----
> > I am going to go with D...discounting the
> outflows
> > at a lower cost of capital would result in
> > evaluating it at a higher cost which takes into
> > account the added risk, my next guess would be
> > E...but I think D is better.
>
>
> It is a Project with some outflows and 0 inflows.
>
>
> NPV = PV of Inflows- PV of outflows
> in this case since there is 0 inflow
>
> NPV = (-) PV of outflows= CashOutflow/rate of
> return
>
> dont forget the negative sign here.
> So basically discounting the outflows at a higher
> cost of capital would result in evaluating it to
> higher NPV.
>
> My answer would be A.
> Higher risk implies higher required rate of return
> i.e. 13+3
>
> Having said that i would love to hear from the
> veterans. Where are joey and others?
>
> Dsylexic what is the source of this question, more
> importantly the answer.
> The question is interesting though.


whats with everyone telling me the definition of NPV, you started off right but your logic kinda failed when u said that using a higher cost of capital would result in a higher NPV as there are only outflows, -1000*(1/1+0.1)^1=-909 is less than, A GREATER COST reflecting higher risk , than -1000*(1/1+0.16)^1=-862....as the revenue stream is not impacted and it is merely outflows, having a higher % rate would just give it a lower cost at PV....if u subtract the 3 and use 10% it gives u a higher cost, larger negative at PV, and this reflects the higher risk...dyslexic aleady stated the answer is D.....lol so no point in arguing



Edited 1 time(s). Last edit at Friday, July 27, 2007 at 02:49PM by ca-cbv-cfa.
 
"the projects are being evaluated by finding the PV of each set of costs"

Thx Dsylexic for the answer. In looking at the aforementioned and held in isolation, the answer you gave makes perfect sense. But I don't know of any CFO's that would make such a simplistic analysis. Despite no cash inflows, there is always money to be potentially saved over and beyond current methods of production etc and that money saved in the form of incremental cash flows would be used as part of the cash inflows for the sake of analysis.

Thanks again. I guess the lesson learned on this thead is to dumb down the question and not make it more than it is.
 
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