Problem: BPC Inc. 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 PROJECT B
Probability Cash Flows Probability Cash Flows
0.2 $6,000 0.2 $ 0
0.6 $6,750 0.6 $6,750
0.2 $7,500 0.2 $18,000
BPC has decided to evaluate the riskier project at 12 percent and the less-risky project at 10 percent.
Q1. What is each project's expected annual cash flow? Project B's standard deviation is $5,798 and its coefficient of variation (CV) is 0.76. What are the values of standard deviation of project A and the CV of project A?
Q2. Based on their risk-adjusted NPVs, which project should BPC choose?
Q3. If you knew that Project B's cash flows were negatively correlated with the firm's other cash flow, 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?