Risk-Adjusted Discount Rates. One-Hour Dryclean, Inc., is contemplating replacing an obsolete dry-cleaning machine with one of two innovative pieces of equipment. Alternative 1 requires a current investment outlay of $25,373, whereas alternative 2 requires an outlay of $24,199. The following cash flows (cost savings) will be generated each year over the new machines' 4-year lives:
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Probability
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Cash Flow
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Alternative 1
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0.18
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$ 5,000
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|
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0.64
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10,000
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|
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0.18
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15,000
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Alternative 2
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0.125
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$ 8,000
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|
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0.75
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10,000
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0.125
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12,000
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A. Calculate the expected cash flow for each investment alternative.
B. Calculate the standard deviation of cash flows (risk) for each investment alternative.
C. The firm will use a discount rate of 12% for the cash flows with a higher degree of dispersion and a 10% rate for the less risky cash flows. Calculate the expected net present value for each investment. Which alternative should be chosen?