Project Valuation.
Quality Foods, Inc., is a leading grocery retailer in the greater Washington, DC, metropolitan area. The company is currently engaged in an aggressive store refurbishing program and is contemplating expansion of its in-store delicatessen department. A number of investment alternatives are being considered, including the construction of facilities for a new restaurant-quality carryout service for Chinese food. This investment project is to be evaluated using the certainty equivalent adjustment factor method and the risk-adjusted discount rate method. If the project has a positive value when both methods are employed, the project will be undertaken. The project will not be undertaken if either evaluation method suggests that the investment will fail to increase the value of the firm. Expected cash flow after tax (CFAT) values over the 5-year life of the investment project and relevant certainty equivalent adjustment fac- tor information are as follows:
Hot Food Carryout Counter Investment Project
|
Time Period (years)
|
Alpha
|
Project E(CFAT)
|
|
0
|
1.00
|
($75,000)
|
|
1
|
0.95
|
22,500
|
|
2
|
0.90
|
25,000
|
|
3
|
0.85
|
27,500
|
|
4
|
0.75
|
30,000
|
|
5
|
0.70
|
32,500
|
|
Total
|
|
$62,500
|
At the present time, an 8% annual rate of return can be obtained on short-term U.S. government securities; the company uses this rate as an estimate of the risk-free rate of return.
A. Use the 8% risk-free rate to calculate the present value of the investment project.
B. Using this present value as a basis, utilize the certainty equivalent adjustment factor infor- mation given previously to determine the risk-adjusted present value of the project.
C. Use an alternative risk-adjusted discount rate method of project valuation on the assumption that a 15% rate of return is appropriate in light of the level of risk undertaken.
D. Compare and contrast your answers to parts B and C. Should the investment be made?