Page 195 - DMGT405_FINANCIAL%20MANAGEMENT

Unit 9: Capital Budgeting

1. Assuming the probability distributions of cash outflows for future periods are independent, Notes
the firm’s cost of capital is 10% and the firm can invest in 5% treasury bills, determine the
expected NPV.
2. Determine the standard deviation about the expected value.
3. If the total distribution is approximately normal and assumed continuous.
(a) What is the probability of the NPV being zero or less.
(b) Greater than zero.

(c) Profitability index being 1.00 or less.
(d) At least equal to mean.
(e) 10% below mean and 10% above mean.

(f) The probability of NPV being (a) between the range of 15000 and 25,000
(b) between the range of 10000 and 20, 000 (c) at least 35, 000 (d) at least 7000.
Solution:

Period I Period II Period III
Cash Probability Cash Cash Probab- Cash inflow × Cash Probab- Cash inflow ×
inflow inflow × inflow ility probability inflow Ility probability
( ) probability ( ) ( ) ( ) ( )
( )
15000 0.2 3000 20000 0.5 10000 25000 0.1 2500
20,000 0.4 8000 23000 0.1 2300 30,000 0.3 9,000
25,000 0.3 7500 25000 0..2 5000 35,000 0.3 10,500
30,000 0.1 3000 28000 0.2 5600 50,000 0.3 15,000
Mean 21,500 22,900 37,000

Determination of NPV
Total PV
Mean of Cash Inflow PV factor @ 5% (riskless)
( )
Period 1 21500 0.952 20468
Period 2 22900 0.907 20770
Period 3 37000 0.864 31968
73206
Less Cash Outflow 50000
NPV 23206
Determination of standard deviation of each period:

Period 1 Square of Probability Square of Deviation of
Deviation of Mean Mean × Probability
Cash inflow Deviation from
( ) Mean
15000 -6500 42250000 0.2 8450000
20000 -1500 2250000 0.4 900000
25000 3500 12250000 0.3 3675,000
30,000 8500 72250,000 0.1 7225,000
20250000

LOVELY PROFESSIONAL UNIVERSITY 189