Page 205 - DMGT405_FINANCIAL%20MANAGEMENT

Unit 9: Capital Budgeting

Notes
Standard deviation = 163,12,500 = 4,039

The standard deviation of the project X is smaller than that of project Y. Therefore, it can be
concluded that Project X is less risky than project Y.
The conclusion regarding the superiority of Project X over Project Y would hold if the
projects have an equal size of outlay. However, if the size of the projects outlay differs, the
decision-maker should make use of the coefficient of variation to judge the riskiness of the
project. In this case –
Standard Deviation 1,346
Coefficient of variation of Project X = = = 0.18
Arithmetic Mean 7,250

Standard Deviation 4039
Coefficient of variation of Project Y = = = 0.49
Arithmetic Mean 8250
The higher the coefficient of variation, the more risky is the project. Project Y is, therefore,
more risky than Project X.

Task A company is considering Projects X and Y with the following information:

Project
X Y
Expected Net Present Value 60,000 227,000
Standard Deviation 40,000 135,000

Which project will you recommend? Will your answer change if we use coefficient of
variation as a measure of risk instead of standard deviation? Which measure is more
appropriate in this situation? Give reason.

Self Assessment
Fill in the blanks:
17. ……………….analysis provides more than one estimate of future return of a project.
18. If the two prospects have the same expected value (mean) then one that has the greater
…………………..will said to have the higher degree of uncertainty or risk.

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Case Study Case: Mavis Machine Shop

he case is set in an metalworking shop in West Virginia, one of whose products is
drill bits for oil exploration. The time is 1980, in the midst of an oil drilling boom
Tresulting from the oil crises of 1974 and 1979.

Early in 1980, Tom Mavis, President of Mavis Machine shop was considering a project to
modernize his plant facilities. The company operated out of a large converted warehouse
in Salem, West Virginia. It produced machinery or assorted machined metal parts for the
oil and gas drilling and production industry in the surrounding area. One of Mavis major
Contd...

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