What is the risk adjusted npv of each project

P12–3
P12–3 Breakeven cash inflows and risk Blair Gasses and Chemicals is a supplier of highly purified gases to semiconductor manufacturers. A large chip producer has asked Blair to build a new gas production facility close to an existing semiconductor plant. Once the new gas plant is in place, Blair will be the exclusive supplier for that semiconductor fabrication plant for the subsequent 5 years. Blair is considering one of two plant designs. The first is Blair’s “standard” plant, which will cost $30 million to build. The second is for a “custom” plant, which will cost $40 million to build. The custom plant will allow Blair to produce the highly specialized gases that are required for an emerging semiconductor manufacturing process. Blair estimates that its client will order $10 million of product per year if the traditional plant is constructed, but if the customized design is put in place, Blair expects to sell $15 million worth of product annually to its client. Blair has enough money to build either type of plant, and, in the absence of risk differences, accepts the project with the highest NPV. The cost of capital is 12%. a. Find the NPV for each project. Are the projects acceptable? b. Find the breakeven cash inflow for each project. c. The firm has estimated the probabilities of achieving various ranges of cash inflows for the two projects as shown in the following table. What is the probability that each project will achieve at least the breakeven cash inflow found in part b? d. Which project is more risky? Which project has the potentially higher NPV? Discuss the risk–return trade-offs of the two projects. e. If the firm wished to minimize losses (that is, NPV < $0), which project would you recommend? Which would you recommend if the goal were to achieve a higher NPV?
5 Year
30 Million
40 Million
10 Million
15 Million
12%
Probability of achieving
cash inflow in given range
Range of cash inflow ($ millions) Standard Plant Custom Plant
$0 to $5 0% 5%
$5 to $8 10 10
$8 to $11 60 15
$11 to $14 25 25
$14 to $17 5 20
$17 to $20 0 15
Above $20 0 10
SOLUTION:
a. Find the NPV for each project. Are the projects acceptable?
Standard Plant
Millions $
Year Investment Revenue Cash flow Disc rate -12% Present value
A B C D C*D
A+B
0 -30 0 -30 1 -30
1 0 10 10 0.89 8.93
2 0 10 10 0.80 7.97
3 0 10 10 0.71 7.12
4 0 10 10 0.64 6.36
5 0 10 10 0.57 5.67
NPV 6.05
Custom Plant
Millions $
Year Investment revenue Cash flow Disc rate -12% Present value
A B C D C*D
A+B
0 -40 0 -40 1 -40
1 0 15 15 0.89 13.39
2 0 15 15 0.80 11.96
3 0 15 15 0.71 10.68
4 0 15 15 0.64 9.53
5 0 15 15 0.57 8.51
NPV 14.07
b. Find the breakeven cash inflow for each project.
Break even cash inflow Amount
Standard Plant 30
Custom Plant 40
c. The firm has estimated the probabilities of achieving various ranges of cash inflows for the two projects as shown in the following table. What is the probability that each project will achieve at least the breakeven cash inflow found in part b?
Standard Plant
Million
Year Investment Revenue Cash flow Disc rate -12% Present value
A B C D C*D
A+B
0 -30 0 -30 1 -30
1 0 8 8 0.89 7.14
2 0 8 8 0.80 6.38
3 0 8 8 0.71 5.69
4 0 8 8 0.64 5.08
5 0 8 8 0.57 4.54
NPV -1.16
Standard Plant
Million
Year Investment Revenue Cashflow Disc rate -12% Present value
A B C D C*D
A+B
0 -30 0 -30 1 -30
1 0 11 11 0.89 9.82
2 0 11 11 0.80 8.77
3 0 11 11 0.71 7.83
4 0 11 11 0.64 6.99
5 0 11 11 0.57 6.24
NPV 9.65
Custom Plant
Millions
Year Investment revenue Cash flow Disc rate -12% Present value
A B C D C*D
A+B
0 -40 0 -40 1 -40
1 0 11 11 0.89 9.82
2 0 11 11 0.80 8.77
3 0 11 11 0.71 7.83
4 0 11 11 0.64 6.99
5 0 11 11 0.57 6.24
NPV -0.35