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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:
Probability
Cash Flow
Alternative 1
0.18
$ 5,000
0.64
10,000
15,000
Alternative 2
0.125
$ 8,000
0.75
12,000
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?
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Explain the effects that inventory transactions have on the statement of cash flows.
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