Risk-adjusted discount rates

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Reference no: EM13966968

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
	0.18	15,000
Alternative 2	0.125	$ 8,000
	0.75	10,000
	0.125	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?

Reference no: EM13966968

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