MANAGERIAL ECONOMICS

Homework #3 - Capital Budgeting and Risk Analysis

The homework should be written on 8 1/2 by 11, 8 1/4 by 10 1/2, or A4 paper. When calculations are required, you must show all work unless the answer is obvious. The homework is due on Thursday, May 7.

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1.  A company is considering investing $1,000,000 in a project that yields the following net cash flows:

Suppose the discount rate is 0.10.

a.  Calculate the net present value for this project.

b.  Should the firm undertake the project?  Explain briefly.

c.  Calculate the profitability index for this project.

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2.  Suppose a company pays interest of 11 percent on its bonds, faces a marginal tax rate of 30 percent, and has a beta of 1.5.  The rate on government bonds is 7.5 percent and the return on the stock market overall is 11.5 percent.

a.  Calculate the cost of debt for this company.

b.  Calculate the cost of equity capital for this company.

c.  If the firm wants to raise 35 percent of its capital by borrowing, calculate the composite cost of capital for this company.

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3. Suppose a firm is considering a project with the following probability distribution:

Calculate the expected value and standard deviation for this project.

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4. A company can build a large plant for $4 million or a small plant for $2 million.  The present value of net cash flows (in millions) for each plant depends as follows on the state of the economy:

Construct a decision tree to show which plant the company should build.

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5.  Suppose a firm has the following payoff matrix:

a.  What is the best project for the firm according to the maximin criterion?  Explain briefly.

b.  What is the best project for the firm according to the minimax regret criterion?  Explain briefly.