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488 Corporate Finance BRILLIANT’S

Riskless discount rate is 6% Project A is less risky compared to Project B. The management
considers risk premium rates at 6% for Project A and 10% for Project B for discounting the
cash inflows. [Ans. RADR: A = 12%, B – 16%, NPV: A = ` (–) 2543, B = ` (–) 4057]

CERTAINTY EQUIVALENT APPROACH
5.2.2 Aradhana Ltd. is considering a project with the following expected cash flows. Initial
investment ` 1,00,000. Expected cash inflows:
1st year = 70,000
2nd year = 60,000
3rd year = 45,000
Cost of capital is 10% due to uncertainty of future cashflows, the management decides to
reduce the cash inflows to certainty equivalent by taking only 80%, 70% and 60%
respectively.
Is it worthwhile to take up the project? [Ans. NPV = ` 5,873]
STANDARD DEVIATION METHOD
5.2.3 A company is considering a proposal to purchase a new machine. The machine has an
initial cost of ` 50,000. The expected cashflows generated by the project during its useful life
of 3 years are:
Year 1 Year 2 Year 3
CF Probability CF Probability CF Probability

15,000 0.20 20,000 0.50 25,000 0.10
20,000 0.40 23,000 0.10 30,000 0.30
25,000 0.30 25,000 0.20 35,000 0.30
30,000 0.10 28,000 0.20 50,000 0.30

The firm’s cost of capital is 10% determine:
(i) Expected NPV
(ii) Standard deviation for each year
[Ans. Expected NPV = ` 8,832; SD for year 1 = 4,500, year 2 = 9,555, year 3 = 9,000]

BREAK EVEN POINT
5.2.4 You are the financial manager of Johnson Products Ltd. (JPL). JPL is planning to set up an
extrusion plant at Ajmer. Your project staff has developed the following cashflow forecast
for the extrusion plant project: (In lakhs)

Particulars Years 0 Year (1–10)

Investment (–) 250
Sales 200
Variable cost (60% of sales) 120