Heywood Diagnostic Enterprise Is Evaluating A Project

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Heywood Diagnostic Enterprise is evaluating a project with the following net cash flows and probabilities: Year Prob = 0.2 Prob = 0.6 Prob = 0.2. The Year 5 values include salvage value. Heywood's corporate cost of capital is 10%. The assignment involves calculating the expected (base case) NPV assuming average risk, determining most likely, worst, and best case NPVs, computing the expected NPV based on scenario analysis, and assessing the project's standard deviation of NPV. Additionally, the project’s attractiveness must be evaluated considering a lower risk assessment and a policy to adjust the discount rate accordingly.

Paper For Above instruction

Evaluation of investment projects using Net Present Value (NPV) analysis is fundamental in financial decision-making. For Heywood Diagnostic Enterprise, assessing a particular project involves calculating its expected NPV under various risk scenarios, understanding the range of possible outcomes, and determining whether the project aligns with the company's risk tolerance and strategic goals.

1. Calculation of the Expected (Base Case) NPV Assuming Average Risk

Given the net cash flows and probabilities for each year, the first step is to compute the expected cash flows, which serve as the base case for NPV calculation. Suppose, for simplicity, the cash flows are consistent across the three probability scenarios (e.g., -$100,000 initially, with final year salvage value). The expected cash flow for each year is calculated as:

Expected Cash Flow = (Probability of Scenario 1 Cash Flow Scenario 1) + (Probability of Scenario 2 Cash Flow Scenario 2) + (Probability of Scenario 3 * Cash Flow Scenario 3)

Assuming the cash flows are identical across scenarios, the expected annual cash flow would be simply the cash flow multiplied by the probability. For simplicity, if cash flows are same, and considering the salvage value in year 5, the expected cash flows are used to compute the NPV:

NPV = Σ (Expected Cash Flow in Year t) / (1 + discount rate)^t

Using the corporate cost of capital at 10%, the calculation involves discounting the expected cash flows, including the salvage value in Year 5, to present value. If the detailed cash flow amounts are given, they can be substituted directly into the formula to determine the expected NPVs.

2. Best, Worst, and Most Likely Case NPVs

The most likely NPV is based on the scenario with the highest probability, often 0.6 or as specified. Worst-case NPV assumes the scenario with the lowest cash flows and salvage values, while the best-case scenario assumes the highest possible cash flows. These NPVs are calculated by substituting the worst and best possible cash flows into the NPV formula, applying the discount rate. This approach provides a range of potential NPVs, aiding in understanding the project's risk profile.

3. Scenario Analysis and Expected NPV

Scenario analysis involves considering all possible future states of the project, each with their associated probabilities and NPVs. The expected NPV is derived by summing the products of each scenario's probability and its corresponding NPV:

Expected NPV = Σ (Probability of Scenario i * NPV of Scenario i)

This comprehensive measure accounts for the full spectrum of potential outcomes and their likelihoods, offering a robust estimate of project value.

4. Standard Deviation of NPV

The standard deviation indicates the variability or risk associated with the project's NPV. It is calculated as:

Standard Deviation = √Σ (Probability of Scenario i * (NPV of Scenario i - Expected NPV)^2)

This statistical measure helps quantify the uncertainty surrounding the expected NPV, enabling better risk management decisions.

5. Adjusting for Differential Risk and Financial Attractiveness

If managers judge the project to have lower-than-average risk, and the company's policy is to adjust the discount rate by ±3 percentage points accordingly, the project’s risk-adjusted NPV can be reevaluated. A reduced risk might lead to lowering the discount rate to 7%, making the project potentially more attractive. Conversely, a higher discount rate would diminish its attractiveness. Comparing the risk-adjusted NPV to the initial estimate helps determine whether the project remains financially viable under the revised risk profile.

In this context, if the adjusted NPV remains positive, the project could be considered financially attractive, especially when accounting for the lower risk and potentially higher risk-adjusted returns.

Conclusion

Calculating the expected NPV, analyzing the range of NPVs under various scenarios, and understanding the associated risk through standard deviation are essential steps in evaluating the desirability of a project. Appropriately adjusting the discount rate for risk ensures more accurate assessments aligning with corporate risk policies. For Heywood Diagnostic Enterprise, these quantitative analyses facilitate informed investment decisions, balancing risk and return effectively.

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