XYZ Ltd. is considering taking up one of the two projects-Project-X and Project-Y. Both the projects having same life require equal investment of…

CA Final · Advanced Financial Management · MTP · November 2024
XYZ Ltd. is considering taking up one of the two projects-Project-X and Project-Y. Both the projects having same life require equal investment of 1600 lakhs each. Both are estimated to have almost the same yield. As the company is new to this type of business, the cash flow arising from the projects cannot be estimated with certainty. An attempt was therefore, made to use probability to analyse the pattern of cash flow from other projects during the first year of operations. This pattern is likely to continue during the life of these projects. The results of the analysis are as follows: Project X Cash Flow (in ₹ Lakh) Probability 220 0.10 260 0.20 300 0.40 340 0.20 380 0.10 Project Y Cash Flow (in ₹ Lakh) Probability 180 0.10 260 0.25 340 0.30 420 0.25 500 0.10 Required: Evaluate which of the two projects bears more risk for every percent of expected return.

Suggested Answer and Working Notes:

To determine which of the two projects bears more risk for every percent of expected return first we shall calculate Variance and Standard Deviation of both the projects. (i) Project X Expected Net Cash Flow = (0.10 x 220) + (0.20 x 260) + (0.40 x 300) + (0.20 x 340) + (0.10 x 380) = 22 + 52 + 120 + 68 + 38 = 300 σ² = 0.10 (220 – 300)² + 0.20 (260 – 300)² + 0.40 (300 – 300)² + 0.20 (340 - 300)² + 0.10 (380 – 300)² = 640 + 320 + 0 + 320 + 640 = 1920 σ = √1920 = 43.82 (ii) Project Y Expected Net Cash Flow = (0.10 X 180) + (0.25 X 260) + (0.30 X 340) + (0.25 X 420) + (0.10 X 500) = 18 + 65 + 102 + 105 + 50 = 340 σ² = 0.10 (180 - 340)² + 0.25 (260 - 340)² + 0.30 (340 - 340)² + 0.25 (420-340)² + 0.10 (500 - 340)² = 2560 + 1600 + 0 + 1600 + 2560 = 8320 σ = √8320 = 91.21 Now we shall calculate Coefficient of Variation Coefficient of Variation = Standard Deviation / Mean Project X = 43.82 / 300 = 0.146 or 14.61% Project Y = 91.21 / 340 = 0.268 or 26.83% Project Y bears more risk for every percent of expected return.

Topics: Advanced Capital Budgeting Decisions

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