Question :

After graduating your MBA a month ago, you took the position of Assistant Corporate Financial Manager at Ulrich Drug Company. You are working as a special assistant for capital budgeting to the CEO. Your latest assignment involves the analysis of several risky projects. Because this is your first assignment with the company dealing with risk analysis, you have been asked not only to provide a recommendation on the projects in question, but also to respond to a number of questions aimed at judging your understanding of risk analysis and capital budgeting. The memorandum you received outlining your assignment follows:

TO:   The Assistant Corporate Financial Manager

FROM:   Mr. V. Donaldson, CEO, Ulrich Drug Company

SUBJECT:  Capital Budgeting and Risk Analysis

Provide a response to the following questions:

(a) In capital budgeting risk can be measured from three perspectives. What are those three measures of a project's risk?

(b) According to the Capital Asset Pricing Model (CAPM), which measurement of a project's risk is relevant? What complications does reality introduce into the CAPM view of risk and what does that mean for our view of the relevant measure of a project's risk?

(c) What are the similarities and differences between the risk-adjusted discount rate and certainty equivalent methods for incorporating risk in the capital budgeting decision?

(d) Explain how managerial or real options can change capital budgeting decisions.

(e) Our company is considering the introduction of a new drug and to develop and market it on a national basis will cost Rs 6 million in each year over the next two years. The cash flows that are expected from the project for years 3 through to 8 are Rs1 million, Rs 2 million, Rs 4 million, Rs 4 million, Rs 3 million, and Rs1million, respectively. If the project is successful, at the end of year 5 our company will have the option to invest an additional Rs10 million to secure the regional African market. The probability of success is 0.60; if not successful, our company will not invest the Rs10 million and there will be no incremental expected cash flows. If successful, however, cash flows are expected to be Rs 6 million higher in each of the years 6 through 10 than would otherwise be the case with a probability of 0.50, and Rs 4 million higher with a probability of 0.50. Our policy is to evaluate investment projects at a discount rate of 14 percent.

(i) What is the net present value of the initial project? Is it acceptable?

(ii) What is the worth of the project if we take account of the option to expand? Is the project acceptable?