At the present time, an 8% annual rate of return can be obtained on short-term U.S. government securities; the company uses this rate as an estimate of the risk-free rate of return.
A. Use the 8% risk-free rate to calculate the present value of the investment project.
B. Using this present value as a basis, utilize the certainty equivalent adjustment factor information given previously to determine the risk-adjusted present value of the project.
C. Use an alternative risk-adjusted discount rate method of project valuation on the assumption that a 15% rate of return is appropriate in light of the level of risk undertaken.
D. Compare and contrast your answers to parts B and C. Should the investment be made?
A. The present value of this investment project can be calculated easily using a handheld calculator with typical financial function capabilities or by using the tables found in Appendix B. Using the appropriate discount factors corresponding to an 8% risk-free rate, the present value of the investment project is calculated as follows:
Hot Food Carryout Counter Investment Project
Time Period Present Value Project of E (CFAT)
1 0.9259 22,500 20,833
2 0.8573 25,000 21,433
3 0.7938 27,500 21,830
4 0.7350 30,000 22,050
5 0.6806 32,500 22,120 Total $62,500 $33,266
B. Using the present value given in part A as a basis, the certainty equivalent adjustment factor information given previously can be employed to determine the risk-adjusted present value of the project:
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