Project A will generate $10,000.00 of revenue next year. Project B will generate $5,000.00 (50% probability)or $15,000.00 (50% probability)of revenue next year. Assuming both projects cost $8,000.00 and have a 10% APR discount rate, which project is preferred by a risk averse manager?
A)Project A
B)Project B
C)Neither project
D)Cannot be determined

Question

Quizplus · Accepted Answer

To determine the net present value (NPV) of each project, we need to discount the expected cash flows to present value using the given discount rate of 10% APR.

For Project A: 
NPV = $10,000 / (1 + 0.1) = $9,090.91 - $8,000.00 = $1,090.91

For Project B: 
Expected value of revenue = 0.5($5,000) + 0.5($15,000) = $10,000 
NPV = $10,000 / (1 + 0.1) - $8,000.00 = $1,818.18

Therefore, Project B has a higher expected NPV than Project A. However, a risk averse manager may prefer Project A because it has less variability in its expected cash flows. Project A has a certain cash flow of $10,000, while Project B has two possible outcomes with equal probabilities. Therefore, Project A is a safer choice for a risk averse manager.

Project a Will Generate $10,000