Which should I choose?

Question

if there are two projects that are mutually exclusive and the net present value (NPV) calculations for each take into account the project’s risk.Project A: NPV : $3 million.: very risky Project B: NPA: 2.5 million : very safe.

Answer 1

The way a NPV computation should work is the risk of a project needs to be reflected in the interest (discount) rate.



So discounting cash flows on a government bond you would use something like 5% as the discount rate. The 5% reflects the safety of a government bond.



Discounting the expected cash flows on a blue chip stock, you might use 10%. This is near the historical return from large stocks. Certainly the stock is riskier than the government bond so a higher rate of return is needed to reflect the greater risk.



Another example might be a friend of yours wants to start a business and needs some money. Now this is High risk. But to Bill Gates lending someone $250,000 really is low risk to him as his net worth is so high. So he might use 15%.



But to someone else it might be their total net worth, the $250k. They might want 40% return to make it worth while.



What I am getting at is that without knowing your age, your risk profile (how much risk is a lot to you), your net worth, the details of the project, etc. It is impossible for someone to answer your question.



You need to think it over and come up with an appropriate discount rate for both projects. Then the one with the highest NPV is the best project.

Answer 2

In today's day and age I would go with Project B: NPA:2.5 million - very safe.

Answer 3

That's easy. The risk/reward for project B by far outweights that of project A.

///