Question

Tobacco Company of America is a very stable billion-dollar company with sales growth of about 5 percent per year in good or bad economic conditions. Because of this stability (a correlation coefficient with the economy of +.3 and a standard deviation of sales of about 5 percent from the mean), Mr. Weed, the vice-president of finance, thinks the company could absorb some small risky company that could add quite a bit of return without increasing the company’s risk very much. He is trying to decide which of the two companies he will buy. Tobacco Company of America’s cost of capital is 10 percent.

Computer Whiz Company (CWC) (cost $75 million)			American Micro-Technology (AMT) (cost $75 million)
Probability	Aftertax Cash Flows for 10 Years ($ millions)		Probability	Aftertax Cash Flows for 10 Years ($ millions)
0.3	$ 6		0.2	$(1)
0.3	10		0.2	3
0.2	16		0.2	10
0.2	25		0.3.	25
			0.1	31

a. What is the expected cash flow for each company?

b. Which company has the lower coefficient of variation?

c. Compute the net present value of each company.

d. Which company would you pick, based on net present values

Answer 1

a) Expected Cash flow for CWC = [(0.3*6) + (0.3*10) + (0.2*16) + (0.2*25)]

Expected Cash flow for CWC = $ 13 million

Expected Cash flow for AMT = [(0.2*1) + (0.2 * 3) + (0.2*10) + (0.3*25) + (0.1 * 31)]

Expected Cash flow for AMT = $ 13 million

b) The coefficient of variation allows investors to determine how much volatility, or risk, is assumed in comparison to the amount of return expected from investments. The lower the ratio of standard deviation to mean return, the better risk-return trade-off.

For CWC, Coefficient of variation = $6.93/$13 =0.533

For AMT = Coefficient of variation = $11.69/$13 =0.899

In above case, CWC has lower coefficient of variation.

c) Net Present value = PV of inflows - PV of Outflows

PV of Inflows = $13 million x 6.145 PVIF @ 10%,n = 10 yrs,= $79.885

PV of outflows = 75.000

So, Net Present Value = $ 4.885 million

The net present value is the same for both companies since they each have the same expected cash flow of $13 million.

Note: Please let us know if details regarding any calculation part is required