Tobacco Company of America is a very stable billion-dollar company with sales gr

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%u2019s risk very much. He is trying to decide which of the two companies he will buy. Tobacco Company of America%u2019s cost of capital is 10 percent.

Computer Whiz Company (CWC)
(cost $75 million)

Probability AfterTax CashFlows for 10years in millions

.3 $6million

.3 $10million

.2 $16million

.2 $25million


American Micro-Technology (AMT) (cost $75 million)

Probabilty AfterTax CashFlows for 10years in millions

.2 ($1million)

.2 $3million

.2 $10million

.3 $25million

.1 $31million

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?

e .Would you change your mind if you added the risk dimensions to the problem? Explain

f. what if computer whiz company had a correlation coeefficient with the economy of +.5 and american micro-tech had one of -.1? which of the companies would give you the best portfolio effects for risk reduction?

g. what might be the effect of the aquisitions on the market value of tobacco companys stock? explain

Type your question here

Explanation / Answer

a) Expected for CWC is 0.3 * 6 + 0.3 * 10 + 0.2 * 16 + 2 * 0.25 = 13million

AMT is 0.2 * -1 + .2 * 3 + .2 * 10 + .3 *25 + .1 * 31 = 13 million

b) lower variation is for CWC

c)

NPV is -75 + 13/1.1 + ... 13/1.1^10 = $4,879,372.37

d) both companies are the same based on NPV

e) yes, if risk is to be considered I would pick CWC as it has lesser variation

f) AMT will be picked in this case as it can be used as a hedge against the primary business during bad market conditions

g) The market value of tobacco companys stock might increase as the investment has +ve NPV

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