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Capital Budgeting: Compute expected return, standard deviation, covariance, proforma

See the attached Excel file.

Betsy Cotner went to work for a title company after graduation from college. The department she worked in provided disbursement advice to banks with regard to oil/gas-related loans. When a bank granted a construction loan, the money was paid out according to progress made. Someone had to monitor the project and authorize disbursement of cash under the loan agreement. While most banks monitor progress themselves, a few rely on outside firms to do the monitoring, and this is what Cotner's department did.

Cotner spent nearly a decade learning the business and working her way up to assistant manager of the department. Then a recession caused a decline in profits for the title company. The title company decided to get out of oil/gas disbursement, and the department manager decided to retire.

Cotner thought that there was still enough business to make a decent living for her if she did not have to bear the overhead cost of the title company. As she informed the lenders of the title company's decision, she also informed them that she would be opening her own office. She had developed an excellent personal reputation, and several major lenders indicated a willingness to continue doing business with her. Thus, Houston Disbursement was born.

At the recession ended, Cotner's business picked up substantially, but she began to worry about the vagaries of the oil business. She decided to diversify into general commercial construction in the Houston area. She hired Brent Ross, a young loan officer in the commercial construction field, with the understanding that he could eventually buy an interest in Houston Disbursement.

Cotner soon came to realize that she gained little from diversification. A drop in oil prices caused the entire Houston economy to turn down, even when the national economy was strong. Based on her experiences, Cotner prepared an estimate of revenue and profits for Houston Disbursement for both a strong and weak economy, and for both high and low oil prices. Her estimates are summarized in Table 1. While the analysis focuses on earnings before tax, this is approximately the same as cash flow because capital investments were limited to office furniture, and net working capital was negligible. Net working capital was kept negligible by the practice of collecting retainer fees from banks at the start of a construction project. Cotner's salary, based on her estimate of what she could get if she were working for another company, is included in the cost figures. The business was organized as a Subchapter S Corporation and Cotner was in a 28 percent tax bracket.

To diversify, Cotner decided to open a second office. She would go to the new location and promote Ross to the manager of the Houston office. Two possibilities that would take advantage of her current contacts were a commercial construction disbursement office in San Francisco and an oil business disbursement office in Alaska. Cotner was quite willing to move to either area.

Cotner's estimates of profitability appear in Table 2. The costs include a fair wage for Cotner; there would be no significant ware savings at the Houston office because a replacement for Cotner would be needed.

Cotner considered high and low oil prices equally likely. However, she believed the probability of a strong economy was twice that of a weak economy. She did not believe a weak economy was likely to last more than 2 years. Low oil prices, on the other hand, could continue for at least 5 years. Oil prices and the economy were both strong at the moment.

It would cost approximately $75,000 to open an office in either San Francisco or Alaska. The costs would be primarily development costs and would be expensed for tax purposes. Fixed assets included in this cost would be under $10,000, and a provision of the tax law allowed expensing up to $10,000 of fixed assets acquisitions. Cotner has approximately $200,000 invested in US government securities earning 9 percent, so she would have no difficulty in getting $75,000.


1. Compute expected return and standard deviation of annual return for each alternative separately.
2. Compute covariance of annual returns between the Alaska and Houston offices, and between the California and Houston offices.
3. Compute the expected return and standard deviation for each of the tow combinations.
4. Prepare pro forma statements for wash new office with the Houston office, using each of the four possible conditions.
5. What would you recommend to Cotner? Why?


Solution Summary

In Excel, the solution shows all the calculations needed to solve the problems. It also includes explanations for the calculations.