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Rate of return/project selection

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1. Your firm makes the most popular widgets for vacuum cleaners. Your operations manager has suggested that due to an economic slowdown, he could re-tool some of the widget machines so that rather than manufacturing widgets for vacuums, you could manufacture either airplane widgets or snow mobile widgets.

After investigating the possible outcomes for both the snow mobile and airplane manufacturing alternative, you have made the estimates shown in the following table:

Snow Mobiles Airplanes
Initial Investment in Re-tooling $25,000 $25,000
Annual rate of return
? Pessimistic
? Most likely
? Optimistic
17%
21%
25%
16%
21%
32%

(a) For the each of the two projects, determine the range of the rates of return. Show all work and calculations with a full explanation of what you are doing.

(b) Which is more risky for the re-tooling, snow mobiles or airplanes? Why?

(c) If you were making this decision, which would you choose? What does your choice say about your risk tolerance?

(d) Let's say that new information has come in that changes the rate of return for the airplane option under the "Most Likely" scenario to 23% per year. All other factors remain as they were. Does this change your response to (c) above? Why or why not?

2. Referring back to problem 1, you are considering once again the mutually exclusive re-tooling option for your vacuum cleaner shop. You have now developed annual cash inflow projections for the three scenarios (pessimistic, most likely and optimistic). The information is given as follows:

Snow Mobiles Airplanes
Initial Investment in Re-tooling (CF0) $25,000 $25,000
Outcome

? Pessimistic
? Most likely
? Optimistic Annual Cash Inflow (CF)
$4,250
5,250
6,250 Annual Cash Inflow (CF)
$4,000
5,250
8,000

(a) For each project, snow mobiles and airplanes, what is the range of annual cash inflows?

(b) You determine that both projects have a 20-year life. Your cost of capital is 8%. Construct a table for the NPVs for both projects. In your table, include the range of NPVs for each project.

(c) Look at your results for (a) and (b). Are these consistent views of the two projects? Explain.

(d) Finally, you must make a recommendation to your CEO. Do you recommend re-tooling for snow mobiles or airplanes? Support your recommendation.

3. You work for a large MNC contemplating an investment in three assets: Mid-Cap Fund, Large Cap Fund, and Small Cap Fund. Your boss states that the CFO is contemplating a four year investment covering the period 2009 - 2012. You calculate the expected return on each of the assets for each of the years as follows:

Expected Return
Year Mid-Cap Large-Cap Small-Cap
2009 4% 7% 2%
2010 5% 7% 2%
2011 6% 6% 3%
2012 7% 5% 3%

Based on your research, you have grouped the assets into three possible alternatives for your firm to consider:

Alternative Investment Mix
1 100% of Mid-Cap
2 50% of Mid-Cap and 50% of Large-Cap
3 50% of Mid-Cap and 50% of Small-Cap

(a) For the four-year period, calculate the expected return for each of the three alternative investments your MNC is considering.

(b) For the four-year period, calculate the standard deviation of returns for each of the three alternative investment packages you've developed.

(c) From what you calculated in parts (a) and (b) above, now calculate the coefficient of variation for each of your three investment package alternatives.

(d) Which of the investment package alternatives would you recommend to the CFO? Why?

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The solution explains how to calculate the rate of return and do the project selection.

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Problem Set 2

Please answer the following questions in the space provided. You may insert additional lines as necessary in order to complete your response fully.

1. Your firm makes the most popular widgets for vacuum cleaners. Your operations manager has suggested that due to an economic slowdown, he could re-tool some of the widget machines so that rather than manufacturing widgets for vacuums, you could manufacture either airplane widgets or snow mobile widgets.

After investigating the possible outcomes for both the snow mobile and airplane manufacturing alternative, you have made the estimates shown in the following table:

Snow Mobiles Airplanes
Initial Investment in Re-tooling $25,000 $25,000
Annual rate of return
• Pessimistic
• Most likely
• Optimistic
17%
21%
25%
16%
21%
32%

(a) For the each of the two projects, determine the range of the rates of return. Show all work and calculations with a full explanation of what you are doing.

The range for Snow Mobiles is between 17% and 25% = 8%
The range for Airplanes is 16% to 32% = 16%

(b) Which is more risky for the re-tooling, snow mobiles or airplanes? Why?

Snow Mobile is less risky. The reason is that the range of outcome for Snow Molbile is lower than the range for Airplanes
(c) If you were making this decision, which would you choose? What does your choice say about your risk tolerance?

The most likely outcome for both the projects is 21% and the initial investment is equal. The choice of the project would depend on the individual risk preference. A risk averse person would select Snow Mobiles ...

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