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) American Micro-Technology (AMT)
(cost $75 million) (cost $75 million)
aftertax cash aftertax cash
flow for flow for
10 years 10 years
probability ($ million) probability ($ million)
.3 $ 6 .2 $(1)
.3 10 .2 3
.2 16 .2 10
.2 25 .3 25
a.What is the expected cash flow for each company?
b.Compute the net present value of each company.
c.Compute the variance and standard deviation.
d.Which company would you pick, based on net present values?
The solution explains how to calculate the expected cash flows, variance, standard deviation and NPV