Your company has identified two projects. A and B. Bach will require a $5 millio

Question

Your company has identified two projects. A and B. Bach will require a $5 million outlay immediately. The possible payoffs (in millions) at year I, which depend on the future health or the economy, are given in the following table. Assume the three states of the economy arc equally probable (each has a probability of 1/3). You have identified the possible payoffs to investors in three stocks. X, Y and Z.: What are the expected cash flow of projects A and B? What are the expected rates of return offered by stocks x, y and Z?

Explanation / Answer

a. What are the expected cash flow of projects A and B?

Ans:- Project A: 4*1/3 +6*1/3 + 8*1/3 = $6 million

       Project B: 5*1/3 + 6*1/3 + 7*1/3 = $6 million

b. What are the expected rates of return offered by stocks X,Y, and Z?

Ans:- Stock X: Expected price = 80*1/3 +116*1/3+170*1/3=$122. Expected rate of return = (122-112)/112 = 8.93%

Stock Y: Expected price = 40*1/3 +48*1/3+56*1/3=$48. Expected rate of return = (48-45)/45 = 6.67%

Stock Z: Expected price = 8*1/3 +12*1/3+16*1/3=$12. Expected rate of return = (12-9.5)/9.5 = 26.32%

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