Tobacco Company of America is a very stable billion-dollar company with sales gr
ID: 2654085 • Letter: T
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’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)
(cost $75 million)
American Micro-Technology (AMT) (cost $75 million)
Probability
Aftertax Cash Flows for 10 Years
($ millions)
Probability
Aftertax Cash Flows for 10 Years
($ millions)
0.3
$ 6
0.2
$(1)
0.3
10
0.2
3
0.2
16
0.2
10
0.2
25
0.3.
25
0.1
31
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?
Computer Whiz Company (CWC)
(cost $75 million)
American Micro-Technology (AMT) (cost $75 million)
Probability
Aftertax Cash Flows for 10 Years
($ millions)
Probability
Aftertax Cash Flows for 10 Years
($ millions)
0.3
$ 6
0.2
$(1)
0.3
10
0.2
3
0.2
16
0.2
10
0.2
25
0.3.
25
0.1
31
Explanation / Answer
Answer:
a
Calculation of expected cash flow
CWC
Probability
Aftertax CF
Expected CF
($ millions)
($ millions)
A
B
A*B
0.3
6.00
1.80
0.3
10.00
3.00
0.2
16.00
3.20
0.2
25.00
5.00
Expected CF
13.00
AMT
Probability
Aftertax CF
Expected CF
($ millions)
($ millions)
A
B
A*B
0.2
(1.00)
(0.20)
0.2
3.00
0.60
0.2
10.00
2.00
0.3
25.00
7.50
0.1
31.00
3.10
Expected CF
13.00
c.
Calculation of NPV
CWC
($ Millions)
Expected CF (A)
13.00
PVAF (10%, 10 years) (B)
6.14457
Present value of CF= C =A-B
79.88
Initial cost (D)
75.00
NPV = C-D
4.88
CWC
($ Millions)
Expected CF (A)
13.00
PVAF (10%, 10 years) (B)
6.14457
Present value of CF= C =A-B
79.88
Initial cost (D)
75.00
NPV = C-D
4.88
d.
NPV of both companies is same , hence we can pick any Company
a
Calculation of expected cash flow
CWC
Probability
Aftertax CF
Expected CF
($ millions)
($ millions)
A
B
A*B
0.3
6.00
1.80
0.3
10.00
3.00
0.2
16.00
3.20
0.2
25.00
5.00
Expected CF
13.00
AMT
Probability
Aftertax CF
Expected CF
($ millions)
($ millions)
A
B
A*B
0.2
(1.00)
(0.20)
0.2
3.00
0.60
0.2
10.00
2.00
0.3
25.00
7.50
0.1
31.00
3.10
Expected CF
13.00
c.
Calculation of NPV
CWC
($ Millions)
Expected CF (A)
13.00
PVAF (10%, 10 years) (B)
6.14457
Present value of CF= C =A-B
79.88
Initial cost (D)
75.00
NPV = C-D
4.88
CWC
($ Millions)
Expected CF (A)
13.00
PVAF (10%, 10 years) (B)
6.14457
Present value of CF= C =A-B
79.88
Initial cost (D)
75.00
NPV = C-D
4.88
d.
NPV of both companies is same , hence we can pick any Company
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