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.
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Computer Whiz Company (CWC)
(cost $75 million)
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American Micro-Technology (AMT) (cost $75 million)
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Probability
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Aftertax Cash Flows for 10 Years
($ millions)
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Probability
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Aftertax Cash Flows for 10 Years
($ millions)
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0.3
|
$ 6
|
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0.2
|
$(1)
|
|
0.3
|
10
|
|
0.2
|
3
|
|
0.2
|
16
|
|
0.2
|
10
|
|
0.2
|
25
|
|
0.3.
|
25
|
|
|
|
|
0.1
|
31
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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