Comprehensive problem on page 431(Gibson Appliance)
Gibson Appliance Co is a very stable billion-dollar company with a sales growth of about 7% per year in good or bad economic conditions. Because of this stability (a coefficient of correlation with the economy of + .4 and a standard deviation of sales of about 5% from the mean), Mr Hoover, the vice-president of finance, thinks the company could absorb a 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 2 companies he will buy, using the figures below. Gibson’s cost of capital is 12%.
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Genetic Technology Co
(cost $80 million)
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Silicon Microchip Co
(cost $80 million)
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Cash Flow for 10 Years ($ millions)
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Probability
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Cash Flow for 10 Years ($ millions)
|
Probability
|
|
2
|
.2
|
5
|
.2
|
|
8
|
.3
|
7
|
.2
|
|
16
|
.2
|
18
|
.3
|
|
25
|
.2
|
24
|
.3
|
|
40
|
.1
|
|
Question 1: What is the expected cash flow from both companies?
Question 2: Which company has the lower coefficient variation?
Question 3: Compute the net present value of each company.
Question 4: Which company would you pick, based on the net present values?
Question 5: Would you change your mind if you added the risk dimensions to the problem? Explain.
Question 6: What if Genetic Technology Co had a coefficient of correlation with the economy of -.2 and Silicon Microchip Co had one of +.5? Which of these companies would give you the best portfolio effects for risk reduction?
Question 7: What might be the effect of the acquisitions on the market value of Gibson Appliance Co’s stock?