Scenario Analysis.
Problem 1: The common stock of Leaning Tower of Pita, Inc., a restaurant chain, will generate the following payoffs to investors next year:
Dividend Stock Price
Boom $5.00 $195
Normal economy 2.00 100
Recession 0 0
The company goes out of business if a recession hits. Calculate the expected rate of return and standard deviation of return to Leaning Tower of Pita shareholders. Assume for simplicity that the three possible states of the economy are equally likely. The stock is selling today for $90.
Problem 2:
Replacement Decision. You are operating an old machine that is expected to produce a cash inflow of $5,000 in each of the next 3 years before it fails. You can replace it now with a new machine that costs $20,000 but is much more efficient and will provide a cash flow of $10,000 a year for 4 years. Should you replace your equipment now? The discount rate is 15 percent.