Question: 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
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|
2
|
.2
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5
|
.2
|
|
8
|
.3
|
7
|
.2
|
|
16
|
.2
|
18
|
.3
|
|
25
|
.2
|
24
|
.3
|
|
40
|
.1
|
|
Q1. What is the expected cash flow from both companies?
Q2. Which company has the lower coefficient variation?
Q3. Compute the net present value of each company.
Q4. Which company would you pick, based on the net present values?
Q5. Would you change your mind if you added the risk dimensions to the problem? Explain.
Q6. 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?
Q7. What might be the effect of the acquisitions on the market value of Gibson Appliance Co’s stock?