Problem 1: Calculating Project Cash Flows and NPV.
Pappy’s Potato has come up with a new product, the Pet Potato (they are freeze-dried to last longer). Pappy’s paid $120,000 for a marketing survey to determine the viability of the product. It is felt that Pet Potato will generate sales of $270,000 per year. The fixed costs associated with this will be $115,000 per year, and variable costs will amount to 30 percent of sales. The equipment necessary for production of the Potato Pets will cost $200,000 and will be depreciated in a straight-line manner for the four years of the product life (as with all fads, it is felt the sales will end quickly). This is the only initial cost for the production. Pappy’s is in a 40 percent tax bracket and has a required return of 9 percent. Calculate the payback period, NPV, and IRR.
Problem 2: Portfolio Returns and Deviations.
Consider the following information on a portfolio of three stocks:
State of Economy Probability of State of Economy Stock A Rate of Return Stock B Rate of Return Stock C Rate of Return
Boom .20 .06 .20 .60
Normal .70 .10 .10 .20
Bust .10 .12 -.12 -.40
a. If your portfolio is invested 30 percent each in A and B and 40 percent in C, what is the portfolio’s expected return? The variance? The standard deviation?
b. If the expected T-bill rate is 4.25 percent, what is the expected risk premium on the portfolio?
c. If the expected inflation rate is 3 percent, what is the expected real return on the portfolio? What is the expected real risk premium on the portfolio?