Problem:
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.
Computer Whiz Company(CWC)
(cost $75 million)
Probability Aftertax Cash Flows
for 10 Years
($ millions)
0.3 $6
0.3 $10
0.2 $16
0.2 $25
American Micro-Technology(AMT)
(cost $75 million)
Probability Aftertax Cash Flows
for 10 Years
($ millions)
0.2 -$1
0.2 $3
0.2 $10
0.3 $25
0.1 $31
Q1. Which company has the lower coefficient of variation?
Q2. Compute the net present value of each company?
Q3. Which company would you pick, based on net present values?
Q4. Would you change your mind if you added the risk dimensions to the problem? Explain.
Q5. What is Computer Whiz Company had a correlation coefficient with the economy of +.5 and American Micro-Technology had one of -.1? Which of the companies would give you the best portfolio effects for risk reduction?
Q6. What might be the effect of the acquisitions on the market value of Tobacco Company's stock?