(i). Consider a ten-year project that costs $40,000 today, which is expected to generate $5,000 at the end of the second year and then the cash flows will increase by $1,500 every year for the following three years and then stagnate for the rest of the project life. The cost of capital is 7 percent. What is the project’s NPV? What is the discounted payback period? (7 marks)
(ii). Scotia Vintners Co-operative is considering two mutually exclusive projects: A and B. Project A requires a $20,000 cash outlay today and is expected to generate after-tax cash flows of $11,000 in year 1, $9,000 in year 2, and $7,000 in year 3. Project B requires a $30,000 cash outlay today and is expected to generate after-tax cash flows of $7,000 in year 1, $9,000 in year 2, $11,000 in year 3, and $16,000 in year 4. Both projects can be replicated at the end of its life. The appropriate discount rate for both projects is 10 percent.
a) Calculate the NPV of both projects. Given that the projects are mutually exclusive and can be replicated, which project should be accepted? (11 marks)
b) Calculate the payback periods of both projects if cash flows occur evenly throughout the year. (3 marks)
c) Calculate the discounted payback periods of both projects if cash flows occur evenly throughout the year. (6 marks)
d) What is the profitability index of both projects? (2 marks)
e) Using the information in (a) – (d), which project should be chosen? Why? (3 marks)
Question 4: Introduction to Risk and Return (25 marks)
(i). You are advising an investor who has $30,000 to invest in two securities: Spot and Dot. After doing an extensive analysis of the economy and the two securities, you came up with the following forecasts:
State of the Economy
|
Probability of Occurrence
|
Spot Expected Return
|
Dot Expected Return
|
Boom
|
15%
|
-8%
|
35%
|
Natural
|
60%
|
14%
|
20%
|
Bust
|
25%
|
18%
|
-10%
|
a) What are the expected returns of Spot and Dot shares? (4 marks)
b) What are the standard deviations of the returns on Spot and Dot? (5 marks)
c) Estimate the covariance of the returns on Spot and Dot (2.5 marks)
d) What is the correlation coefficient between Spot and Dot returns? (2.5 marks)
e) How much of the money should be invested in Spot and how much in Dot if you wish to have an expected return of 12 percent on the portfolio? (5 marks)
f) Compute the standard deviation of the portfolio in (e) (3 marks)
(ii) Why does diversification reduce risk? Answer the question with reference to why the standard deviation of the portfolio in (f) above is lower than the standard deviation of the two stocks (in b) that make up the portfolio. (3 marks)
**No reference needed.