27. 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.

a. What is the expected cash flow for each company?

b. Which company has the lower coefficient of variation?

c. Compute the net present value of each company.

d. Which company would you pick, based on net present values?

e. Would you change your mind if you added the risk dimensions to the problem?
Explain.
f What if 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?
g. What might be the effect of the acquisitions on the market value of Tobacco Company’s stock?

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Computer Whiz Company (CWC) (cost $75 million) .3 .3. Aftertax Cash Flows for 10 Years American Micro-Technology (AMT) (cost $75 million) Aftertax Cash Flows for 10 Years ($ millions) $(1) Probability ($ millions) Probability $6 .2. 322 10 .2 3 16 25 23 .2 .3 .1 225 10 25 31