Newman manufacturing is considering a cash purchase

2 Questions

1 Risk and probability Micro-Pub, Inc., is considering the purchase of one of two

microfilm cameras, R and S. Both should provide benefits over a 10-year period, and

each requires an initial investment of $4,000. Management has constructed the table

of estimates of rates of return and probabilities for pessimistic, most

likely, and optimistic results.

a. Determine the range for the rate of return for each of the two cameras.

b. Determine the expected value of return for each camera.

c. Purchase of which camera is riskier? Why?

Camera R Camera S

Amount Probability Amount Probability

Initial Investment $4,000 1.00 $4,000 1.00

Annual rate of return

Pessimistic 20% 0.25 15% 0.20

Most Likely 25% 0.50 25% 0.55

Optimistic 30% 0.25 35% 0.25

2 Assessing return and risk Swift Manufacturing must choose between two asset purchases.

The annual rate of return and the related probabilities given in the following

table summarize the firm’s analysis to this point.

Project 257 Project 432

Rate of return Probability Rate of return Probability

(-10%) 0.01 10% 0.05

10 0.04 15 0.10

20 0.05 20 0.10

30 0.10 25 0.15

40 0.15 30 0.20

45 0.30 35 0.15

50 0.15 40 0.10

60 0.10 45 0.10

70 0.05 50 0.05

80 0.04

100 0.01

a. For each project, compute:

(1) The range of possible rates of return.

(2) The expected value of return.

(3) The standard deviation of the returns.

(4) The coefficient of variation of the returns.

b. Construct a bar chart of each distribution of rates of return.

c. Which project would you consider less risky? Why?

1 Question

3 Basic bond valuation Complex Systems has an outstanding issue of $1,000-parvalue

bonds with a 12% coupon interest rate. The issue pays interest annually and

has 16 years remaining to its maturity date.

a. If bonds of similar risk are currently earning a 10% rate of return, how much

should the Complex Systems bond sell for today?

b. Describe the two possible reasons why the rate on similar-risk bonds is below the

coupon interest rate on the Complex Systems bond.

c. If the required return were at 12% instead of 10%, what would the current value

of Complex Systems’ bond be? Contrast this finding with your findings in part a

and discuss.

Another 2 Questions

4 Common stock value—Constant growth Use the constant-growth model (Gordon

model) to find the value of each firm shown in the following table.

Firm Dividend expected next year Dividend growth rate Required return

A $1.20 8% 13%

B 4.00 5 15

C 0.65 10 14

D 6.00 8 9

E 2.25 8 20

5 Common stock value—Variable growth Newman Manufacturing is considering

a cash purchase of the stock of Grips Tool. During the year just completed, Grips

earned $4.25 per share and paid cash dividends of $2.55 per share (D0=$2.55).

Grips’ earnings and dividends are expected to grow at 25% per year for the next

3 years, after which they are expected to grow at 10% per year to infinity. What is

the maximum price per share that Newman should pay for Grips if it has a required

return of 15% on investments with risk characteristics similar to those of Grips?

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