Question 1

Consider the following information:

State of the

economyProbability of

state of economyReturn on A

(%)Return on B

(%)Growth 0.4 10 4Recession 0.3 -5 0Boom 0.1 24 15Normal 0.2 15 20

a. What is the expected return for A? For B?

b. What is the standard deviation for A? For B?

c. What is the expected return and variance of a portfolio that is 40 per cent invested in A and 60 per cent in B?

Question 2

Orio Ltd. is evaluating a new project that costs $200000, has a five-year life, and no salvage value.

Assume that depreciation is straight-line to zero salvage over the 5-years.

Orio requires a return of 10% on such projects. The tax rate is 30 per cent. Sales are projected at 55000 units per year.

Price per unit is $22, variable cost per unit is $10 and fixed costs are $100000 per year.

a. Calculate the accounting break-even point.

b. Calculate the base-case NPV and IRR. Suppose that you think that the sales projection ranges within 15 per cent. Evaluate the sensitivity of NPV to

changes in that projection, and describe the feasibility of each case (e.g. whether you will accept the project or not).

c. Suppose the projections given all range within 5 per cent except for sales volume, which is ranging within 15 per cent. Calculate the NPV under the

best and worst cases.

Question 3

Case Study: App Electronic

App Electronics is an electronics manufacturer located in Box Hill, Victoria. The company’s Managing director is Shelly Chan, who inherited the

company from her father. The company originally repaired radios and other household appliances when it was founded more than 30 years ago. Over

the years, the company has expanded, and it is now a reputable manufacturer of various specialty electronic items. You have been hired by the company

in the finance department.

One of the major revenue‐producing items manufactured by App Electronics is smart phone. App Electronics currently has one smart phone model

on the market and sales have been excellent. The smart phone is a unique item in that it comes in a variety of colours and is pre‐programmed to play

Jimmy Barnes’s music. However, as with any electronic item, technology changes rapidly, and the current smart phone has limited features in comparison

with newer models. App Electronics has spent $700,000 developing a prototype for a new smart phone that has all the features of the existing one, but

adds new features, such as Wi‐Fi Tethering. The company has spent a further $200,000 for a marketing study to determine the expected sales figures

for the new smart phone.

App Electronics’ production manager has produced estimates of the costs associated with the manufacture of the new smart phone. Variable costs are

estimated at $200 per unit and fixed costs for the operation are expected to run at $5.1 million per year. The estimated sales volume is 64,000 units in

Year 1; 100,000 units in Year 2; 87,000 units in Year 3; 80,000 units in Year 4; and 50,000 units in the final year – Year 5. The unit sale price of the new

smart phone will be $485. The necessary manufacturing equipment can be purchased at the beginning of the project for $34.5 million and will be

depreciated for tax purposes over a seven‐year life (straight‐line to zero). It is believed the value of the manufacturing equipment in five years’ time will

be $5.5 million.

App Electronics has a 30% corporate tax rate and a 12% required return.

Shelly has asked Robert to report that answers the following questions:

1) What is the NPV of the project? Justification of each your cash flow and explanation of why you include it in the project evaluation is expected.

2) Shelly still has concerns about the new smartphone because she was not convinced that the sale projections estimated in question 1 were entirely

accurate. Thus, she has asked Robert to sensitivity analysis to see how changes in the price of the new smartphone will affect the NPV of the

project. She has suggested you to an analysis of the current smart phone market, and you have come up with an estimate of percentage change of

10% in the price of the App Electronics new smartphone. Please conduct this analysis for a) the best case scenario and b) the worst case scenario.

3) Should App Electronics produce the new smart phone based on the NPV estimated in Question 1 and based on the sensitivity analysis in Question

2? Explain your decisions.