Part 1: Case study
You are placed in the role of an analyst for Hill Country Snack Food Co. Hill Country Snack Food Co. is considering investing in a new product, SuperBar. You have been asked by the CEO to provide a recommendation on whether to go ahead with the investment in SuperBar.
The research and development costs so far have totalled $40 million (exotic superfoods and rare minerals of dubious origin are expensive!). If approved by the CEO, SuperBar could be put on the market at the beginning of next year (Year 1), and Hill Country expects it to stay on the market for a total of four years (from Year 1 to Year 4).
If the project proceeds, the initial investment will occur immediately (Year 0), and operational cash flows will occur at the beginning of next year (Year 1). Hill Country must initially invest $1 million in production equipment to make the SuperBar (in Year 0). This equipment can be sold for $800,000 at the end of four years (Year 4). Hill Country would sell the SuperBar through its current channels, so sales will be able to commence as soon as the equipment is operational.
SuperBar is expected to wholesale for $2 per bar. The variable cost to produce each bar is $1. In order to secure appropriate celebrity endorsement for the new SuperBar, Hill Country will incur $20 million in marketing and general administration costs in the first year (Year 1). Both selling price and costs (including variable costs and marketing and general administration costs) are expected to increase at the inflation rate in the subsequent years (Year 2 to Year 4). Hill Country’s corporate tax rate is 35.5 per cent. Annual inflation is expected to remain constant at 3.25 per cent over the life of the project.
Industry research suggests the following sales targets are reasonable: 31 million bars sold in the first year, 20 million in year two, 15 million in year three, and 15 million in year four. The production equipment would be depreciated using the straight-line depreciation method over 4 years to a zero balance. The initial working capital requirement is $100,000 in Year 0. At the end of Year 4, the company will get all working capital back.
For this analysis, assume a 10% discount rate is appropriate.
Please complete the following questions.
Calculate the incremental free cash flow during the project’s life (starting from Year 0 to Year 4). Show workings.
Calculate the NPV, payback period and IRR of the project. Should the project be accepted based on NPV rule? Show workings and explain your answer(s).
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Part 2: Risk and Return
- 1. True or False with Explanation
“According to CAPM, a stock with a beta of zero will offer a zero rate of return.”
Explain whether this statement is true or false.
- “Diversification eliminates idiosyncratic risk but does not eliminate systematic risk.”
Explain whether this statement is true or false.
2. CAPM Scenario Analysis
If the CAPM holds, is the following scenario possible? Provide a detailed explanation for your answer.
| Portfolio | Beta | Expected Return |
|---|---|---|
| Risk-free | 0 | 9% |
| Market | 1 | 17% |
| Stock TED | 1.2 | 15% |
3. Expected Returns and Standard Deviations
Using the following table, answer parts (a)–(c):
| Recession | Normal | Boom | |
|---|---|---|---|
| Probability | 0.25 | 0.5 | 0.25 |
| Stock INV | -10% | 5% | 25% |
| Stock DEV | 10% | 20% | 10% |
Calculate the expected rates of return for Stocks INV and DEV.
Compute the standard deviations of returns for Stocks INV and DEV.
Assume you invest $7,500 in Stock INV and $2,500 in Stock DEV. What is the expected return on your portfolio?
Given the correlation between INV and DEV is -0.082, calculate the standard deviation of the portfolio.
4. Stock Selection Based on Historical Data
Consider the historical prices for Stocks FIM, IFP, and QTB from 2017 to 2023:
| Year | FIM | IFP | QTB |
|---|---|---|---|
| 2017 | 63.8 | 34.6 | 24.3 |
| 2018 | 66.0 | 29.9 | 26.1 |
| 2019 | 77.1 | 32.5 | 30.8 |
| 2020 | 72.2 | 33.8 | 37.9 |
| 2021 | 79.1 | 36.1 | 38.5 |
| 2022 | 85.1 | 41.1 | 35.9 |
| 2023 | 73.5 | 34.4 | 36.7 |
Calculate the return and risk (standard deviation) for each stock.
Based on your calculations, which stock would you choose? Justify