Suppose the risk-free interest rate is 6%, and the stock market will return either 15% or −5%
next year, with 0.6 upside probability and 0.4 downside probability. Compare the following
two investment strategies: (1) invest 50% of your cash in the risk-free asset, and 50% in the
stock market for the next year, or (2) invest all your cash in the stock market for the next year.
a. Which strategy has the higher expected return? (3 Marks)
b. Which strategy has the higher standard deviation for the expected return? (3 Marks)
c. Which strategy do you prefer? Why? (3 Marks)
shipping charges for the equipment are estimated at $21,000 and such costs are to be
depreciated alongside the initial equipment cost. The equipment will be depreciated straight
line over a five-year period. A working capital investment of $18,000 is required immediately
to undertake the project. The working capital will be recovered at the end of the project. The
revenues from the project in year 1 are expected to be $79,000 and the revenues projected to
increase at a growth rate of 5% per year until the end of the project’s life. Operating costs
excluding depreciation are estimated to be $14,000 in year 1 and these costs are projected to
increase at a growth rate of 2% per year until the end of the project’s life. The firm’s marginal
tax rate is 30%. The expected salvage value of the equipment at the end of year 5 is $25,000.
If the firm’s cost of capital is 14%, what is the NPV of this investment? Should the project be
undertaken?