Part 1: Case Study (25 Marks)

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 totaled $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 cost and marketing and general administration cost) 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 percent. Annual inflation is expected to remain constant at 3.25 percent 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 immediate 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 the purposes of this analysis, assume a 10% discount rate is appropriate.

Assignment Questions

1. Calculate the incremental free cash flow during the project’s life (starting from Year 0 to Year 4). Show workings. (15 marks)
2. Calculate the NPV, payback period, and IRR of the project. Should the project be accepted based on the NPV rule? Show workings and explain your answer(s). (10 marks)

Part 2: Risk and Return (25 Marks)

1. Explain the following statement true or false. (2 marks)
   “According to CAPM, stock with a beta of zero will offer a zero rate of return.”
2. Explain the following statement true or false. (2 marks)
   “Diversification eliminates idiosyncratic risk but does not eliminate systematic risk.”
3. If CAPM is valid, is the following scenario possible? Please explain your answers. (2 marks)
   

   Portfolio	Beta	Expected Return
   Risk-free	0	9%
   Market	1	17%
   Stock TED	1.2	15%

4. Using the following table to answer parts (a) – (c). (11 marks)
   

   	Recession	Normal	Boom
   Probability	0.25	0.5	0.25
   Stock INV	-10%	5%	25%
   Stock DEV	10%	20%	10%

   • (a) What are the expected rates of return for Stocks INV and DEV? (2 marks)
   • (b) What are the standard deviations of returns on Stocks INV and DEV? (4 marks)
   • (c) 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, what is the standard deviation of the portfolio? (5 marks)
5. You decide to invest in one of the 3 stocks: FIM, IFP, and QTB. Based on the historical prices presented in the following table, please answer the following questions. (8 marks)
   

   Year	FIM	IFP	QTB
   2017	63.8	34.6	24.3
   2018	66	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

   • (a) Calculate the return and risk (standard deviation) of each stock. (6 marks)
   • (b) Based on your calculation, which stock would you pick? (2 marks)