Scenario Analysis

Q2.a. Consider the following scenario analysis.
Scenario
Probability
Rate of Return
Stocks
Bonds
Recession
0.20
-5%
+14%
Normal
0.60
+15
+8
Boom
0.20
+25
+4

i. Is it reasonable to assume that Treasury bonds will provide higher returns in recessions than booms? Explain your argument.
ii. Calculate the expected rate of return and standard deviation for each investment?
iii. Which investment would you prefer?
10 marks

Q2.b. The treasurer of Holmes & Holmes Co. has projected the cash flows of Project A, B, and C as follows:
Year
Project A
Project B
Project C
0
-$405,000
-$810,000
-$405,000
1
297,000
540,000
324,000
2
297,000
540,000
243,000

Suppose the relevant discount rate is 12% per year.
i. Compute the profitability index for each of the three projects.
ii. Compute the Net Present Value (NPV) for the three projects.
iii. Suppose these three projects are independent. Which project(s) should Holmes & Holmes accept based on the profitability index rule?
iv. Suppose these three projects are mutually exclusive. Which project(s) should Holmes & Holmes accept based on the profitability index rule? Hint: Since the projects are mutually exclusive, choose the project with the highest PI, while taking into account the scales of the project. Consider also the incremental cash flows of the project when the scales of the projects are different.
v. Suppose the company’s budget for these projects is $810,000. The projects are not divisible. Which project(s) should Holmes & Holmes accept?