Managerial Economics Study Set 11

Business

Quiz 16 :

Risk Analysis

Quiz 16 :

Risk Analysis

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When the basic valuation model is adjusted using the risk-free rate, i, what economic factor is being explicitly accounted for?
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According to the basic valuation model,
img …… (1)
The equation (1) shows total value as discounted present worth of future profits where
img future profits are and i is the risk free rate of return. By adjusting the total value with risk free rate of return i, time value of money is explicitly accounted for.

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Risk Preferences. Identify each of the following as being consistent with risk-averse, risk-neutral, or risk-seeking behavior in investment project selection. Explain your answers. A. Larger risk premiums for riskier projects B. Preference for smaller, as opposed to larger, coefficients of variation C. Valuing certain sums and expected risky sums of equal dollar amounts equally D. Having an increasing marginal utility of money E. Ignoring the risk levels of investment alternatives
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Risk averse investors are the ones who aim to minimize the risk. Thus risk averse investors demand for higher risk premium to adjust for the high risk involved in the investment projects.
Risk averse investors have a low expectation of a higher payoff and generally expect a constant payoff with a minimum standard deviation. Thus the risk averse investors prefer lower as opposed to higher coefficients of variation.
Risk neutral investors place a maximum value on a project exactly equal to their expected rewards. Therefore, certain sums and expected risky sums of equal dollar amounts are valued equally by risk neutral investors.
Risk-seeking investors are the ones with increasing marginal utility of money, because increase in their wealth increases the utility of that wealth more than proportionately and thus they are aggressive investors.
Risk neutral investors place a value on project exactly equal to the expected returns, irrespective of variability in returns due to risk involved.

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State-run lotteries commonly pay out 50 percent of total lottery-ticket sales in the form of jackpots and prizes. Use the certainty equivalent concept to quantify the minimum value placed on each risky dollar of expected return by lottery-ticket buyers. Why are such lotteries so popular?
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Investment in form of lottery tickets is a risky investment and Any expected risky amount can be converted to an equivalent certain sum using the certainty equivalent adjustment factor, a, calculated as the ratio of a certain sum divided by an expected risky amount, where both dollar values provide the same level of utility.
img Since for every dollar invested in lottery tickets return is only 50 percent, therefore
img This gives the adjustment factor 1, which accounts for the risk preferring behavior of the lottery buyers. This suggests that for small dollar amounts many consumers are risk-seeking in their behavior and hence lotteries are gaining the popularity.

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Probability Concepts. Firefly Products, Inc., has just completed development of a new line of skin-care products. preliminary market research indicate two feasible marketing strategies: (1) creating general consumer acceptance through media advertising or (2) creating distributor acceptance through intensive personal selling. Sales estimates for under each marketing alternative are as follows: img A. Assume that the company has a 50 percent profit margin on sales (i.e., profits equal one-half of sales revenue). Calculate expected profits for each plan. B. Construct a simple bar graph of the possible profit outcomes for each plan. Which plan appears to be riskier? C. Assume that management's utility function resembles the one illustrated in the following figure. Calculate expected utility for each strategy. Which strategy should the marketing manager recommend?
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Graph the relation between money and its utility for an individual who buys both household fire insurance and state-run lottery tickets.
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The standard deviation measure of risk implicitly gives equal weight to variations on both sides of the expected value. Can you see any potential limitations of this treatment?
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Risk-Adjusted Discount Rates. One-Hour Dryclean, Inc., is replacing an obsolete dry cleaning machine with one of two innovative pieces of equipment. Alternative 1 requires a current investment outlay of $25,373, whereas alternative 2 requires an outlay of $24,199. The following cash flows (cost savings) will be generated each year over the new machines' 4-year lives: img A. Calculate the expected cash flow for each investment alternative. B. Calculate the standard deviation of cash flows (risk) for each investment alternative. C. The firm will use a discount rate of 12 percent for the cash flows with a higher degree of dispersion and a 10 percent rate for the less risky cash flows. Calculate the expected net present value for each investment. Which alternative should be chosen?
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Standard Normal Concept. Speedy Business Cards, Inc., supplies customized business cards to commercial and individual customers. The company is preparing a bid to supply cards to the Nationwide Realty Company, a large association of independent real estate agents. Because paper, ink, and other costs cannot be determined precisely, Speedy anticipates that costs will be normally distributed around a mean of $20 per unit (each 500-card order) with a standard deviation of $2 per unit. A. What is the probability that Speedy will make a profit at a price of $20 per unit? B. Calculate the unit price necessary to give Speedy a 95 percent chance of making a profit on the order. C. If Speedy submits a successful bid of $23 per unit, what is the probability that it will make a profit?
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What is the value of decision trees in managerial decision making?
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Certainty Equivalents. Recently, the housing market suffered the worst slump in nearly two decades. Hot housing markets like Boston, Ft. Lauderdale-Florida, and Washington DC cooled as rising interest rates and tightened lending standards eliminated lots of potential buyers. With job losses in the auto industry, the housing downturn was especially serious in Detroit and surrounding areas. Suppose a real estate speculator seeking to profit from the downturn bought a pool of home mortgages for $1 million on the expectation of quickly selling them to out-of-town investors for $1.5 million. If the deal falls through, the speculator would be able to just as quickly dump the pool of home mortgages in the secondary market for $800,000. A. Calculate the speculator's expected payoff if there is a 50/50 chance of successfully selling the pool of home mortgages to out-of-town investors. B. Calculate the certainty equivalent adjustment factor for this investment. Is the speculator's decision to buy the pool of home mortgages consistent with risk-averse behavior?
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Certainty Equivalent Method. Tex-Mex, Inc., is a rapidly growing chain of Mexican food restaurants. The company has a limited amount of capital for expansion and must carefully weigh available alternatives. Currently, the company is considering opening restaurants in Santa Fe or Albuquerque, New Mexico. Projections for the two potential outlets are as follows: img Each restaurant would require a capital expenditure of $1.4 million, plus land acquisition costs of $1million for Albuquerque and $2 million for Santa Fe. The company uses the 5 percent yield on risk-free U.S. Treasury bills to calculate the risk-free annual opportunity cost of investment capital. A. Calculate the expected value, standard deviation, and coefficient of variation for each outlet's profit contribution. B. Calculate the minimum certainty equivalent adjustment factor for each restaurant's cash flows that would justify investment in each outlet. C. Assuming that the management of Tex-Mex is risk averse and uses the certainty equivalent method in decision making, which is the more attractive outlet? Why?
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Probability Concepts. Narcissism Records, Inc., has just completed an agreement to re-release a recording of "The Boss's Greatest Hits." The Boss had a number of hits on the rock-and-roll charts during the early 1980s. Preliminary market research indicates two feasible marketing strategies: (1) concentration on developing general consumer acceptance by advertising on late-night television or (2) concentration on developing distributor acceptance through intensive sales calls by company representatives. Estimates for sales under each alternative plan and payoff matrices according to an assessment of the likelihood of product acceptance under each plan are as follows: img A. Assuming that the company has a 50 percent profit margin on sales, calculate the expected profits for each plan. B. Construct a simple bar graph of the possible profit outcomes for each plan. Which plan appears to be riskier? C. Calculate the standard deviation and coefficient of variation of the profit distribution associated with each plan. D. Assume that the management of Narcissism has a utility function like the one illustrated in the following figure. Which marketing strategy is best? img
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If the expected net present value of returns from an investment project is $50,000, what is the maximum price that a risk-neutral investor would pay for it? Explain.
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Certainty Equivalents. The certainty equivalent concept can be widely employed in the analysis of personal and business decision making. Indicate whether each of the following statements is true or false and explain why: A. The appropriate certainty equivalent adjustment factor, ?, indicates the minimum price in certain dollars that an individual should be willing to pay per risky dollar of expected return. B. If ?? 1, a certain sum and a risky expected return of different dollar amounts provide equivalent utility to a given decision maker. C. If previously accepted projects with similar risk have ? s in a range from ?= 0.4 to ?= 0.5, an investment with an expected return of $150,000 is acceptable at a cost of $50,000. D. A project for which NPV 0 using an appropriate risk-adjusted discount rate has an implied ? factor that is too large to allow project acceptance. E. State-run lotteries that pay out 50 percent of the revenues that they generate require players who place at least a certain $2 value on each $1 of expected risky return.
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Decision Trees. Keystone Manufacturing, Inc., is analyzing a new bid to supply the company with electronic control systems. Alpha Corporation has been supplying the systems and Keystone is satisfied with its performance. However, a bid has just been received from Beta Controls, Ltd., a firm that is aggressively marketing its products. Beta has offered to supply systems for a price of $120,000. The price for the Alpha system is $160,000. In addition to an attractive price, Beta offers a money-back guarantee. That is, if Beta's systems do not match Alpha's quality, Keystone can reject and return them for a full refund. However, if it must reject the machines and return them to Beta, Keystone will suffer a delay costing the firm $60,000. A. Construct a decision tree for this problem and determine the maximum probability that Keystone could assign to rejection of the Beta system before it would reject that firm's offer, assuming that it decides on the basis of minimizing expected costs. B. Assume that Keystone assigns a 50 percent probability of rejection to Beta Controls. Would Keystone be willing to pay $15,000 for an assurance bond that would pay $60,000 in the event that Beta Controls fails the quality check? (Use the same objective as in part A.) Explain.
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"Market estimates of investors' reactions to risk cannot be measured precisely, so it is impossible to set risk-adjusted discount rates for various classes of investment with a high degree of precision." Discuss this statement
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In economic terms, what is the difference between risk and uncertainty?
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Confronted with a choice between $50 today or $100 1 year from now, economic experiments suggest that the vast majority of people will take the $50 today. At the same time, economic experiments show that most people will opt to take $100 in 10 years over $50 in 9 years. Is such behavior rational? Explain why or why not.
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Expected Value. Perry Chandler, a broker with Caveat Emptor, Ltd., offers free investment seminars to local PTA groups. On average, Chandler expects 1 percent of seminar participants to purchase $25,000 in tax-sheltered investments and 5 percent to purchase $5,000 in stocks and bonds. Chandler earns a 4 percent net commission on tax shelters and a 1 percent commission on stocks and bonds. Calculate Chandler's expected net commissions per seminar if attendance averages 10 persons.
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Domestic investors sometimes miss out on better investment opportunities available to global investors. At the same time, global investors face special risks. Discuss some of the special risks faced by global investors.
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