Week 1 Assignment
1. A generous university benefactor has agreed to donate a large amount of money for student scholarships. The money can be provided in one lump-sum of $10mln, or in parts, where $5.5mln can be provided in year 1, and another $5.5mln can be provided in year 2. Assuming the opportunity interest rate is 6%, what is the present value of the second alternative? Which of the two alternatives should be chosen and why? How would your decision change if the opportunity interest rate was 12%? Please, show all your calculations.
ANSWER. Using the equation PV=FVn/(1+r)n to find the Present Value where n = number of times the percentage is taken, in this case 1. The r is the rate for the first equation it is 0.06 and for the second it is 0.12 representing 6% and 12% respectively. FV is 5.5mil.
5,500,000/1.06 = 5,188,679.25 This means that initially the donor will give $5,500,000 and then on the second year the donor will give ...view middle of the document...
2. An angel investor is considering investing in one of two start-up businesses and is evaluating the expected returns along with the risk of each option in order to choose the better alternative.
* Business 1 is an innovative protein energy drink, which has ENPV of $100,000 with a standard deviation of $40,000.
* Business 2 is a unique chicken wings dipping sauce with an ENPV of $60,000 and a standard deviation of $25,000.
a) Apply the coefficient-of-variation decision criterion to these alternatives to find out which is preferred by the angel investor, assuming that he/she is risk-averse.
ANSWER: According to the textbook, the coefficient-of-variation decision criterion “is calculated as the ratio of the standard deviation to the mean.” (p2.2) So, for Business 1 it would be 40,000/100,000 or 0.4 and for Business 2 it would be 25,000/60,000 or 0.4 (rounded to the nearest 10th) with similar values, this method doesn’t help the investor choose which business to invest in.
b) Apply the maximin criterion, assuming that the worst outcome in Business 1 is to lose $5,000, whereas the worst outcome in Business 2 is to make only $5,000 in profit.
ANSWER. “For the maximin decision rule, we simply compare the two minimum outcomes” (p2.2) Therefore using this rule, the angel investor should opt for Business 2; because the worst case scenario for business 2 is better than the worst case scenario for business 1.
c) If you were the angel investor, what is your certainty equivalent for these two projects? Are you risk-averse, risk-neutral, or risk-lover?
ANSWER: If I were the angel investor, I would utilize the maximin decision rule because I am very conservative. I am not a risk taker by any means! I would prefer to weigh out the worst possible outcome for both of the businesses and then choose the better of the two worst options. I would opt for Business 2 if the criteria for worst possible outcome were as listed in part B of this question. I prefer to have a higher probability of success and a lower probability of loss in order for me to invest my money.
Douglas, E. (2012). Managerial Economics (1st ed.). San Diego, CA: Bridgepoint Education.
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