Economics of Risk Ad Unvertainty Applied Problems

Topics: Risk aversion, Decision theory, Risk Pages: 2 (528 words) Published: April 8, 2013
1. University benefactor

Generous benfactor donates \$10 mln (lump sum) for student scholasrships \$5.5 mln can be provided in year 1
\$5.5 mln can be provided in year 2
Opportunity interest rate 6%

What is the present value of year 2, \$5.5 mln?
cash flowscash flows
010,000,000110,000,000010,000,000110,000,000
1\$5,500,000 0.5188\$5,188,679 1\$5,500,000 0.491\$4,910,714 2\$5,500,000 0.4894\$4,894,980 2\$5,500,000 0.4384\$4,384,566 Totals\$11,000,000 \$20,083,660 Totals\$11,000,000 \$19,295,281

The present value of year 2 is \$4,894,980.
PV = FVn/(1+r)n
PV = FVn/(1+r)n

The two alternatives that I would select is present year and year 1 because anything over 2 years has to be discounted heavily. Douglas (2012) stated, "Cash flows from years 2, 3, 4, 5, and further into the future must be discounted progressively more heavily since even smaller sums held presently would grow to a dollar if allowed to earn interest for more years (i.e., the interest compounds) from the present period out to year 2, 3, 4, or 5 and beyond" (para. 2).

With the opportunity interest rate being 12 %, the present year and year 1 will be the better approach regardless of the interest year.

2. An angel investor

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. "
Coefficient of Variation Cv = Standard...