BUSI 620 CT 7 final draft

Topics: Net present value, Investment, Risk aversion Pages: 7 (2231 words) Published: July 6, 2015
Business 620
Critical Thinking Seven
Salvatore's Chapter 14:
a) Discussion Questions: 12 and 15.
b) Problems: spreadsheet problems 1 and 2.

Discussion Question 12: What is the rationale behind the minimax regret rule? What are some of the less formal and precise methods of dealing with uncertainty? When are these useful? The minimax regret rule is a strategy usually used by risk neutral management. The goal of this strategy is to minimize the maximum possible regret that would be incurred as a result of making the wrong decision. When using the strategy, management would select the option with the lowest regret, also called opportunity cost, based on the assumption that the maximum regret will occur for all of the available decision options. The difficultly with this strategy is that probabilities of outcomes are hard to estimate.

Other ways to deal with uncertainty consist of gathering additional information about each option, developing controls such as patents and copyrights, diversifying product lines, and increasing security holdings. These approaches help a company minimize risk and uncertainty when it is difficult to gasp insight quantitatively.

Discussion Question 15: How does the adverse selection problem arise in the credit-card market? How do credit-card companies reduce the adverse selection problem that they face? To what complaint does this give rise?

Adverse selection is created by asymmetric information before a transaction takes place. In the credit card market, it occurs when potential borrowers who are more likely to produce an undesirable outcome (bad credit/high risk) are the ones who most actively seek out a loan. To reduce the adverse selection problem, credit card can raise interest rates to reduce the risk of defaulting on loans. However, this can cause a problem because higher interest rates will weaken the economy.

Spreadsheet Problem 1: An individual has to choose between investment A and investment B. The individual estimates that the income and probability of the income from each investment are as given in the following table.

Investment A
Investment B
Income
Probability
Income
Probability
4,000
0.2
4,000
0.3
5,000
0.3
6,000
0.4
6,000
0.3
8,000
0.3
7,000
0.2

a) Using Excel’s statistical tools, calculate the standard deviation of the distribution of each investment. b) Which of the two investments is more risky?
c) Which investment should the individual choose?

Investment A
Income
Probability
Expected Value
(X-EV)
4,000
0.2
800
2250000
5,000
0.3
1,500
25000
6,000
0.3
1,800
25000
7,000
0.2
1,400
2250000
 
5,500
 
Standard Deviation
1024.7

Investment B
Income
Probability
Expected Value
(X-EV)
4,000
0.3
1200
400000
6,000
0.4
2400
0
8,000
0.3
2400
400000
 
6000
 
Standard Deviation
1549.19

a) Standard deviation of investment A is 1024.7 and standard deviation of investment B is 1549.19. b) Investment A is less risky because the standard deviation is smaller (1024.7 in comparison to 1549.19), but it also provides a lower expected income of 5,500 versus 6,000 c) Investment B because it yield the greatest return

Spreadsheet Problem 2: An individual is considering two investment projects. Project A will return a zero profit if conditions are poor, a profit of $4 if conditions are good, and a profit of $8 if conditions are excellent. Project B will return a profit of $2 if conditions are poor, a profit of $3 if conditions are good, and a profit of $4 if conditions are excellent. The probably distribution of the conditions is as follows:

Conditions:
Poor
Good
Excellent
Probability
40%
50%
10%

a) Using Excel, calculate the expected value of each project and identify the preferred project according to this criterion. b) Assume that the individual’s utility function for profit is U(X) =X-0.05X2. Calculate the expected utility of each project and identify the preferred project...
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