Problem 1: Jonathon Barrs is a manager for Easy Manufacturing, LLC. He wishes to evaluate three possible investments. These investments are for the purchase of new machine tools from Germany, Japan, and a local US manufacturer. The firm earns 10% on its investments and they have a risk index of 5%. The chart below lays out the expected return and expected risks of the three projects.
|
Investment
|
Expected Return
|
Expected Risk
|
|
German Tools
|
15.00%
|
8.00%
|
|
Japanese Tools
|
13.00%
|
9.00%
|
|
Local Manufacturer
|
11.00%
|
7.00%
|
a. If Jonathon were risk-indifferent, which investments would he select? Explain why.
b. If he were risk-averse, which investments would he select? Why?
c. If he were risk-seeking, which investments would he select? Why?
d. Given the traditional risk preference behavior exhibited by financial managers, which investment would be preferred? Why?
Problem 2: Big Bank, Inc., is considering the purchase of one of two high speed servers, R and S. Both should provide benefits over a 10-year period, and each requires an initial investment of $4,000. Management has constructed the table (at the top of the facing page) of estimates of rates of return and probabilities for pessimistic, most likely, and optimistic results.
a. Determine the range for the rate of return for each of the two servers.
b. Determine the expected value of return for each server.
c. Purchase of which server is riskier? Why?
|
|
Server R
|
Server S
|
|
|
Amount
|
Probability
|
Amount
|
Probability
|
|
Initial Investment
|
$4,000.00
|
1
|
$4,000.00
|
1
|
|
|
Annual rate of
return
|
|
|
|
|
Pessimistic
|
20.00%
|
0.25
|
15.00%
|
0.2
|
|
Most likely
|
25.00%
|
0.5
|
25.00%
|
0.55
|
|
Optimistic
|
30.00%
|
0.25
|
35.00%
|
0.25
|
Note: Question B use the following format.
|
|
Possible
Outcomes
|
Probability
|
Expected Return
|
Expected Return
|
|
Server R or S
|
Pessimistic
|
|
|
|
|
Most likely
|
|
|
|
|
Optimistic
|
|
|
|
|
|
|
Expected Return
|
|
Question 3:
You have been given the return data shown in the first table on three countries—China, India, and South Korea—over the period 2007–2010
|
|
Expected return
|
|
Year
|
China
|
India
|
South Korea
|
|
2009
|
16%
|
17%
|
14%
|
|
2010
|
17%
|
16%
|
15%
|
|
2011
|
18%
|
15%
|
16%
|
|
2012
|
19%
|
14%
|
17%
|
Using these countries, you have isolated the three investment alternatives shown in the following table:
|
Alternative Investment
|
|
1
|
100% of China
|
|
2
|
50% of China and 50% or India
|
|
3
|
50% of China and 50% of South Korea
|
a. Calculate the expected return over the 4-year period for each of the three alternatives.
b. Calculate the standard deviation of returns over the 4-year period for each of the three alternatives.
c. Use your findings in parts a and b to calculate the coefficient of variation for each of the three alternatives.
d. On the basis of your findings, which of the three investment alternatives do you recommend? Why?
Question 4:
James Secretarial Services is considering the purchase of one of two new personal computers, P and Q. Both are expected to provide benefits over a 10-year period, and each has a required investment of $3,000. The firm uses a 10% cost of capital. Management has constructed the following table of estimates of annual cash inflows for pessimistic, most likely, and optimistic results.
|
|
Computer P
|
Computer Q
|
|
Initial Investment CFo
|
$3,000.00
|
$3,000.00
|
|
Outcome
|
Annual Cash Flows
|
|
Pessimistic
|
$500.00
|
$400.00
|
|
Most Likely
|
$750.00
|
$750.00
|
|
Optimistic
|
$1,000.00
|
$1,200.00
|
1. Determine the range of annual cash inflows for each of the two computers.
2. Construct a table similar to this for the NPVs associated with each outcome for both computers.
3. Find the range of NPVs, and subjectively compare the risks associated with purchasing these computers.