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:
Annual Profit
|
City
|
Outcome
|
Contribution
|
Probability
|
|
Albuquerque
|
Failure
|
$100,000
|
0.5
|
|
|
Success
|
200,000
|
0.5
|
|
Santa Fe
|
Failure
|
$60,000
|
0.5
|
|
|
Success
|
340,000
|
0.5
|
Each restaurant would require a capital expenditure of $700,000, plus land acquisition costs of $500,000 for Albuquerque and $1 million for Santa Fe. The company uses the 10% yield on risk- less 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 equiva- lent method in decision making, which is the more attractive outlet? Why?