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Running Head: WEEK 2 TEXT ASSIGNMENTS
Week 2 Text Assignments
Michael T. Ryan
University of Phoenix
FIN 419 – Finance for Decision Making
Dana Williams
June 20, 2010
Week 2 Text Assignments
5.3)Risk preferences Sharon Smith, the financial manager for Barnett Corporation, wishes to evaluate three prospective investments: X, Y, and Z. Currently, the firm earns 12% on its investments, which have a risk index of 6%. The expected return and expected risk of the investments are as follows:
Investment / Expected Return / Expected risk indexX / 14% / 7%
Y / 12 / 8
Z / 10 / 9
a. If Sharon were risk-indifferent, which investments would she select?
Explain why.
b. If she were risk-averse, which investments would she select? Why?
c. If she were risk-seeking, which investments would she select? Why?
d. Given the traditional risk preference behavior exhibited by financial managers, which investment would be preferred? Why?
(a)The risk-indifferent manager would accept Investments X and Y because these have higher returns than the 12% required return and the risk doesn’t matter.
(b)The risk-averse manager would accept Investment X because it provides the highest return and has the lowest amount of risk. Investment X offers an increase in return for taking on more risk than what the firm currently earns.
(c)The risk-seeking manager would accept Investments Y and Z because he or she is willing to take greater risk without an increase in return.
(d)Traditionally, financial managers are risk-averse and would choose Investment X, since it provides the required increase in return for an increase in risk.
5.4)Risk analysis Solar Designs is considering an investment in an expanded product line. Two possible types of expansion are being considered. After investigating the possible outcomes, the company made the estimates shown in the following table:
Expansion A / Expansion BInitial Investment / $12,000 / $12,000
Annual Rate of Return:
Pessimistic / 16% / 10%
Most Likely / 20% / 20%
Optimistic / 24% / 30%
a. Determine the range of the rates of return for each of the two projects.
b. Which project is less risky? Why?
c. If you were making the investment decision, which one would you choose? Why? What does this imply about your feelings toward risk?
d. Assume that expansion B’s most likely outcome is 21% per year and that all other facts remain the same. Does this change your answer to part c? Why?
(a)
Expansion / RangeA / 24% 16% 8%
B / 30% 10% 20%
(b)Project A is less risky, since the range of outcomes for A is smaller than the range for
Project B.
(c)Since the most likely return for both projects is 20% and the initial investments are equal, the answer depends on your risk preference.
(d)The answer is no longer clear, since it now involves a risk-return trade-off. Project B has a slightly higher return but more risk, while A has both lower return and lower risk.
5.13)Portfolio analysis You have been given the return data shown in the first table on three assets—F, G, and H—over the period 2007–2010.
Expected ReturnYear / Asset F / Asset G / Asset H
2007 / 16% / 17% / 14%
2008 / 17 / 16 / 15
2009 / 18 / 15 / 16
2010 / 19 / 14 / 17
Using these assets, you have isolated the three investment alternatives shown in the following table:
Alternative / Investment1 100% of asset F
2 50% of asset F and 50% of Asset G
3 50% of asset F and 50% of asset H
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?
(a)Expected portfolio return:
Alternative 1: 100% Asset F
Alternative 2: 50% Asset F 50% Asset G
Year / Asset F(wFkF) / Asset G
(wGkG) / Portfolio Return
kp
2007 / (16%0.50 8.0%) / / (17%0.50 8.5%) / / 16.5%
2008 / (17%0.50 8.5%) / / (16%0.50 8.0%) / / 16.5%
2009 / (18%0.50 9.0%) / / (15%0.50 7.5%) / / 16.5%
2010 / (19%0.50 9.5%) / / (14%0.50 7.0%) / / 16.5%
Alternative 3: 50% Asset F 50% Asset H
Year / Asset F(wFkF) / Asset H
(wHkH) / Portfolio Return
kp
2007 / (16%0.50 8.0%) / / (14%0.50 7.0%) / 15.0%
2008 / (17%0.50 8.5%) / / (15%0.50 7.5%) / 16.0%
2009 / (18%0.50 9.0%) / / (16%0.50 8.0%) / 17.0%
2010 / (19%0.50 9.5%) / / (17%0.50 8.5%) / 18.0%
(b)Standard Deviation:
(1)
(2)
(3)
(c)Coefficient of variation: CV
(d)Summary:
kp: Expected Valueof Portfolio / kp / CVp
Alternative 1 (F) / 17.5% / 1.291 / 0.0738
Alternative 2 (FG) / 16.5% / 0 / 0.0
Alternative 3 (FH) / 16.5% / 1.291 / 0.0782
Since the assets have different expected returns, the coefficient of variation should be used to determine the best portfolio. Alternative 3, with positively correlated assets, has the highest coefficient of variation and therefore is the riskiest. Alternative 2 is the best choice; it is perfectly negatively correlated and therefore has the lowest coefficient of variation.
10.4)Basic sensitivity analysis Murdock Paints is in the process of evaluating two mutually exclusive additions to its processing capacity. The firm’s financial analysts have developed pessimistic, most likely, and optimistic estimates of the annual cash inflows associated with each project. These estimates are shown in the following table.
Project A / Project BInitial Investment / $8,000 / $8,000
Outcome / Annual cash inflows
Pessimistic / $200 / $900
Most Likely / 1000 / 1000
Optimistic / 1800 / 1100
a. Determine the range of annual cash inflows for each of the two projects.
b. Assume that the firm’ s cost of capital is 10% and that both projects have 20-year lives. Construct a table similar to this for the NPVs for each project. Include the range of NPVs for each project.
c. Do parts a and b provide consistent views of the two projects? Explain.
d.Which project do you recommend? Why?
(a)Range A $1,800 $200 $1,600Range B $1,100 $900 $200
(b)
NPVProject A / Project B
Outcome / Table Value / Calculator
Solution / Table Value / Calculator
Solution
Pessimistic / $6,297 / $6,297.29 / $337 / $337.79
Most likely / 514 / 513.56 / 514 / 513.56
Optimistic / 7,325 / 7,324.41 / 1,365 / 1,364.92
Range / $13,622 / $13,621.70 / $1,702 / $1,702.71
(c)Since the initial investment of projects A and B are equal, the range of cash flows and the range of NPVs are consistent.
(d)Project selection would depend upon the risk disposition of the management. (A is more risky than B but also has the possibility of a greater return.)