P5 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 index X 14% 7% Y 12 8 Z 10 9

a. If Sharon were risk-indifferent, which investments would sheselectExplain 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?

P5 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 B Initial 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?

P5-13

Portfolio return and standard deviationJamie Wong is considering buildingan investment portfolio containing two stocks, L and M. Stock L will represent 40%of the dollar value of the portfolio, and stock M will account for the other 60%.The expected returns over the next 6 years, 2010 2015, for each of these stocks

are shown in the following table:

a.

Calculate the expected portfolio return, rp,for eachof the 6 years.

a.

Calculate the expected value of portfolio returns, ,over the 6-year period.

c.Calculate the standard deviation of expected portfolio returns, rp, over the 6-year period.

d.How would you characterize the correlation of returns of the two stocks L and M?

P10-4

Basic scenario analysisMurdock Paints is in the process of evaluating two mutuallyexclusive additions to its processing capacity. The firm s financial analysts have developedpessimistic, most likely, and optimistic estimates of the annual cash inflowsassociated with each project. These estimates are shown in the table on page 488.

a.

Determine the rangeof 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 rangeof NPVs for each project.

c.

Do parts a andb provide consistent views of the two projects? Explain.

d.

Which project do you recommend? Why?

Dec 14 2020 09:27 AM

1 Approved Answer

Shantanu P
answered on
December 16, 2020

5
Ratings,(11 Votes)

1) 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...

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