A firm must decide between investing in two alternative risky projects, each requiring the same initial investment. Project A has an equal probability of four possible payoffs: £80m, £100m, £120m or £140m. Project B has a 50:50 chance of a payoff of £90m or £126m. Assuming that the firm's managers are risk averse, which project would they prefer, and why?

A firm must decide between investing in two alternative risky projects, each requiring the same initial investment. Project A has an equal probability of four possible payoffs: £80m, £100m, £120m or £140m. Project B has a 50:50 chance of a payoff of £90m or £126m. Assuming that the firm's managers are risk averse, which project would they prefer, and why?

Essentials Of Investments

11th Edition

ISBN:9781260013924

Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.

Publisher:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.

Chapter1: Investments: Background And Issues

Section: Chapter Questions

Problem 1PS

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Suppose there are two potential projects for investment. Project 1 has a certain payoff of $50 in one year, while project 2 has a 50% chance of generating $100 in one year, and another 50% chance of generating $0 in one year. Suppose the company has an outstanding debt = $50. (1)Which project will shareholders prefer? Justify your answer. (2)Which project will debt holders prefer? Justify your answer. (3)Which project will the financial manager prefer? Justify your answer.
Which of the following statements is correct? a. Since investors prefer more return and less risk, one will never hold a dominated asset in the risk-return sense. In other words, if asset A has a higher expected return and lower standard-deviation than asset B, then investors would only hold asset A in their optimal portfolio. b. The IRR method correctly ranks mutually exclusive projects. c. When an investment project is evaluated today, the spending that occurred in the last year has to be included in the NPV analysis. d. The payback period criterion properly considers the time value of money. e. When there are two mutually exclusive projects, the project with the highest NPV should be chosen.
A project under consideration has an internal rate of return of 18% and a beta of 0.5. The risk-free rate is 6%, and the expected rate of return on the market portfolio is 18%. a. What is the required rate of return on the project? (Do not round intermediate calculations. Enter your answer as a whole percent.) b. Should the project be accepted? c. What is the required rate of return on the project if its beta is 1.50? (Do not round intermediate calculations. Enter your answer as a whole percent.) d. If project's beta is 1.50, should the project be accepted?
You are considering a risky investment that you expect will either be worth 115,000 in 1 year, or 65,000, with probabilities of 0.65 and 0.35 for each outcome, respectively. You could invest in riskless T-bills at 0.058. If you invest in this risky investment, you would expect to earn a risk premium of 0.091 Given this information, what would you be willing to pay for this investment? 84,856 78,059 79,001 73,655 82,693
Royal Bank of Belgium (RBB) will be worth €100 million or €120 million with equal probability in one year. RBB is highly leveraged and has bonds outstanding promising to pay €90 million next year. RBB is considering a risky project that will payoff €50 million or -€65 million with equal probability. Would RBB’s shareholders want you to engage in the risky project? What is the expected payoff to RBB’s existing shareholders? How would your answers change if the bondholders could convert the bond to 80% of RBB’s equity?
2. Consider the model of Moral Hazard where firms choose between investing one unit of output in a less risky or more risky project. The safer project yields with probability and zero otherwise while the risky project yields 2 with probability and zero otherwise i.e. TG = G = TB B = 2. Suppose firms finance their investment by borrowing 1 unit from a the fiinancial market at interest rate R. The financial market is risk neutral and requires an expected rate of return equal to the risk free rate which is assumed to be zero. Will there be an equilibrium with lending to firms from the financial market A. Yes B. No C. Not enough information D. None of A-C
Adam Andler Corp is analyzing an average-risk project, and the following data have been developed. Unit sales will be constant, but the sales price should increase with inflation. Fixed costs will also be constant, but variable costs should rise with inflation. The project should last for 3 years. This is just one of many projects for the firm, so any losses on this project can be used to offset gains on other firm projects. What is the project's expected NPV? Do not round the intermediate calculations and round the final answer to the nearest whole number. WACC or cost of capital Net investment cost (depreciable basis) The salvage value of its equipment No other fixed assets will be acquired for following years The company will require an increase in net working capital at the $10,000 beginning The company will liquidate all working capital at the end of the project -10,000 Units sold (constant through years) 60,000 $30.00 $50,000 $17.00 Average price per unit, Year 1 Fixed operating…
(Capital Asset Pricing Model) Johnson Manufacturing, Inc., is considering several investments. The rate on Treasury bills is currently 7.5 percent, and the expected return for the market is 10.5 percent. What should be the expected rate of return for each investment (using the CAPM)? Security A B C D Beta 1.62 1.02 0.71 1.34 a. The expected rate of return for security A, which has a beta of 1.62, is%. (Round to two decimal places.)
7. Introduction to real options Consider the following statement about real options: Sometimes real options can give managers the flexibility to decide to invest in a project or wait to make a more calculated decision. A. True or False: The preceding statement is correct. True False B. Which type of real option allows a firm to postpone a project until it can gather more information? Flexibility option Expansion option Abandonment option Timing option Consider the following example: Clemens Inc. is considering a $100 million investment in a new line of soft drinks. However, $100 million is a huge investment for Clemens; if things turn bad, it could wipe out the company. A few senior managers have suggested a smaller investment of $20 million to see if the market is as strong as they hope it is. If demand is strong and the opportunity is still available, Clemens will increase its investment at a later date.…
You are going to allocate capital into safe and risky assets. The risky asset will earn 200% return if the economy is good (with a 55% chance). If, otherwise, it will lose 60% of the investment principal. States of Rate of Prob. nature Return According to the Kelly's criterion, how much do you have to allocate for the risky asset to maximize final wealth? (The safe asset earns zero return.) → (1) 35%; (2) 47%; (3) 59%; (4) 65%; 1 Good 55% 200% your |(5) 69%; (6) 75%; (7) 85%; (8) 97%; (9) 102%; (10) 114%; (11) 115%; Bad 45% -60%
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