Investment Benefits - Essay Example

Exercise – Week 2 Exercise 5.3 – Risk Preferences: a. If Sharon were risk in – different, it would indicate that she exhibits neutral behaviour to the risks of the various investments. Hence only the returns will be considered. In this case, Sharon will prefer Investments X and Y, as X has the highest return of 14 % and Y has that of 12 % which is the same as the current return. As she is risk neutral, she will not prefer investment Z, as it has a lower return than the current earnings from the firm. b. If Sharon were risk – averse, she would prefer to opt for the low risk option. It is evident that investment X has the lowest expected risk compared to others. Hence this will be the preferred investment, as the return is substantial and the risk is the lowest. c. If Sharon were risk – seeking, she would prefer the investment with the highest risk, unless a higher return is promised for a lower risk rate. In this case, investment X has a higher return for a lower risk. Also, investment Y has a return of 12%, same as that of the current return. Investment Y will also be preferred due to the risk seeking attitude. d. Based on the traditional risk preference behaviour exhibited by financial managers, the most preferred investment would be investment X. The main reason is that it has the lowest risk per unit of return (7%/14%) of 0.5 which is the same as that of the current investments of the firm. Exercise 5.4 – Risk Analysis: a. Range of Rates of Return: Expansion A: Range of Rate of Return = 24 % - 16 % = 8 % Expansion B: Range of Rate of Return = 30 % - 10 % = 20 % b. Less Risky Project: It is evident that the most likely values for both the options are the same. However, the worst case scenario for expansion A is a 16 % return whereas that of Expansion B is 10 %. Also, the return for expansion A lies within + 4 % of the most likely return of 20 %, whereas it is +8 % for expansion B. Hence the less risky project is Expansion A. c. If given the choice, I would prefer to take up the Expansion A, as it has lesser risk and the most likely return is the same as that of the high risk Expansion B. This certainly implies that I have a risk - averse behaviour. d. If the most likely outcome is 21% for expansion B, I would still prefer to opt for expansion A. the main reason is that the risk associated with expansion A is much lesser and the pessimistic outcome is very close to the most likely outcome. Exercise 5.13 – Portfolio Analysis: Year Asset F Asset G Asset H 2007 16% 17% 14% 2008 17% 16% 15% 2009 18% 15% 16% 2010 19% 14% 17% Expected Return 17.50% 15.50% 15.50% Std. Deviation 1.29% 1.29% 1.29% a. Expected Return: Portfolio 1 (100% F) = 100% Rf = 17.5 % Portfolio 2 (50% F and 50% G) = 50% Rf + 50% Rg = (0.5 * 17.5%) + (0.5 * 15.5%) = 16.5 % Portfolio 3 (50% F and 50% H) = 50% of Rf + 50% of Rh = (0.5 * 17.5%) + (0.5 * 15.5%) = 16.5 % b. Standard Deviation: Portfolio 1 (100% F) = √ (12 * σf2) = 1.29 % Portfolio 2 (50% F and 50% G) = √ (0.52 * σf2) + (0.52 * σg2) + (2*0.5*0.5* σf *σg) = 1.29 % Portfolio 3 (50% F and 50% H) = √ (0.52 * σf2) + (0.52 * σh2) + (2*0.5*0.5* σf *σh) = 1.29 % c. Coefficient of Variation: Coefficient of variation is computed as the ratio of the expected return to the standard deviation. CV of Portfolio 1 = R1 / σ1 = 17.5 % / 1.29 % = 13.57 CV of Portfolio 2 = R2 / σ2 = 16.5 % / 1.29 % = 12.79 CV of Portfolio 3 = R3 / σ3 = 16.5 % / 1.29 % = 12.79 d. The expected return is the highest at 17.5 % for the portfolio 1 containing 100% of asset F compared to that of the other two alternatives. It is also evident that the three investment portfolios have the same risk associated with the returns. The coefficient of variation (return per unit of risk) is also higher for portfolio 1. Hence it is clear that portfolio 1 (100% of asset F) is the best option. Exercise 10.4 – Basic Sensitivity Analysis: a. Range of Annual Cash Flows: Project A: Range of Cash Flows = $ 1,800 - $ 200 = $ 1,600 Project B: Range of Cash Flows = $ 1,100 - $ 900 = $ 200 b. Assuming that the probability for most likely outcome as 50% and that of pessimistic and optimistic outcomes as 25% each, the expected annual cash flows can be computed. Project A     Cash Flow (Xi) Probability (Pi) Pi Xi 200 0.25 50 1000 0.5 500 1800 0.25 450   Σ Pi Xi 1000 Project B     Cash Flow (Xi) Probability (Pi) Pi Xi 900 0.25 225 1000 0.5 500 1100 0.25 275   Σ Pi Xi 1000 The Net Present Values of the two projects are computed as follows: Project Cash Flow Annuity factor PV of Cash Flows NPV A 1000 8.5136 8513.6 513.6 B 1000 8.5136 8513.6 513.6 c. Part a and Part b do not provide consistent views on the two projects. The re is a high difference in the range of the cash flows for the two projects. However the expected returns and the NPV calculated for the two projects are identical. The ranges depend on the value of the possible returns. However, the expected returns depend on the possible returns and also on the probabilities of outcomes. Both the projects are evenly spread across the entire range and thus the pessimistic outcome offsets the optimistic outcome. Hence the expected returns are similar for the two projects. d. From the range calculations, it is evident that the Project B has a very low range of $ 200. It is also evident that the expected returns from both the projects are the same. Hence it will be best to opt for project B, as the amount of uncertainty associated with the returns is limited to a narrow range of $ 200; as lesser uncertainty indicates lower associated risk. Read More