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**STUDENT SOLUTIONS MANUAL
**

Thomas E. Copeland J. Fred Weston Kuldeep Shastri

Managing Director of Corporate Finance Monitor Group, Cambridge, Massachusetts Professor of Finance Recalled, The Anderson School University of California at Los Angeles Roger S. Ahlbrandt, Sr. Endowed Chair in Finance and Professor of Business Administration Joseph M. Katz Graduate School of Business University of Pittsburgh

Reproduced by Pearson Addison-Wesley from electronic files supplied by author. Copyright © 2005 Pearson Education, Inc. Publishing as Pearson Addison-Wesley, 75 Arlington Street, Boston, MA 02116 All rights reserved. This manual may be reproduced for classroom use only. Printed in the United States of America. ISBN 0-321-17954-4

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Contents

Preface...............................................................................................................................................v Chapter 1 Chapter 2 Chapter 3 Chapter 4 Chapter 5 Chapter 6 Chapter 7 Chapter 8 Chapter 9 Chapter 10 Chapter 11 Chapter 12 Chapter 13 Chapter 14 Chapter 15 Chapter 16 Chapter 17 Chapter 18 Chapter 19 Introduction: Capital Markets, Consumption, and Investment................................1 Investment Decisions: The Certainty Case..............................................................6 The Theory of Choice: Utility Theory Given Uncertainty ....................................13 State Preference Theory.........................................................................................32 Objects of Choice: Mean-Variance Portfolio Theory............................................44 Market Equilibrium: CAPM and APT...................................................................60 Pricing Contingent Claims: Option Pricing Theory and Evidence........................77 The Term Structure of Interest Rates, Forward Contracts, and Futures ................90 Multiperiod Capital Budgeting under Uncertainty: Real Options Analysis ..........97 Efficient Capital Markets: Theory .......................................................................119 Efficient Capital Markets: Evidence....................................................................125 Information Asymmetry and Agency Theory......................................................128 The Role of the CFO, Performance Measurement, and Incentive Design ..........133 Valuation and Tax Policy ....................................................................................137 Capital Structure and the Cost of Capital: Theory and Evidence ........................140 Dividend Policy: Theory and Empirical Evidence ..............................................160 Applied Issues in Corporate Finance ...................................................................166 Acquisitions, Divestitures, Restructuring, and Corporate Governance ...............172 International Financial Management ...................................................................184

From the crowd on screen an individual is heard to shout. The words computer. This is already happening. Most theory texts in Finance do not have end-of-chapter questions and problems. Additionally. Today the emphasis is on answering the question — why have things come to be the way we observe them? If we understand why then we can hope to understand whether or not it is advisable to change things. but it does force us to use more precise language and to understand the relationship between assumptions and conclusions. technical terms are becoming a world language. Such extrapolative questions ask the student to go beyond simple feedback of something he has just read. The more scientific and more mathematical Finance becomes the more magical it appears to the layman who would like to understand and use it. v . This solutions manual and the textbook which it accompanies represent an effort to bridge the gap between the academic and the layman. transistor. By the way — the movie scientist did know what to do. ordinary calculus. Needless to say. statistics and econometrics. In Finance. Problem sets are useful because they help the reader to solidify his knowledge with a hands-on approach to learning. How are real and financial assets valued? Does the market place provide the best price signals for the allocation of scarce resources? What is meant by risk and how can it be incorporated into the decision-making process? Does financing affect value? These will probably always be the central questions. the answers to them have changed dramatically in the recent history of Finance. and car are familiar throughout the globe. The usual approach to the question of “why” is to build simple mathematical models. The basic questions remain the same. In fact. But it is also necessary for the layman to learn a little mathematics. We assume a basic understanding of algebra and simple calculus. However. We are hoping that the reader will meet us halfway. Students learned about the way things were rather than why they came to be that way. academicians have adopted more and more complex mathematics. On the other hand it is at a higher level than that which the layman usually sees. He’ll know what to do!” It was almost as if the scientist was being equated with a magician or witchdoctor. problems can be used to stretch the reader’s understanding of the textbook material by asking a question whose answer cannot be found in the text. The student is asked to combine the elements of what he has learned into something slightly different — a new result. differential equations. variance is a precise measure of risk and yet almost everyone has an intuitive grasp for its meaning. This has the effect of widening the gap between theory and application. he can usually understand the introduction and conclusions.Preface The last forty years have seen a revolution in thought in the field of Finance. We remember a quote from an old Japanese science fiction movie where a monster is about to destroy the world. “Go get a scientist. In their efforts to gain better understanding of complex natural phenomena. He must think for himself instead of just regurgitating earlier material. probability theory. A serious student of Finance must seek prerequisite knowledge in matrix algebra. this is infrequently the case in the real world. Unfortunately. Forty years ago the field was largely descriptive in nature. mathematics cannot solve every problem. stochastic calculus. This bewildering set of applied mathematics makes the best academic journals in Finance practically incomprehensible to the layman. In order to narrow the gap between the rigorous language in academic Finance journals and the practical business world it is necessary for the academician to translate his logic from mathematics into English. but little more. Notable exceptions were Fama’s Foundations of Finance and Levy and Sarnat’s Capital Investment and Financial Decisions. The mathematics employed here is at a much lower level than in most academic journals. Technical words in English can be found unchanged in almost every language throughout the world. mathematical programming. In most articles.

This is also the objective of the end-of-chapter problems in our text. we highly recommend that the solutions manual be made available to the students as an additional learning aid. CA 90024 vi . Thomas E. It cannot be effectively employed if kept behind locked doors as an instructor’s manual. If our efforts stimulate you. criticisms and corrections. and the MBA students at UCLA. We wish to express our thanks to the following for their assistance in the preparation of this solutions manual: Betly Saybolt. Fred Weston Anderson Graduate School of Management University of California Los Angeles. we will welcome your suggestions. Copeland Monitor Groups Cambridge. PA J. MA 02141 Kuldeep Shastri University of Pittsburgh Pittsburgh. We think the users will agree that we have broken some new ground in our book and in the end-ofchapter problems whose solutions are provided in this manual. Students can order it from the publisher without any restrictions whatsoever. Consequently.The objective of education is for each student to become his own teacher. Any kinds of communications will be welcome. to other new ideas. comments. the user.

with current income of y0 and end-of-period income of y1. the present value of his endowment is his current wealth.e. Assume the individual is initially endowed.1 Fisher separation for the lender case equals the market rate of interest at point B. C1 which has a present value of 0 W0∗ = C∗ + 0 ∗ C1 1 + rf . This determines the optimal investment in production (P0. W0: W0 = y0 + y1 1 + rf The individual will take on investment up to the point where the marginal rate of return on investment Figure S1. Consumption. and Investment 1. Finally. in order to achieve his maximum utility (on indifference curve U1) the individual will lend (i. P1). at point A. consume less than P0) along the capital market line until he reaches point C.Chapter 1 Introduction: Capital Markets. Using the market rate. At this point his ∗ optimal consumption is C∗ ..

3. Some individuals who were lenders become borrowers under the new. 2 2 (b) Because borrowers and lenders face the same investment opportunity set and choose the same optimal investment (at A before the interest rate decreases and at A’ afterward). After the decrease in interest rate. their utility has increased unambiguously from UB to U′ . from U L to U L′ . (c) The amount of investment increases from I to I’. B The case for those who were originally lenders is ambiguous. Fourth Edition 2. then it increases to W0′ . This implies a capital market line with a 45° slope (a slope of minus 1) as shown in Figure S1. Assuming that there are no opportunity costs or spoilage costs associated with storage. Originally it is at W0. lower. then the rate of return from storage is zero. and experience an increase in utility from U L 1 to UB ′1 . Borrowers originally chose levels of current consumption to the right of A. The remaining lenders experience a decrease in utility. Figure S1.3.2 Copeland/Shastri/Weston • Financial Theory and Corporate Policy. Figure S1.2 An exogenous decline in the interest rate (a) An exogenous decrease in the interest rate shifts the capital market line from the line through AW0 to the line through A′W0′.3 Market rate cannot fall below net rate from storage . current wealth is the intercept of the capital market line with the C0 axis. rate.

4.Chapter 1 Introduction: Capital Markets. The conclusion is that the market rate of interest cannot fall below the storage rate.e. which represents a negative borrowing and lending rate. then exchange would make it possible to attain point B.3 are infeasible. He would also prefer to borrow at a negative rate rather than storing backward (i. In order to borrow at a negative rate it is necessary that someone lend at a negative rate. one of them is not feasible.. Any rational investor would choose to store forward from his initial endowment (at y0. . If his time preference is such that he desires to save some of his current consumption and store it.3. he will do so and move to point A in Figure S1. Figure S1. Consequently. it may not be possible. points along line segment YZ in Figure S1. These dominant alternatives are represented by the heavy lines in Figure S1. If next year’s coconut supply does not mature until then. An individual who wished to consume more than his current allocation of wealth could contract with other individuals for some of their wealth today in return for some of his future wealth.4 Storage as the only investment On the other hand. In this case he is storing forward. However. 4. If we were not assuming a Robinson Crusoe economy. Clearly. consuming tomorrow’s endowment today). it may be impossible to store coconuts backward. and Investment 3 Also shown is a line with lower absolute slope. Consumption. y1) rather than lending (to the left of y0). Assume that Robinson Crusoe has an endowment of y0 coconuts now and y1 coconuts which will mature at the end of the time period. if the individual wishes to consume more than his current supply of coconuts in order to move to point B. no one will be willing to do so because storage at a zero rate of interest is better than lending at a negative rate.

000.000 5. Project D B A C One Plus the Rate of Return 1.4 Copeland/Shastri/Weston • Financial Theory and Corporate Policy.000. consumption foregone along the C0 axis) and the extra consumption provided at the end of the investment period.6.000.000 2. if only project D were undertaken then $3 million in current .000 7.e. Figure S1.6 Investment opportunity set 6.000 1. Figure S1.30 1.000.000 The production opportunity set plots the relationship between resources utilized today (i. This is done below. Fourth Edition * 5.000. Figure S1.000. The marginal rate of substitution between C0 and C1 is a constant. all of which have the same rate of return.5 shows a schedule of investments.20 1. R .04 Outlay for the ith Project $3.000.000.000 4. In order to graph the production opportunity set. first order the investments by their rate of return and sum the total investment required to undertake the first through the ith project. For example.08 1..5 All investment projects have the same rate of return The resultant investment opportunity set is a straight line with slope –(1 + R*) as shown in Figure S1.000 Sum of Outlays $3.000 1.

9 million in end-of-period consumption.Chapter 1 Introduction: Capital Markets.8 Production opportunity set .8. The answer to part b of the question is found by drawing in a line with a slope of −1. This is graphed below in Figure S1.7. and Investment 5 consumption would be foregone in order to receive 1.6364 million 1.7 If we aggregate all investment opportunities then $7 million in consumption could be foregone and the production opportunity set looks like Figure S1.1 C1 Figure S1. Figure S1.1 and finding that it is tangent to point B. The present value of this decision is W0 = + C0 1+ r 5. Consumption. Hence the optimal production decision is to undertake projects D and B.3 × ($3 million) = $3.1 = + 3 = $7.

000 $18.000)(1 − . (a) Earnings before depreciation.4)(0) = 28.4) + .000 100.4(10.000) = 28.000 12.000 − 100.000 10.800 $7. interest and taxes Depreciation (Dep) EBIT Taxes @ 40% Net income Using equation 2-13: CF = (∆Rev − ∆VC)(1 − τ c ) + τ c ∆dep = (140.200 .000 10.000 12.000 4. 10 years) − I 0 N $140.000 = 58. equation 2-13a can be used: CF = ∆NI + ∆dep + (1 − τ c )∆ k d D = 18.000 Alternatively.Chapter 2 Investment Decisions: The Certainty Case 1. (a) Cash flows adjusted for the depreciation tax shelter Sales = cash inflows Operating costs = cash outflows Earnings before depreciation.000) − 100.000 (b) Net present value using straight-line depreciation NPV = ∑ (Revt − VCt )(1 − τ c ) + τ c (dept ) − I0 (1 + WACC)t t =1 = (annual cash inflow) (present value annuity factor @12%.000 = 158.000 40.200 − 100.000 30.000 + (1 − .000 + 10. interest and taxes Depreciation (straight-line) EBIT Taxes @ 40% Net income $22.200 2.000 = (5.650)(28.

214.281.000 (1/55)100.29 4.200 + 6.000 22.27 NPV = PV of inf lows − I 0 NPV = 100.27 − 100.322 (6) PV 18.58 8.893 .000 (3/55)100.958.272.000 22.91 13.27 (5) PV Factor .540.200 + 3.000) = 17.454.650) − 100.18 13.200 + 7.000 22.200 + 5.09 13.545.12 13.818.181.737.200 NPV = ∑ CFt − I0 (1 + WACC)t t =1 = (annual cash flow) (present value annuity factor @ 12%.31 6.82 13.282.4(10.45 13.94 11.000 22.452 .200 + 2.180 − 100.000 (5/55)100.633.636.404 .909.000 = 958. 10 years) − I 0 = 17.958.000 = −2.567 .000 (2/55)100.14 15.26 5.820 (b) NPV using sum-of-years digits accelerated depreciation In each year the depreciation allowance is: Dep t = T +1− t N ∑i i =1 T = T + 1− t .000 (3) Dept (10/55)100.000 22.636 .54 13.200 + 2.200 + 727.507 .363.000 (9/55)100.000 (6/55)100.72 13.200 + 4.4) + .36 13.64 13.290.712 . .000 = 97.000)(1 − .797 .000 22.27 Notice that using accelerated depreciation increases the depreciation tax shield enough to make the project acceptable.484.958.Chapter 2 Investment Decisions: The Certainty Case 7 Net present value using straight-line depreciation CF = (∆Rev − ∆VC)(1 − τc ) + τc ∆dep = (22.090.000 22.03 7.000 22.000 (8/55)100.200 + 5.02 9. where T = 10 55 In each year the cash flows are as given in the table below: (1) Year 1 2 3 4 5 6 7 8 9 10 (2) Revt − VCt 22.536.200(5.58 100.000 22.200 + 1.000 (4/55)100.000 (4) (Revt − VCt)(1 − τc) + τcdep 13.361 .000 (7/55)100.

00 –15. The correct definition of cash flows for capital budgeting purposes (equation 2-13) is: CF = (∆Rev − ∆VC) (1 − τc) + τc ∆dep In this problem Rev = revenues. Fourth Edition 3.000 Year 0 0 0 PVIF @ 12% Present Value 1.404 4.840 Present value of inflows = $117.400 –2.000 –15.600 4.000 12.968 92. years 1–8 Savings from new investment Tax savings on depreciation $100.405 1–8 4.000 4.00 –10. buy the new machine.245 Net present value = $117.245 If the criterion of a positive NPV is used.000 31.000 –5.936 .968 $92.859 4.000 1.000 = $34.000 Amount after Tax $100.968 24.000 = $17.000 Net cash outlay = $75.000 τc = the tax rate = .405 4. Replacement with salvage value Amount before Tax Outflows at t = 0 Investment in new machine Salvage value of old Tax loss on sale Inflows.500 Amount after Tax $100. VC = cash savings from operations = −3. Replacement Amount before Tax Outflows at t = 0 Cost of new equipment Inflows.0 Present Value $100.000 12. 5.000 $18.000 –10.600 5.000 1.8 Copeland/Shastri/Weston • Financial Theory and Corporate Policy.176 $31.000 –25.245 − 100.176 − 75. years 1–8 Savings from new machine Depreciation saving on new Depreciation lost on old Salvage value of new $100.000 1–8 4.000 1–8 1–8 1–8 8 Using the NPV rule the machine should be replaced.000 12.00 $100.000 11.000 18.000 –15.848 Net cash inflows = $109.000 Year 0 PVIF @ 12% 1.4 dep = depreciation = 2.176 Net present value = $109.000 .968 –9. 4.968 21. There is no change in revenues.

but it has no economic meaning. . Note also that the function is undefined at IRR = −1.58 −751.27 −657. the project should be rejected.8 percent.78 −578. namely.1 The internal rate of return ignores the order of cash flows 1 There is a second IRR at −315.000) = 2.66 1. 6.1 graphs NPV versus the discount rate. that it does not consider the order of cash flows.000 −200 @ 10% 363.41 Figure S2. Figure S2. it should be rejected (even though the IRR is greater than the cost of capital).83 344. The NPV at different positive rates of return is @ 0% 400 400 −1.000 + 2.Chapter 2 Investment Decisions: The Certainty Case 9 Therefore.600(2.64 330.4(2.991) = −2.70 32.223.600 The net present value of the project is NPV = −10.75%.10 1 Discounted Cash Flows @ 15% @ 16% 347.83 302. the project has a negative NPV.40 Therefore.44 −7.33 277. At an opportunity cost of capital of 10 percent.32 −57.46 297.23 @ 20% 333.000(1 − . the annual net cash flows for years one through five are CF = 3. therefore. This is an interesting example which demonstrates another difficulty with the IRR technique. The IRR on this project is approximately 15.52 −640.4) + .

We are told that the IRR for these cash flows is −200%. as well as their costs. But how is this determined? One way is to graph the NPV for a wide range of interest rates and observe which rates give NPV = 0.55 The project should be accepted. . we see that the IRR is −200%.4) + . the discount factor for a three year annuity paid in arrears (at 10%). These rates are the Figure S2. it would be “double counting” to include financing costs (or the tax changes which they create) in cash flows for capital budgeting purposes. 3 years)* – 1.2 An IRR calculation internal rates of return for the project. Sources of financing. The cash flows are: (∆Rev − ∆VC − ∆FCC − ∆dep)(1 − τ c ) + τ c ∆dep = (200 − (−360) − 0 − 0)(1 − .200 = 33. All of the information about the financing of the project is irrelevant for computation of the correct cash flows for capital budgeting. First calculate cash flows for capital budgeting purposes: CFt = (∆Revt − ∆VCt )(1 − τ c ) + τ c ∆dep = (0 − (−290))(1 − . By inspection.4(400) = 336 + 160 = 496 NPV = 496 (PVIFa: 10%.2 plots NPV against various discount rates for this particular set of cash flows.5) + . 9. Therefore. These are the cash flows for project A which was used as an example in section E of the chapter.5(180) = 145 + 90 = 235 * Note: PVIFa: 10%. 3 years. Fourth Edition 7.487) – 1. are included in the computation of the cost of capital. Figure S2. 8.10 Copeland/Shastri/Weston • Financial Theory and Corporate Policy.200 = 496 (2.

Therefore. it should be irrelevant when considering a choice between A and B.75 −. B was preferred. Project (A + C) has a two-year payback. Payback violates value additivity.000 . Project C has a three-year payback.66 C −1 0 0 3 PV (C) −1.3 of this chapter.000(1 + IRR)) .91 Project A has a two-year payback. Because C is an independent choice. k. Project B has a one-year payback. 10. the results change if we use the payback criterion. project B would be preferable according to both capital budgeting techniques.91 0 . Using the method discussed in section F. Project (B + C) has a three-year payback.000 and expects to earn IRR.751 A −1 0 2 −1 PV (A) −1. calculate the NPV: NPV = ∑ CFt − I0 t t =1 (1 + WACC) = (CFt ) (present value annuity factor @ 10%. NPV does obey the value additivity principle. 5 years) − I 0 = 235(3.10 B −1 1 0 1 PV (B) −1. this is not true.91.909 .00 0 1. The net present values are calculated below: Year 0 1 2 3 PVIF 1. at the end of the first time period.12 The project should be rejected because it has negative net present value. Previously.89 − 900. Therefore.15 NPV(B + C) = 1.00 = 890. NPV = $1. On the other hand. in the first year the firm invests $5. The amount borrowed is (10.000(1 + IRR) During the second period the firm borrows from the project at the opportunity cost of capital.65 −.00 0 0 2. Therefore.25 1. we have 5.791) − 900. Once Project C is combined with A or B.00 = −9. if projects A and B are mutually exclusive.000 − 5. NPV does not. Now A + C is preferred. NPV = $1. with payback.826 . B + C is preferred.Chapter 2 Investment Decisions: The Certainty Case 11 Next. 11.75 . However. Its NPV is simply the sum of the NPV’s of B and C separately.00 .25 A+C −2 0 2 2 B+C −2 1 0 4 5 NPV(A + C) = 1.15.

45% −5.000 − 5.000(1 + IRR)) (1 + k) The firm then lends 3.10 − 10.000 at the end of the second time period: 3.10) Solving for IRR. we have 3.000(1 + IRR)) (1.000 .000 − 1 = IRR = 45.000 − 5.000 1.000 = (10. Fourth Edition By the end of the second time period this is worth (10.12 Copeland/Shastri/Weston • Financial Theory and Corporate Policy.

the result must be positive.2. f(Z)..19: dE − ∫ U′(E + σZ)Zf(Z)dZ = dσ ∫ U′(E + σZ)f(Z)dZ (3. MU(W) > 0. (d) The probability density function must be a normal (or two parameter) distribution. Since the integral in the numerator is preceded by a minus sign. The minimum set of conditions includes (a) • • • • • The five axioms of cardinal utility complete ordering and comparability transitivity strong independence measurability ranking (b) Individuals have positive marginal utility of wealth (greed). is positive and because the frequency.Chapter 3 The Theory of Choice: Utility Theory Given Uncertainty 1. the same f(Z)) negative returns. the entire numerator is negative and the marginal rate of substitution between risk and return for a risk lover is negative. of any level of wealth is positive. is always higher than the marginal utility of equally likely (i. i. In order to see that the integral in the numerator is positive. In order to know the shape of a risk-lover’s indifference curve. we need to know the marginal rate of substitution between return and risk.19) The denominator must be positive because marginal utility. +Z. Therefore. when all equally likely returns are multiplied by their marginal utilities.1 on the following page. look at Figure S3. matched. dMU(W)/dW > 0. The marginal utility of positive returns. E[U(W)] < U[E(W)]. To do so. −Z. a risk lover has positive marginal utility of wealth. 2. . U’ (E + σZ). and summed. (c) The total utility of wealth increases at a decreasing rate (risk aversion). look at equation 3.e. This leads to indifference curves like those shown in Figure S3. As shown in Figure 3.e.6.. which increases with increasing wealth.

the individual would be indifferent between the gamble and $4.5ln(3.5ln(5.006368) + .1 Total utility of normally distributed returns for a risk lover Figure S3.000 plus or minus $1.02. given his first loss.14 Copeland/Shastri/Weston • Financial Theory and Corporate Policy. he would not buy insurance for $125.517193) = 8.98 = W Now the individual would be willing to pay up to $127.5(8. Fourth Edition Figure S3.4967825 eln W = W e8.000) + .000) = .000) + .000. (b) The second gamble.02 for insurance.5(8. is $4.872.4967825 = $4.98 for sure.26178 = $3.699515) = 8.000) = .5(8.2 Indifference curves of a risk lover 3. Therefore. This amounts to a risk premium of $101.5ln(6.5(8.898.26178 eln W = e8. Its expected utility is E[U(W)] = .98 = W Therefore.898.5ln(4. Since insurance costs only $125. . (a) E[U(W)] = .29405) + . he will buy it.

1.999.001.000.000.87 = $50.81551 The level of wealth with the same utility is ln W = 13.000) = .001.000) + .000.81551 W = e13.205315 W = e9. .5)) = .5 ln 999.000. the expected utility of the gamble is E(U(999.000 + .5ln1.10498) + .11.47 = $0.205315 = $9.000.000.000.000. U(W) = − e − aW . the individual would be willing to pay $1.5 ln11.000 + . .5(9.5(9.5 U(11.000 is a large change in wealth relative to $10.3. The expected utility of the gamble is E(U(9.000. we can use the concept of risk aversion in the large (Markowitz). If current wealth is $1.55249 + 4.652825 = 9.999.5 U(9.000 = .000.000 = .5(13.81451) + . (a) The utility function is graphed in Figure S3.00 − 999.205315 The level of wealth which has the same utility is ln W = 9.87 Therefore.81651) = 13.000 − 9. Because $1.5)) = . 5.13 in order to avoid the risk involved in a fifty-fifty chance of winning or losing $1.53 to avoid the gamble.949.5(13.949.47 Therefore.81551 = $999.Chapter 3 The Theory of Choice: Utility Theory Given Uncertainty 15 4.5 ln9.30565) = 4. the individual would be willing to pay up to $10.

For any other value of a > 0. is ARA = − ARA = − U′′(W) U′(W) −a 2 e − aW =a ae − aW Therefore. Fourth Edition Figure S3. the utility function will be a monotonic transformation of the above curve. U′(W) = dU(W) = −( −a)e −aW > 0 dW Therefore. regardless of the level of wealth. (b) Marginal utility is the first derivative with respect to W. This can also be seen in Figure S3. U′′(W) = dMU(W) = a( − a)e − aW = −a 2 e − aW < 0 dW Therefore. (d) Relative risk aversion is equal to RRA = W(ARA) = −W = Wa Therefore.16 Copeland/Shastri/Weston • Financial Theory and Corporate Policy. in this case relative risk aversion is not constant. It increases with wealth. (c) Absolute risk aversion. Instead it has constant absolute risk aversion. as defined by Pratt-Arrow. U′′(W) U′(W) . the function does not exhibit decreasing absolute risk aversion. marginal utility is positive.3 because the slope of a line tangent to the utility function is always positive.3 Negative exponential utility function The graph above assumes a = 1. Risk aversion is the rate of change in marginal utility. the utility function is concave and it exhibits risk aversion.

4.4 Gambling and insurance 7.3) ∂2U <0 ∂W2 (3. from (1) and (2) we know that U(A) − U(B) U(C) − U(D) < A−B C−D Using equation (3.3) becomes 1 1 < A−B C−D A−B>C−D A+D>C+B 1 1 1 1 A+ D> C+ B 2 2 2 2 1 1 1 1 U (A) + (D) > U (C) + (B) 2 2 2 2 In general.1). an average.Chapter 3 The Theory of Choice: Utility Theory Given Uncertainty 17 6. but the utility of (1/2)B + (1/2)C is the utility of an expected outcome. (3.2) . We are given that Also. Therefore. risk averse individuals will experience decreasing utility as the variance of outcomes increases.1) Assuming the individual is risk-averse. At the same time he will be willing to buy a lottery ticket which offers him a (small) probability of enormous gains in wealth because his utility function is convex above his current wealth. Figure S3. we know that Transposing. then and (3. equation (3. Friedman and Savage [1948] show that it is possible to explain both gambling and insurance if an individual has a utility function such as that shown in Figure S3. we have A>B>C>D U(A) + U(D) = U(B) + U(C) U(A) − U(B) = U(C) − U(D) ∂U >0 ∂W Therefore. The individual is risk averse to decreases in wealth because his utility function is concave below his current wealth. he will be willing to buy insurance against losses.

5 W + 1.000 = 500W W = 2.292322 W = e10.000. the level of wealth corresponding to any utility is W = –(U(W)) –1 Therefore.1(10.292322 W = 29.81978) + .000) + .51293) = 10.000 .000 −1 W− = 500 −W W2 = 1.5(−(W − 1.8U(100.505 The maximum insurance premium is Risk premium = E (W) – certainty equivalent = $85. we have to compute the expected utility of the individual’s risk.1(0) + . The utility function is Next.1 9.000 is W.1 − $29.000. minus the certainty equivalent level of wealth for the gamble is just equal to the cost of the insurance.18 Copeland/Shastri/Weston • Financial Theory and Corporate Policy.1U(50.000) = .000)−1 ) + . First.000.000 −W2 − 1. W = −[.1U(1) + .8(11.5 + . E(U(W)) = ∑ pi U(Wi ) = .000.000 W − 1. what level of wealth would make him indifferent to the risk? U(W) = − W −1 Therefore.292322 ln W = 10.000 W+ = 500 −W 2 2 W − W + 1.495. Thus.5(−(W + 1. the certainty equivalent wealth for a gamble of ±1. we have the condition W − W = 500 1 W − − = 500 −1 −1 . $500. W.000)−1 )]−1 The point of indifference will occur where your current level of wealth. Fourth Edition 8.505 = $55.

5) probability of ending after the second flip (one head and one tail).000 . and utility of payoffs for n consecutive heads. we have ∑2 i=0 ∞ 1 i = 1 + 12 + 14 + 1 + ⋅⋅⋅ 8 = 1+ 1/ 2 =2 1 − 1/ 2 . expected payoffs. and so on. Table S3. However.5 probability of ending after the first coin flip (i.50 .000.e.1 shows the payoffs. you will be indifferent.386 ln 8 = 2.130 N ln 2 N 1 = 0 2 + 2 The gamble has a . which is infinite. The expected payoff of the gamble is the sum of the expected payoffs (column four).079 ln 2 = N ln 2 N E U(Payoff) . a (.50 U(Payoff) ln 1 = . The expected utility of the gamble is E(U) = ∑ ( 1 2)i +1 ln 2i i=0 N E(U) = 1 2 ∑ ( 1 2)i i ln 2 i =0 N E(U) = 1 2 ln 2 ∑ i =0 N i 2i Proof that ∑2 i =0 ∞ i i = 2 follows: First. Consequently. if your current level of wealth is $2. Table S3. Below that level of wealth you will pay for the insurance while for higher levels of wealth you will not.50 . The reason is that people are usually risk averse.1 Number of Consecutive Heads = N 0 1 2 3 N Probability = (1/2)n+1 1/2 1/4 1/8 1/16 (1/2) N+1 Payoff N =2 1 2 4 8 2 N E(Payoff) $. they would be willing to pay an amount whose utility is equal to the expected utility of the gamble.Chapter 3 The Theory of Choice: Utility Theory Given Uncertainty 19 Therefore. note that the infinite series can be partitioned as follows: ∑ 2 =∑ i=0 i ∞ i 1+ i −1 ∞ 1 ∞ i −1 =∑ i + ∑ i 2i i=0 i=0 2 i =0 2 ∞ Evaluating the first of the two terms in the above expression. no one has ever paid an infinite amount to accept the gamble.693 ln 4 = 1.50 . 10.173 .50 . no heads).173 .000 ln 2 = ..

98) + 5.98) + 5. Fourth Edition Evaluating the second term.000(.000 insurance) = 0(.005) + 40.000(.000(. 11. we have i −1 1 1 1 1 = −1 + + + + + ⋅⋅⋅ i 2 4 8 16 i=0 2 ∞ i −1 ∑ 2i = −1 + 1 = 0 i=0 ∑ ∞ Adding the two terms.000 insurance) = 0(.005) = $350 . we have the desired proof that i ∞ 1 ∞ i −1 ∑ 2i =∑ 2i + ∑ 2i = 2 + 0 = 2 i=0 i=0 i=0 ∞ Consequently.98) + 5.000(.005) = $300 AVL 3 ($50.000(. AVL1 ($30. since 2i i=0 N ∑2 i=0 N i i = 2 If the expected utility of wealth is ln2. we have ∑ i=0 ∞ i −1 1 2 3 4 = −1 + 0 + + + + + ⋅⋅ ⋅ i 2 4 8 16 32 The above series can be expanded as −1 = −1 1 1 1 1 1 + + + + ⋅⋅⋅ = 4 8 16 32 2 1 1 1 1 + + + ⋅⋅⋅ = 8 16 32 4 1 1 1 + + ⋅⋅⋅ = 16 32 8 1 1 + ⋅⋅⋅ = 32 16 Therefore. we have E(U) = 1/ 2 ln2∑ i = ln 2. since the insurer sets the premiums.000(.005) + 30.000 insurance) = 0(.000(. (a) First calculate AVL from the insurer’s viewpoint. the corresponding level of wealth is U(W) = ln2 eln2 = W = $2 Therefore.000(.005) = $250 AVL 2 ($40. an individual with a logarithmic utility function will pay $2 for the gamble.005) + 50.01) + 10.01) + 10.000(.20 Copeland/Shastri/Weston • Financial Theory and Corporate Policy.01) + 10.

8931(.98) 5 + 2(1.105 1.14 − .000 insurance 1.5 = 6.035 − 1. Contingency Values Of Wealth And Utility of Wealth (Savings = $20.10 Table S3. find the expected utility of wealth for each amount of insurance.14 0.) Finally.6312(.8148 $10.005) = 1.03 − 2 ≅ 5.9600 With $50.14 With $30. The utility of each ending wealth can be found from the utility function U(W) = ln W.8931 $5.005) 5 + 2.005) 5 + 2.995) + 1.0 ≅ 6.9582 With $30.8091(.995) 5 + 2.000 loss (P = .0280(1. calculate the insuree’s ending wealth and utility of wealth in all contingencies (states).000.000 $40.9615 No loss (P = .9657(.14 − .14 − 5.6312 $20.Chapter 3 The Theory of Choice: Utility Theory Given Uncertainty 21 We can now calculate the premium for each amount of coverage: Amount of Insurance $30.11 With $40.005) 5 + 2.005) 5 + 2.07) = 7.01) 5 + 2. (See Table S3.000 Premium 30 + 250 = $280 27 + 300 = $327 24 + 350 = $374 Next.8148(.0) 5 + 2. given his utility function.000 insurance 1. E(U(W)) = ∑ Pi U(Wi ) i and choose the amount of insurance which yields the highest expected utility.000) Utility of End-of-Period Wealth Wealth (in $10.9598 With $40.005) + 0. .14 − 1.105 With $50.8091 $10.000 $50.000 loss (P = .0 = 2.2a With no Insurance: E(U(W)) = 1.9615(.9601 Therefore.14 − .005) = 1.64 1.0 = 6.9657 No loss (P = . Casadesus is $50.14 1.9608(.7608 $50. the optimal insurance for Mr.005) = 1.14 − . Assume he earns 7 percent on savings and that premiums are paid at the beginning of the year.000 loss (P = .9601 No loss (P = 1.7608(.000 insurance: E(U(W)) = 1.14 − .000’s) U(W) = ln W With no insurance 1.000 loss (P = .0327(1.995) 5 + 2.9608 No loss (P = .000 loss (P = .01) + 1.11 1.14 − .000 insurance: E(U(W)) = 1.0374(1.07) ≅ 7.07) ≅ 7.2a.98) + 1.07) ≅ 7.995) + 1.000 insurance 1.000 insurance: E(U(W)) = 1.

4) – .01) $10.4) – .3413) + .4) = –.98(200/71. (c) The end-of-period wealth for all contingencies has been calculated in part a).98) $5.000 insurance: E(U(W)) = (1)1.000’s) With no insurance No loss (P = .000 in savings instead of $20.07) = 39.2b above for these calculations.01(1.0 = 34.) With no Insurance: E(U(W)) = .24 − .3663) + .030 – .3543 1.000 loss (P = .01(U(66.0 ≅ 38.4)) + .005(1.000 insurance No loss (P = . the analysis illustrates that a relatively wealthy individual may choose no insurance. while a less wealthy individual may choose maximum coverage. only with $320.98(U(71.366071 With $50. so we can calculate the expected utilities for each amount of insurance directly.5 = 38.3663 1.07) ≅ 39.005 (1.000) Utility of Wealth U(W) = ln W (Wealth in $100.4)) + .22 Copeland/Shastri/Weston • Financial Theory and Corporate Policy.3140) .3413 1.0) 5 + 32.3404) = 1. With no insurance: E (U(W)) = .995) $10.24 − .000 loss (P = .005U(21.005(200/21.98(1.24 − .2308) = 1.366162 = 1.995(1.366092 = 1.000’s) 1.005) With $30.3662 1.07) ≅ 39.0327(1.995(1.74 5 + 34.005) With $40.3662) + .00(1.000 loss (P = .4) – .000.005) $50.07) ≅ 39.005(1. (See Table S3.24 − .000 loss (P = .24 − 5.24 − 1.005(1.000 insurance No loss (P = .3140 1.20 (b) Follow the same procedure as in part a).3671) + .205 5 + 34.005(200/61. Fourth Edition Table S3.3543) + .745 – .005(U(61.03 − 2 ≅ 37.21 5 + 34.838 With $30.3404 1.3661 End-of-Period Wealth (in $10.000 insurance No loss (P = 1.366092 The optimal amount of insurance in this case is no insurance at all.01(200/66.3671 1.21 5 + 34.000 insurance: E(U(W)) = .24 5 + 34.4) = –2.366038 With $40.205 5 + 34.995) $20.0374(1.2308 1.005) With $50.035 − 1.24 − .000 insurance: E(U(W)) = .24 5 + 34.4)) + .000 loss (P = . Although the numbers are close with logarithmic utility.2b Contingency Values of Wealth and Utility of Wealth(Savings = $320.047 = –2.24 − .24 5 + 34.0 = 38.016 – .028(1.

819 With $40.005(200/51. Case 1 (a) Second order dominance—B dominates A because it has lower variance and the same mean. To see this. . Case 2 (a) Second order dominance—A dominates B because it has a higher mean while they both have the same variance. he would prefer not to take out any insurance.005(U(61.995(U(71.1)) + .05) – . once his wealth is large enough.1) – .995(200/71.Chapter 3 The Theory of Choice: Utility Theory Given Uncertainty 23 With $30. the mean and variance are the only relevant parameters. It lies to the right of B.1)) = – . Mr. Eventually.995(U(71. (b) First order dominance—There is no dominance because the cumulative probability functions cross.0164 = –2. U(W) = −200. Because returns are normally distributed.000 insurance: E(U(W)) = . make his savings account = $400.000W− : MUW = 200.005(U(51.005(200/61. with this utility function.020 = –2.000.05)) = – .000W < 0 W −MU′ W ARA = = 2W-1 > 0 MUW -3 nonsatiation risk aversion ∂ARA = −2W-2 < 0 ∂W RRA = W(ARA) = 2 > 0 ∂RRA =0 ∂W decreasing absolute risk aversion constant relative risk aversion Since the individual has decreasing absolute risk aversion. Casadesus would renew his policy for $50.000 insurance: E(U(W)) = . 12.05) = –2.8172 With $50. 1 Properties of this utility function.1) = –2.000. (b) First order dominance—A dominates B because its cumulative probability is less than that of B.799 – .8008 – . as his savings account is increased he prefers to bear greater and greater amounts of risk.000 insurance: E(U(W)) = (1)( −200/71) = −2.8169 Hence.05) + .000W-2 > 0 MU′ = −400.995 (200/71.

4 Xi − E(X) −16.2 .36) = 6.0 3.69) = 2.3 .4 E(X) = 6.2 . (a) Prob X .4 −1.272 var (X) = 37.5 First order dominance not possible 13. as shown in Figure S3.29) = 3.896 .6 pi(Xi − E(X)) . it is not possible for B to dominate A according to the first order criterion.4 2 3 1.5(7.784 .49) = 59.0 E(Y) = 5.1(590.4 3.5 shows an example.7 24.738 .96) = 26.24 Copeland/Shastri/Weston • Financial Theory and Corporate Policy. Figure S3.645 .1 Y pi Yi .7 −1.1(268.7 Yi − E(Y) −3.7 −2.2(31.3(12.578 .888 .89) = . (b) First order dominance—Given normal distributions. Because Σ(F − G) is not less than (or greater than) zero for all outcomes. .0 2.3 on the following page.4(1.049 var(Y) = 66.0 2.2 X −10 5 10 12 pi Xi −1. there is no second order dominance.96) = 3.840 2 Prob Y .8 30 3.6 5. (b) Second order stochastic dominance may be tested as shown in Table S3.010 2 X is clearly preferred by any risk averse individual whose utility function is based on mean and variance. Fourth Edition Case 3 (a) Second order dominance—There is no dominance because although A has a lower variance it also has a lower mean.3 pi (Yi − E(Y)) .2(13.2(2.6. Figure S3.5 4 .1 .5 . because X has a higher mean and a lower variance than Y.96) = .4 .

1 −.1 .9 .6 Because Σ (F − G) is not less than (or greater than) zero for all outcomes.1 .9 .0 F−G .1 .1 0 Σ (F − G) .5 .3 –1.9 .1 0 0 0 0 0 0 0 0 0 0 0 0 0 0 .3 .1 .1 .9 .1 .5 .8 −.0 1.9 –1.1 .1 .1 .1 .3 −.1 .5 .1 .9 .Chapter 3 The Theory of Choice: Utility Theory Given Uncertainty 25 Table S3.9 .9 .8 .0 1.5 .7 .9 .9 1.1 .1 .4 −.9 .1 .8 –. .2 .1 .0 1.1 .9 .7 –1.2 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 1.0 1.6 −.1 .5 –1.0 1.9 .0 1.0 1.0 1.1 .1 .0 1.9 .3 0 .4 −.9 .9 –.5 –2.5 –1.1 .1 –1.1 .1 .1 .0 1.1 .1 .0 Prob(Y) 0 0 0 0 0 0 0 0 0 0 0 0 .4 –2.1 –1.0 1.8 –1.1 .0 1.9 .1 .6 –1.7 .9 .0 1.1 .0 1.1 1.8 1.9 .1 .1 .3 –2.9 .9 .5 −.5 .9 .4 0 0 0 0 .4 −.1 .6 .9 1.2 1.7 –.1 .3 Outcome −10 −9 −8 −7 −6 −5 −4 −3 −2 −1 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 Prob(X) .1 .4 −.1 .1 .1 .9 –2.1 .4 –2.1 .1 .1 . there is no second order dominance.9 .0 Σ Px = F .0 1.1 .0 1.1 .0 1.1 −.4 –1.0 1.4 .5 .0 –.5 .0 1.6 –.3 –2.1 .9 .2 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 .2 −2.2 .9 .9 .2 .1 1.2 –1.7 –1.0 Σ Py = G 0 0 0 0 0 0 0 0 0 0 0 0 .1 .1 −1.4 −.1 .9 .9 .1 −.8 .

00 pi Ai 0 .1 .40 . Figure S3.60 .144 −.00 4.1 Co.4500 .8 below. (a) False.26 Copeland/Shastri/Weston • Financial Theory and Corporate Policy.0875 E(A) = 1.00 Co. Using second order stochastic dominance. E(B) = 1.324 .5 on the following page. which has higher return and higher variance.2 .44 pi[B − E(B)]2 .50 σA = .40 .50 −.50 1.4 shows the calculations.6250 2. Fourth Edition Figure S3.30 1.128 . while a less risk averse investor (#2) will prefer B. but A has lower variance.098 −.10 .4000 . (b) Figure S3. (a) Table S3.016 .25 1. A 0 .2 .00 3.05 . 15.60 . B −. .710 1.50.05 .6 Asset X is preferred by mean-variance risk averters 14.20 pi Bi pi [A − E(A)]2 . Table S3.84 σB = 1.4 .00 2. But there is no first order stochastic dominance because they have the same mean and hence the cumulative probability distributions cross.7 shows that a risk averse investor with indifference curves like #1 will prefer A.4 pi .40 .50 3. A dominates B because they have the same mean.6125 0 .20.7 Risk-return tradeoffs (c) The second order dominance criterion is calculated in Table S3. Compare the normally distributed variables in Figure S3.

2 Because Σ (F − G) is not always the same sign for every return.7 .9 .7 .4 −.6 −.25 .0 1.8 .1 .00 1.3 .50 1.25 1.7 .50 −.8 −.25 2.4 0 0 .25 0 .2 0 .0 G (B) − F(A) .7 . .25 3.2 0 0 0 .1 1.00 3.0 1.7 .8 −.1 −.0 Prob(B) .7 .3 .9 .0 G(B) . Payoff $1 $2 $3 $4 Prob (A) 0 .7 .0 Prob (B) .7 .9 1.00 2.3 .3 .1 .0 G (B) .60.7 1.5 1.5 0 1.3 .1 0 0 0 0 1.9 .9 .2 0 0 .0 1.0 1.2 0 0 0 0 0 0 .50.3 .2 1.4 0 0 0 .75 3.1 0 Σ (F − G) −.3 .00 (Problem 3. there is no second order stochastic dominance in this case. E(B) = $2.50 2.2 .14) Second Order Stochastic Dominance Prob(A) 0 0 .6 .4 .3 0 var(A) = $.50 .7 .75 2.3 1.0 E(A) = $2.25 squared var(B) = $1.1 −.3 −.1 .3 .3 .9 .9 1.8 First order stochastic dominance does not obtain (b) False.9 1.75 1.2 .2 .1 −. and there is no first order dominance.Chapter 3 The Theory of Choice: Utility Theory Given Uncertainty 27 Figure S3.2 .3 .0 F(A) 0 0 .1 1.1 .7 .5 Return −.3 −. Table S3.4 0 0 0 0 0 .3 .1 .50 3.3 .4 0 0 0 .44 squared The cumulative probability distributions cross.2 .75 4.5 .4 .1 . Consider the following counterexample.9 .8 −.4 .2 −.0 1.1 0 .2 0 0 0 .1 . F (A) 0 .0 1.1 .0 F−G −.

C. the only trusts which might be inferior by FSD are B. but her tastes for risk are not clear. As Figure S3.2 0 . (d) True. 17. E(A) = 6. The second property of FSD is a cumulative probability F(X) that never crosses but is at least sometimes to the right of G(Y). and F.000 In this case shareholders would be obligated to make debt payments from their personal wealth when corporate funds are inadequate. . Second order stochastic dominance is equivalent to maximizing expected utility for risk averse investors.000 Using either first order or second order stochastic dominance. Utility functions which have positive marginal utility and risk aversion are concave.6 0 . hence he will always choose the set of returns which has the highest mean. 16.2 −3000 . their payoffs are Project 1 Probability Payoff . Therefore.2 −4000 . B. Project 2 clearly dominates Project 1. D.2 E(E) = 6. and project 2 is no longer stochastically dominant.4 2. shareholder payoffs would be the following: Project 1 Probability Payoff .4 −8000 . From the point of view of shareholders.2 E(F) = 6.9 shows.6 −3000 .4 0 . A > C and D > F. A risk neutral investor has a linear utility function.0 E(C) = 6. Fourth Edition (c) False.2 0 Project 2 Probability Payoff .1 One property of FSD is that E(X) > E(Y) if X is to dominate Y.0 E(D) = 6. E.2 −2000 Project 2 Probability Payoff .28 Copeland/Shastri/Weston • Financial Theory and Corporate Policy.2 0 . (a) The first widow is assumed to maximize expected utility.2 E(B) = 6. first order stochastic dominance is the appropriate selection criterion.4 2. so the feasible set of trusts for investment is A. If there were not limited liability. Hence.

0 −1.2 0 0 0 0 0 A>D A<E SSD (DB) −.4 0 1.1 0 −.9 .3 −.4 −1.2 −.0 1.6 1.3 1.6 1.7 1.8 1.1 . and E > D.4 0 .0 1.6 −1.0 1.0 .6 1.1 −. as in the comparison of B and D.0 .7 −1.5 0 1. The pairwise comparisons of the remaining four funds.2 −.2 −.2 1. there is no second order stochastic dominance.8 0 1.0 1.8 −1.4 0 1.4 0 .9 .0 0 1.1 0 .2 0 .9 .0 .2 1.0 −2.6 .8 −1.0 1.5 −1.2 A>B SSD SSD (DA) (EA) 0 0 .8 −.1 0 0 .0 . so second order stochastic dominance is the appropriate selection criterion.4 0 .2 −.4 . By SSD.4 0 1.2 −.8 . Since C and F are eliminated by FSD.6 −.2 0 .8 0 1.4 2.10.0 −1.8 1.2 1.4 .1 0 0 −.Chapter 3 The Theory of Choice: Utility Theory Given Uncertainty 29 Figure S3.2 0 .1 −. If the sum of cumulative differences crosses the horizontal axis.2 1.9 −1.1 −.1 −. .2 0 0 D<E * cumulative probability ** SSD calculated according to Σ (F(X) − G(Y)) where F(X) = cumulative probability of X and G(Y) = cumulative probability of Y.2 B<E SSD (ED) 0 −.7 0 .0 0 .8 1.2 .0 1. Σ(F(X) − G(Y)) are presented in Table S3. so the optimal investment is E.2 −.0 .1 .9 −2.5 −. they are also inferior by SSD.3 .2 0 .9 First order stochastic dominance (b) The second widow is clearly risk averse.1 0 0 −.4 −.2 −.5 .4 −.4 0 .0 .5 .3 .4 .2 0 .6 −1.2 no 2nd order dominance SSD (EB) −.4 −1.8 −.0 .0 .0 .4 0 1.6 on the following page and graphed in Figure S3.6 Ret. −2 −1 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 Second Order Stochastic Dominance SSD** P(A)* P(B) P(D) P(E) (BA) 0 . E > A.0 .0 .4 1. E > B.5 .5 .1 −1.0 .8 0 .6 .6 0 1.1 0 .1 0 .8 1.7 .6 .4 −.6 0 .7 −.2 −.8 1. Table S3.0 .5 .8 .5 1.

(a) Mean-variance ranking may not be appropriate because we do not know that the trust returns have a two-parameter distribution (e.7. normal). Fourth Edition 18. or higher mean and lower or equal variance. D. B. Figure S3. The only other unambiguous dominance is C > B. F and A > B. D has the highest mean of the four remaining trusts. D. C. but also the highest variance. The next in rank cannot be determined. C. To dominate Y.g. E > A.. F.30 Copeland/Shastri/Weston • Financial Theory and Corporate Policy. Means and variances of the six portfolios are shown in Table S3.10 Second order stochastic dominance . By mean-variance criteria. X must have higher or equal mean and lower variance than Y.

D > F A > B.7 A B C D E F E(X) 6. B. C.2 6.36 0. D.89 (b) Mean-variance ranking and SSD both select trust E as optimal. A > D A > B.80 2. E E E Dominance Relationships A > C. Optimal A.96 26.2 6.0 6.36 26.1 var(X) 1. However.Chapter 3 The Theory of Choice: Utility Theory Given Uncertainty 31 Table S3.2 6. C > B FSD SSD M-V . F. D.00 28.0 6. the rankings of suboptimal portfolios are not consistent across the two selection procedures.

20 P1 = . 20P1 + 40P2 = 10 2 + 40P2 = 10 40P2 = 8 P2 = .10 P2 = . 20P1 + 40P2 = 10 −[120P1 + 40P2 = 20] 100P1 = 10 P1 Substituting into the first equation.20 = . (a) State 1 $30 $20 Payoff State 2 $10 $40 Price PA = $5 PB = $10 Security A Security B (b) The prices of pure securities are given by the equations below: P1QA1 + P2QA2 = PA P1QB1 + P2QB2 = PB Qij = dollar payoff of security i in state j Pi = price of security i (i = A. B) Pj = price of pure security j (j = 1.Chapter 4 State Preference Theory 1. 30P1 + 10P2 = 5 20P1 + 40P2 = 10 Multiplying the first equation by 4 and subtracting from the second equation. 2) Substituting the correct numbers.10 .

and subtracting the second equation from the first. and the prices of pure securities for states 1 and 2.8 for P2 in the first equation. and Pj is the price of security j. 6 St. 10 4P1 + 36P2 = St. Substitution of payoffs and prices for securities j and k in the situation given yields 12P1 + 20P2 = 22 24P1 + 10P2 = 20 Multiplying the first equation by two. Pi. P1 and P2.8) = 22 12P1 = 22 – 16 P1 = 6/12 = . 4 S2 = War St.00 3. Pi = P1Qil + P2Qi2 = . Thus. 12P1 + 20(. (a) The payoff table is: Nova Nutrients = j Galactic Steel = k S1 = Peace St.8 Substituting . 6 St. (a) The equations to determine the prices of pure securities.Chapter 4 State Preference Theory 33 2. 36 To find the price of pure securities. 24P1 + 40P2 = 44 −[24P1 + 10P2 = 20] 30P2 = 24 P2 = 24 / 30 = . can be determined by the payoff of i in states 1 and 2.5(6) + .8(10) =3+8 = $11. are given below: P1Qj1 + P2Qj2 = Pj P1Qk1 + P2Qk2 = Pk where Qj1 is the payoff of security j in state 1. solve two equations with two unknowns: 6P1 + 6P2 = St.8. 20 . P1 and P2. P1 = . P1 is the price of a pure security which pays $1 if state 1 occurs.5 and P2 = .5 (b) The price of security i. From part a) we know the prices of pure securities.

If he buys N. he must pay out at most –njQj1. 60] −32P1 = − 40 P1 = St.S. (c) For sales of j (N.25) + 6P2 = 10 P2 = . and W2 = his final wealth if war prevails.34 Copeland/Shastri/Weston • Financial Theory and Corporate Policy.N. 1. he can buy 50 shares. Fourth Edition Multiplying the first equation by six. Therefore. and subtracting it from the second equation.N.800 St. If he buys G.S. If he buys only Galactic Steel.4167 (b) Let nj = number of Nova Nutrients shares and nk = number of Galactic Steel shares. 4P1 + 36P2 = St. Let W1 = his final wealth if peace prevails. which will return at least [(–njPj + W0)/Pk]Qk1.: W1 = njQj1 = 100(6) = 600 St.) . Then nj = W0/Pj = 1.000/10 = 100 nk = W0/Pk = 1. With this he can buy at most (–njPj + W0)/Pk shares of k.25 6(1. he can buy 100 shares.000) 20 –2nj + 200 = –6nj nj = –50 shares of j (N. and with his initial W0 he will have –njPj + W0.N. W2 = nkQk2 = 50(36) = 1.): If he sells –nj shares of j.) and purchases of k (G.000/20 = 50 If he buys only Nova Nutrients. the minimum –nj is determined by −n j Pj +W0 Pk Qk1 = −n jQ j1 4 = −6n j (−10n j + 1.: W1 = nkQk1 = 50(4) = 200 St. he receives –njPj. 20 −[36P1 + 36P2 = St. W2 = njQj2 = 100(6) = 600 St.

2 . he receives –nkPk. and with his initial W0 he will have –nkPk + W0.2 .25(28) + .8W1−.1 on the following page.8 W2. he must pay out at most –nkQk2. (f) The slope of the budget line must equal the slope of the utility curve (marginal rate of substitution) at optimum. Therefore.000) 6 = −36n k 10 –12nk + 600 = –36nk nk = –25 shares of k (G. the minimum –nk is determined by −n k Pk + W0 Q j2 = −n k Q k2 Pj (−20n k + 1.4167(36) = 35 + 15 = 50 St.8 = 4W1−1 W2 = 4W2 / W1 . this equality results in . as given in the equation below: −∂W2 / ∂W1 = −[∂U / ∂W1 ÷ ∂U / ∂W2 ] With utility function U = W1.) (d) Let Pa = price of Astro Ammo. With this he can buy at most (–nkPk + W0)/Pj shares of j.2 W2 ÷ .2W1. which will return at least [(–nkPk + W0) /Pj]Qj2.S.8 W2−. Then Pa = P1Qa1 + P2Qa2 = 1. (e) See Figure S4.Chapter 4 State Preference Theory 35 For sales of k and purchase of j: If he sells –nk shares of k.

000 = (5/4) (4/3)W2 + (5/12)W2 = (20/12)W2 + (5/12)W2 = (25/12)W2 W2 = (1.000)(12/25) = $480 W1 = (4/3)480 = $640 . 4W2 = 3W1 W1 = (4/3)W2 The wealth constraint is: W0 = P1W1 + P2W2 Substituting the correct numbers. Fourth Edition Figure S4. ∂W2 / ∂W1 = P1 / P2 4W2 / W1 = P1 / P2 = (5/ 4) /(5/12) = (12 / 4) = 3 Therefore.1 State payoffs in peace and war In equilibrium.36 Copeland/Shastri/Weston • Financial Theory and Corporate Policy. 1.

she receives –njPj. in this case the investor buys 110 shares of Nova Nutrients and issues five shares of Galactic Steel.200 final wealth in state 1 W2 = njQj2 = 120(12) = $1. solve the two simultaneous equations W1 = njQj1 + nkQk1 W2 = njQj2 + nkQk2 Substituting the correct numbers. she must pay out at most –njQj2. with this she can buy at most (–njPj + W0)/Pk shares of k which will return at least [(–njPj + W0)/Pk]Qk2. Then W W 1. Let nj = the number of shares the investor can buy if she buys only j.000 final wealth in state 1 W2 = nkQk2 = 100(8) = $800 final wealth in state 2 (b) For sales of j and purchases of k: If she sells –nj shares of j. n k = 0 = = 100 (a) Pj 10 Pk 12 If she buys j: W1 = njQj1 = 120(10) = $1. 640 = 6nj + 4nk 480 = 6nj + 36nk Subtracting the second equation from the first yields 160 = –32nk nk = –5 Substituting –5 for nk in equation 2 gives a value for nj: 480 = 6nj – 36(5) = 6nj – 180 660 = 6nj nj = 110 Hence (nj = 110.Chapter 4 State Preference Theory 37 To find optimal portfolio.440 final wealth in state 2 If she buys k: W1 = nkQk1 = 100(20) = $2.200 nj = 0 = = 120. and with her initial wealth W0 she will have –njPj + W0. 4.200 1. and nk the number she can buy if she buys only k. the minimum –nj is determined by: −n j Pj +W0 Pk (Qk2 ) = − n jQ j2 −10n j + 1. Therefore. 400 = −36n j n j = −150 . nk = –5) is the optimum portfolio. 200 (8) = −12n j 12 − 20n j + 2.

200 = = 150 Pi 8 . and with her initial wealth W0 she will have –nkPk + W0. she receives –nkPk. 20P1 + 24P2 = 20 −[20P1 + 8P2 = 12] 16P2 = 8 P2 = .40)5 + (.2. she must pay out at most –nkQk1. the number of shares she can buy is given by ni = W0 1. solve two equations for two unknowns as follows: 10P1 + 12P2 = 10 20P1 + 8P2 = 12 Multiplying the first equation by two.38 Copeland/Shastri/Weston • Financial Theory and Corporate Policy. Therefore.200 (10) = − 20n k 10 n k = − 150 Final wealth for sales of j and purchases of k: State 1: –150(10) + 225(20) = 3. and subtracting the second equation from the first equation.50)12 =2+6 =8 (e) (The state contingent payoffs of a portfolio invested exclusively in security i are plotted in Figure S4.50 for P2 in equation 1. Fourth Edition For sales of k and purchases of j: If she sells –nk shares of k. the minimum –nk is determined by: −n k Pk + W0 (Q j1 ) = −n k Q k1 Pj −12n k + 1.) If the investor places all of her wealth in i.400 (c) To find the price of pure securities.5) = 10 P1 = . with this she can buy at most (–nkPk + W0)/Pj shares of j. 10P1 + 12(.40 (d) The price of security i is given by Pi = P1Qi1 + P2Qi2 = (. which will return at least [(–nkPk + W0)/Pj]Qj1.50 Substituting .000 State 2: –150(12) + 225(8) = 0 Final wealth for sales of k and purchases of j: State 1: 300(10) – 150(20) = 0 State 2: 300(12) – 150(8) = 2.

Chapter 4 State Preference Theory 39 Her wealth in state one would be niQi1 = 150(5) = $750 Her wealth in state two would be niQi2 = 150(12) = $1. This portfolio plots as the W2 intercept in Figure S4. j. her wealth in state one will be zero.875W2 .800 If the investor sells k to purchase j. ∂W2 = (. resulting in zero wealth in state two.5 = 0.8 1.2 State payoffs for securities i.5W2/W1 = .6 W2.6W1−. and k In equilibrium: dW2/dW1 = P1/P2 1.4/.8W1 W1 = 1.5W2 = 0.2 on the following page.6 ) ∂W1 = 1. The W1 intercept is the portfolio of j shares sold to buy k.4 and substituting the correct numbers.4 W2. (f) Set the slope of the budget line equal to the slope of the utility curve in accordance with the equation below: ∂W2 / ∂W1 = (∂U / ∂W1 ) ÷ (∂U / ∂W2 ) Given utility function U = W1.5W2 / W1 Figure S4.4W2−6 W1.4 ) ÷ (.

25 = 960 W1 = 1. we can use them to determine its equation.800 Optimal portfolio: Solve the two simultaneous equations for the final wealth in each state: W1 = njQj1 + nkQk1 W2 = njQj2 + nkQk2 Solve for nk and nj.800 – 10nj nk = (1. he can buy $720 = 90 shares with payout $8 If he spends $720 on security k.3 on page 42).200/1. W1 = 1.800 Since both of these payouts lie on the budget constraint (see Figure S4.800 – 10nj)/20 nk = 75 The investor should buy 30 shares of j and 75 shares of k. S2 = $1. S2 = $800 S1 = $900. the number of shares of each security to be purchased. and substituting this value into equation two: 20nk = 1.400.4(1.800 = 60nj + 3.200 = . Fourth Edition Wealth constraint: W0 = P1W1 + P2W2 1.800 – 10nj) ÷ 20] 4.875(960) = 1.800 – 10nj) ÷ 20 960 = 12nj + 8 [(1.800 = 10nj + 20nk W2 = 960 = 12nj + 8nk Solving equation one for nk in terms of nj. 5.200 = 40nj nj = 30 nk = (1. he can obtain $720 = 80 shares with payout $9 S1 = $2. it will be possible to determine what an equal payout will be. Substituting the correct numbers.40 Copeland/Shastri/Weston • Financial Theory and Corporate Policy. (a) If we know the maximum payout in each state.600 – 20nj 1.5W2 W2 = 1. The equation for the line is W2 = a + bW1 . If the individual uses 100 percent of his wealth to buy security j.875W2) + .

440] n k 50 = 1. the slope is − 1.400. regardless of the state of nature which occurs.400 = $1.800 = a − 2 (900) 3 a = 2.500 3 2 and the intercept is 3 1.500) − Therefore. the payout of the risk-free asset is W1 = 2.400) = W1 = $3.000 2 = b =− 1.440 = W2 5/ 3 If you buy nj shares of asset j and nk shares of k. we have nj 20 + nk 60 = 2.400 − A risk-free asset is one which has a constant payout.440 nk = 28.6 .Chapter 4 State Preference Theory 41 Substituting in the values of the two points.8 and nj = 57.800 = a + b(900) –[800 = a + b(2.000 = b(–1. we want to find the point along the budget line where W2 = W1.400 The maximum wealth in state two is $2. we obtain two equations with two unknowns.880 −[n j 20 + n k 10 = 1.400 − W1 = 2.400)] 1.440 nj20 + nk10 = 1. The maximum wealth in state one is 2 W1 3 3/2(2. We now have two equations and two unknowns W2 = 2.440 Multiplying the first equation by 2 and subtracting. Therefore.” 1. “a” and “b.400 − W2 = W1 2 W1 (the budget constraint) 3 (equal payout) 2 W1 3 Substituting the second equation into the first.600 0 = 2. which we have already determined. your payout in states one and two will be State 1: State 2: nj10 + nk30 = 1.

No feasible solution exists. the risk-free rate of return is 720 = 1 + rf = 1.4Q 2 3Q 2 or 1. It costs $720 and returns $1. In general.440 1 + rf 1. We to solve Max[log C + 2/3 log Q1 + 1/3 log Q2] subject to C + .6Q1 + .2) and substitute for C in (4. Max[log (50.6Q1 – .2Q2 = 50.3) Take the partial derivative with respect to Q2 and set it equal to zero: −.1) (4.4) . 6.4Q2) + 2/3 log Q1 + 1/3 log Q2] Take the partial derivative with respect to Q1 and set it equal to zero: −.4Q2 (4. Any attempt to solve the problem would require solving for three unknowns with only two equations.4Q2 = 50.000 We can solve for C in (4. Therefore. Fourth Edition Figure S4.8 shares of asset k.000 – .3 The budget constraint (b) The risk-free portfolio contains 57.4 1 + = 0 50.000 – 1.6Q1 – . it is necessary to have at least as many assets as states of nature in order for complete capital markets to exist.42 Copeland/Shastri/Weston • Financial Theory and Corporate Policy.2Q1 – .4Q 2 3Q1 (4.2) or 1.6 2 + =0 50.440 =2 720 rf = 100% (c) It would be impossible to find a completely risk-free portfolio in a world with more states of nature than assets (if all assets are risky).8Q2 (4. 000 −.8Q1 = 100.440 for sure.6Q1 − .000 − .1).000 – .6Q1 − .6 shares of asset j and 28.

3) and (4.67 – $8.333.4Q2 = 50.40 each for a total of $8. (4. and 20.777.2) and (4.60 each for a total of $16. or Q1 = 1.8Q1 = 2.33 = $25. C = $50.666.33 hence Q1 = 27.666.833.777. C = 1.4).000 also from (4.833.2Q2 = 25.000 Q2 = 20.000 Hence.333.000 – $16.67. Substituting into (4.78 units of pure security 1 at $0. the investor divides his wealth equally between current and future consumption (which we would expect since the risk-free rate is zero and there is no discounting in the utility functions).33 units of pure security 2 at $0. but he buys more of pure security 1 (because its price per probability is lower) than of pure security 2.2).Chapter 4 State Preference Theory 43 Together.4Q2.4) imply 1.33. (b) From (4.3333Q2 .3) yields 2.78 (a) The risk-averse individual will purchase 27.

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