Risk Analysis: Questions & Answers Q17.1 Q17.1 ANSWER

Chapter 17
RISK ANALYSIS
QUESTIONS & ANSWERS

Q17.1
In economic terms, what is the difference between risk and uncertainty?
Q17.1
ANSWER
Economic risk is the chance of loss because all possible outcomes and their
probability of happening are unknown. Actions taken in such a decision
environment are purely speculative, such as the buy and sell decisions made by
traders and other speculators in commodity, futures, and options markets. All
decision makers are equally likely to profit as well as to lose; luck is the sole
determinant of success or failure. Uncertainty exists when the outcomes of
managerial decisions cannot be predicted with absolute accuracy but all possibilities
and their associated probabilities are known. Under conditions of uncertainty,
informed managerial decisions are possible. Experience, insight, and prudence allow
managers to devise strategies for minimizing the chance of failing to meet business
objectives. Although luck still plays a role in determining ultimate success,
managers can deal effectively with an uncertain decision environment by limiting the
scope of individual projects and developing contingency plans for dealing with
failure.
Q17.2
Domestic investors sometimes miss out on better investment opportunities available

to global investors. At the same time, global investors face special risks. Discuss
some of the special risks faced by global investors.
Q17.2
ANSWER
Cultural risk is borne by companies that pursue a global investment strategy. Product
market differences due to distinctive social customs make it difficult to predict which
products might do well in foreign markets. For example, breakfast cereal is
extremely popular and one of the most profitable industries in the United States,
Canada, and the United Kingdom. However, in France, Germany, Italy, and many
other foreign countries, breakfast cereal is less popular and less profitable. In
business terms, breakfast cereal doesn't "travel" as well as U.S.-made entertainment
like movies and television programming.
Presented by Suong Jian & Liu Yan, MGMT Panel , Guangdong University of Finance.
- 496 -
Risk Analysis
Currency risk is another important danger facing global businesses because
most companies wish to eventually repatriate foreign earnings back to the domestic
parent. When the U.S. dollar rises in value against foreign currencies such as the
Canadian dollar, foreign profits translate into fewer U.S. dollars. Conversely, when
the U.S. dollar falls in value against the Canadian dollar, profits earned in Canada
translate into more U.S. dollars. Because price swings in the relative value of
currencies are unpredictable and can be significant, many multinational firms hedge
against currency price swings using financial derivatives in the foreign currency
market. This hedging is not only expensive but can be risky during volatile markets.
Global investors also experience government policy risk because foreign
government grants of monopoly franchises, tax abatements, and favored trade status
can be tenuous. In the "global friendly" 1990s, many corporate investors seem to
have forgotten the widespread confiscations of private property owned by U.S.
corporations in Mexico, Cuba, Libya, the former Soviet Union, and in a host of other
countries. Expropriation risk, or the risk that business property located abroad might
be seized by host governments, is a risk that global investors must not forget. During
every decade of the twentieth century, U.S. and other multinational corporations have
suffered from expropriation and probably will in the years ahead.
Q17.3
The standard deviation measure of risk implicitly gives equal weight to variations on
both sides of the expected value. Can you see any potential limitations of this
treatment?
Q17.3
ANSWER
Yes. If investors had a constant marginal utility for money, then random gains, the
segment of the probability distribution to the right of the expected value, would be
weighted equally with random losses, the segment of the distribution to the left of the
expected value. This equality of random gains and losses would produce
indifference to risk, making formal risk analysis unnecessary. However, empirical
evidence argues that many, if not most, investors display investing behavior which
can only be described as risk averse. These investors place a greater weight on
downside versus upside return variation. This fact reduces the value of the standard
deviation measure as an indicator of risk.
Q17.4
State-run lotteries commonly pay out 50% of total lottery ticket sales in the form of
jackpots and prizes. Use the certainty equivalent concept to quantify the minimum
value placed on each risky dollar of expected return by lottery ticket buyers. Why
are such lotteries so popular?
- 497 -
Chapter 17
Q17.4
ANSWER
Any expected risky amount can be converted to an equivalent certain sum using the
certainty equivalent adjustment factor, , calculated as the ratio of a certain sum
divided by an expected risky amount, where both dollar values provide the same
level of utility. The certain sum numerator and expected return denominator may
vary in dollar terms, but they provide the exact same reward in terms of utility. In
the case of state-run lotteries, in which a certain sum of $1 (the lottery ticket price)
provides same utility as an expected risky return of 504, the certainty equivalent
adjustment factor = 2 = $1/$0.50. This means that the "price" of one dollar in risky
expected return is 504 in certain dollar terms.
Lotteries have proven wildly popular. This suggests that for small dollar
amounts many consumers are risk-seeking in their behavior. This is particularly true
in the case of the elderly and the uneducated. Apparently, such consumers place a
very high price on the small and unlikely chance of winning a substantial amount.
Q17.5
Graph the relation between money and its utility for an individual who buys both
household fire insurance and state lottery tickets.
Q17.5
ANSWER
In buying household fire insurance, this individual displays risk averse behavior
when faced with the small probability of a catastrophic loss. This implies a concaveto-the-origin relation between money and its utility at low levels of wealth.
Conversely, the purchase of state-run lottery tickets is consistent with risk seeking
behavior when faced with the small probability of a huge windfall gain -- given that
the amount placed at risk (the lottery ticket cost) is relatively insignificant. This
implies a convex-to-the-origin relation between money and its utility at high levels of
wealth.
- 498 -
Risk Analysis
Q17.6
When the basic valuation model is adjusted using the risk-free rate, i, what economic
factor is being explicitly accounted for?
Q17.6
ANSWER
When the basic valuation model is adjusted using the risk-free rate i, the time value
of money or cost of postponing consumption is being explicitly accounted for.
Q17.7
If the expected net present value of returns from an investment project is $50,000,
what is the maximum price that a risk-neutral investor would pay for it? Explain.
Q17.7
ANSWER
$50,000. A risk neutral investor places a maximum value on a project in an amount
exactly equal to the expected return. Therefore, risk neutral investors ignore risk in
project evaluation. If this seems anomalous, it is only because most studies find
investors are risk averse rather than risk neutral.
Q17.8
AMarket estimates of investors= reactions to risk cannot be measured precisely, so it

is impossible to set risk-adjusted discount rates for various classes of investment with
a high degree of precision.@ Discuss this statement.
- 499 -
Chapter 17
Q17.8
ANSWER
This statement has considerable validity. It is impossible to precisely measure an
individual=s attitude to risk, and the problem is further compounded by the
conceptual necessity of aggregating individual risk indifference curves to form a
market risk indifference curve. Further, even if it were possible to make the required
estimates at a given point in time, it would be difficult to use these estimates for
long-run planning purposes. Furthermore, investor attitudes to risk depend on
psychological factors which vary over time.
Despite these practical difficulties, the logic of the concept is appealing, and
one must ask the question: Is it better to make subjective estimates and to construct
an imperfect set of risk-adjusted discount rates for use in evaluating assets with
different degrees of risk, or is it preferable to use a constant discount rate for all
projects? It is often preferable to make an admittedly imprecise estimate of the
appropriate risk-adjusted discount rate rather than to assume that no differences exist.
And finally, market estimates of investor attitudes toward risk can be inferred
for the firm as a whole based upon the values investors place on the firm=s debt and
equity securities. If the return offered bond and stockholders is too low given the
level of risk encountered, bond and stock prices will fall. If the return offered is high
given investor risk expectations, bond and stock prices will rise.
Q17.9
What is the value of decision trees in managerial decision making?
Q17.9
ANSWER
Decision trees are like road maps. They provide a means for plotting one=s
alternatives in a decision problem and determining where each alternative leads.
Q17.10
When is it most useful to use game theory in decision analysis?
Q17.10
ANSWER
The use of game theory is most appropriate in decision analysis when the
probabilities of various states of nature cannot be determined a priori with any high
degree of reliability, as well as when certain states of nature involve untenable
outcomes (e.g., bankruptcy). It is also useful in those situations where the state of
nature outcome is dependent, at least in part, on the decision makers= choice among
decision alternatives. For example, a decision to cut prices will often result in a
pricing response by competitors.
SELF-TEST PROBLEMS & SOLUTIONS

- 500 -
Risk Analysis
ST17.1
Certainty Equivalent Method. Courteney-Cox, Inc., is a Texas-based manufacturer

and distributor of components and replacement parts for the auto, machinery, farm,
and construction equipment industries. The company is presently funding a program
of capital investment that is necessary to reduce production costs and thereby meet
an onslaught of competition from low-cost suppliers located in Mexico and
throughout Latin America. Courteney-Cox has a limited amount of capital available
and must carefully weigh both the risks and potential rewards associated with
alternative investments. In particular, the company seeks to weigh the advantages
and disadvantages of a new investment project, project X, in light of two other
recently adopted investment projects, project Y and project Z:
Expected Cash Flows After Tax (CFAT)
Per Year
Year
Project X
Project Y
Project Z
2001
$10,000
$20,000
$0
2002
10,000
18,000
2,500
2003
10,000
16,000
5,000
2004
10,000
14,000
7,500
2005
10,000
12,000
10,000
2006
10,000
10,000
12,500
2007
10,000
8,000
15,000
2008
10,000
6,000
17,500
2009
10,000
4,000
20,000
2010
10,000
2,000
22,500
$91,131
$79,130
$60,000
$50,000
PV of Cash Flow @ 5%
Investment
Outlay in 2000:
$60,000
A.
Using a 5% risk-free rate, calculate the present value of expected cash flows
after tax (CFAT) for the ten-year life of project X.
B.
Calculate the minimum certainty equivalent adjustment factor for each

project=s CFAT that would justify investment in each project.
- 501 -
Chapter 17
C.
Assume that the management of Courteney-Cox is risk averse and uses the
certainty equivalent method in decision making. Is project X as attractive or
more attractive than projects Y and Z?
D.
If the company would not have been willing to invest more than $60,000 in
project Y nor more than $50,000 in project Z, should project X be undertaken?
ST17.1
SOLUTION
A.
Using a 5% risk-free rate, the present value of expected cash flows after tax (CFAT)
for the ten-year life of Project X is $77,217, calculated as follows:
Expected Cash Flows After Tax (CFAT) Per Year
PV of $1
PV of CFAT
Year
Project X
at 5%
at 5%
2001
$10,000
0.9524
$9,524
2002
10,000
0.9070
9,070
2003
10,000
0.8638
8,638
2004
10,000
0.8227
8,227
2005
10,000
0.7835
7,835
2006
10,000
0.7462
7,462
2007
10,000
0.7107
7,107
2008
10,000
0.6768
6,768
2009
10,000
0.6446
6,446
2010
10,000
0.6139
6,139
PV of Cash Flow @ 5%
B.
$77,217
To justify each investment alternative, the company must have a certainty equivalent
adjustment factor of at least X = 0.777 for project X, Y = 0.658 for project Y, and
Z = 0.632 for project Z, because:
Certain Sum
Expected Risky Sum
- 502 -
Risk Analysis
Investment Outlay (Opportunity cost)

Present Value CFAT
Project X
$60, 000
= 0.777
$77, 217
Project Y
$60, 000
= 0.658
$91,131
Project Z
$50, 000
= 0.632
$79,130
In other words, each risky dollar of expected profit contribution from project X must
be Aworth@ at least (valued as highly as) 77.74 in certain dollars to justify
investment. For project Y, each risky dollar must be worth at least 65.84 in certain
dollars; each risky dollar must be worth at least 63.24 to justify investment in project
Z.
C.
Given managerial risk aversion, project X is the least attractive investment because it
has the highest Aprice@ on each risky dollar of expected CFAT. In adopting projects
Y and Z, Courteney-Cox implicitly asserted that it is willing to pay between 63.24
(project Z) and 65.84 (project Y) per each expected dollar of CFAT.
- 503 -
Chapter 17
D.
No. If the prices described previously represent the maximum price the company is
willing to pay for such risky returns, then project X should not be undertaken.
ST17.2
Project Valuation. The Central Perk Coffee House, Inc., is engaged in an

aggressive store refurbishing program and is contemplating expansion of its in-store
baking facilities. This investment project is to be evaluated using the certainty
equivalent adjustment factor method and the risk-adjusted discount rate method. If
the project has a positive value when both methods are employed, the project will be
undertaken. The project will not be undertaken if either evaluation method suggests
that the investment will fail to increase the value of the firm. Expected cash flow
after tax (CFAT) values over the five-year life of the investment project and relevant
certainty equivalent adjustment factor information are as follows:
In-store Baking Facilities
Investment Project
Time
Period
(Years)
Alpha
Project
E(CFAT)
1.00
($75,000)
0.95
22,500
0.90
25,000
0.85
27,500
0.75
30,000
0.70
32,500
Total
$62,500
At the present time, an 8% annual rate of return can be obtained on short-term U.S.
government securities; the company uses this rate as an estimate of the risk-free rate
of return.
A.
Use the 8% risk-free rate to calculate the present value of the investment
project.
B.
Using this present value as a basis, utilize the certainty equivalent adjustment
factor information given previously to determine the risk-adjusted present
value of the project.
- 504 -
Risk Analysis
C.
Use an alternative risk-adjusted discount rate method of project valuation on

the assumption that a 15% rate of return is appropriate in light of the level of
risk undertaken.
D.
Compare and contrast your answers to parts B and C. Should the investment
be made?
ST17.2
SOLUTION
A.
The present value of this investment project can be calculated easily using a handheld calculator with typical financial function capabilities or by using the tables
found in Appendix A. Using the appropriate discount factors corresponding to an
8% risk-free rate, the present value of the investment project is calculated as follows:
Hot Food Carryout Counter Investment Project
Time
Period
(Years)
Present Value
of $1 at 8%
Project
E(CFAT)
Present Value
of E(CFAT)
at 8%
1.0000
($75,000)
($75,000)
0.9259
22,500
20,833
0.8573
25,000
21,433
0.7938
27,500
21,830
0.7350
30,000
22,050
0.6806
32,500
22,120
$62,500
$33,266
Total
B.
Using the present value given in part A as a basis, the certainty equivalent adjustment
factor information given previously can be employed to determine the risk-adjusted
present value of the project:
In-store Baking Facilities Investment Project
Time
Period
(Years)
Present Value
of $1 at 8%
Project
E(CFAT)
Present Value
of E(CFAT)
at 8%
Alpha
Risk-Adjusted
Value
1.0000
($75,000)
($75,000)
1.00
($75,000)
0.9259
22,500
20,833
0.95
19,791
- 505 -
Chapter 17

Time
Period
(Years)
2
Present Value
of $1 at 8%
0.8573
Project
E(CFAT)
25,000
Present Value
of E(CFAT)
at 8%
21,433
Alpha
0.90
Risk-Adjusted
Value
19,290
0.7938
27,500
21,830
0.85
18,556
0.7350
30,000
22,050
0.75
16,538
0.6806
32,500
22,120
0.70
$62,500
$33,266
Total
C.
15,484
$14,659
An alternative risk-adjusted discount rate method of project valuation based on a

15% rate of return gives the following project valuation:
Time
Period
(Years)
0
1
2
3
4
5
Total
D.
Present Value
of $1 at 15%
1.0000
0.8696
0.7561
0.6575
0.5718
0.4972
Project
E(CFAT)
($75,000)
22,500
25,000
27,500
30,000
32,500
$62,500
Present Value of
E(CFAT) at 15%
($75,000)
19,566
18,903
18,081
17,154
16,159
$14,863
The answers to parts B and C are fully compatible; both suggest a positive riskadjusted present value for the project. In part B, the certainty equivalent adjustment
factor method reduces the present value of future receipts to account for risk
differences. As is typical, the example assumes that money to be received in the
more distant future has a greater risk, and hence, a lesser certainty equivalent value.
In the risk-adjusted discount rate approach of part C, the discount rate of 15% entails
a time-factor adjustment of 8% plus a risk adjustment of 7%. Like the certainty
equivalent adjustment factor approach, the risk-adjusted discount rate method gives a
risk-adjusted present value for the project. Because the risk-adjusted present value of
the project is positive under either approach, the investment should be made.
- 506 -
Risk Analysis
PROBLEMS & SOLUTIONS
P17.1
Risk Preferences. Identify each of the following as being consistent with risk-averse,
risk-neutral, or risk-seeking behavior in investment project selection. Explain your
answers.
A.
Larger risk premiums for riskier projects
B.
Preference for smaller, as opposed to larger, coefficients of variation
C.
Valuing certain sums and expected risky sums of equal dollar amounts equally
D.
Having an increasing marginal utility of money
E.
Ignoring the risk levels of investment alternatives
P17.1
SOLUTION
A.
Risk-averse investors demand higher risk premiums as project risk levels increase.
B.
Risk-averse investors place a relatively low value on small probabilities of a high

payoff. As a result, they prefer a lower standard deviation in project returns, holding
expected return constant, and, therefore, lower as opposed to higher coefficients of
variation (risk-reward ratios).
C.
Risk-neutrality implies that a given decision maker places a value on an investment

project that is just equal to the project expected return. Therefore, certain sums and
expected risky sums of equal dollar amounts are valued equally.
D.
Risk-seeking investors display behavior consistent with an increasing marginal utility

of money. because increases in income or wealth provide more than proportionate
increases in well-being, these individuals display very aggressive investment
behavior.
E.
Risk-neutrality results in a value being placed on individual projects equal to their

expected return, irrespective of the underlying variability in returns.
P17.2
Certainty Equivalents. The certainty equivalent concept can be widely employed in

the analysis of personal and business decision making. Indicate whether each of the
following statements is true or false and explain why:
- 507 -
Chapter 17
A.
The appropriate certainty equivalent adjustment factor, , indicates the

minimum price in certain dollars that an individual should be willing to pay
per risky dollar of expected return.
B.
An 1 implies that a certain sum and a risky expected return of different

dollar amounts provide equivalent utility to a given decision maker.
C.
If previously accepted projects with similar risk have s in a range from =

0.4 to = 0.5, an investment with an expected return of $150,000 is acceptable
at a cost of $50,000.
D.
A project for which NPV > 0 using an appropriate risk-adjusted discount rate
has an implied factor that is too large to allow project acceptance.
E.
State lotteries that pay out 50% of the revenues that they generate require
players who place at least a certain $2 value on each $1 of expected risky
return.
P17.2
SOLUTION
A.
False. The certainty equivalent adjustment factor indicates the maximum price in
certain dollars that an individual is willing to pay per risky dollar of expected return.
B.
True. The factor is the ratio of a certain sum divided by an expected risky amount
that are equivalent in terms of utility, but may differ in strict dollar terms, as in the
case of 1.
C.
True. If similar projects implicitly involve =s in a range from = 0.4 to = 0.5,

then the maximum certain sum equivalent of an expected risky $150,000 falls in the
range between $60,000 (= 0.4 $150,000) and $75,000 (= 0.5 $150,000), because:
Certain sum
Certain sum
Expected risky amount
= Expected risky amount
- 508 -
Risk Analysis
Therefore, a project cost of $50,000 would not only be acceptable, but represents a
bargain!
D.
False. A project which has NPV > 0 using the risk adjusted discount rate approach
has an factor below the maximum acceptable level. Such a project will be
desirable, because it has a Aprice per risky dollar of return@ below that necessary to
induce investment.
E.
True. State lotteries that pay back 50% of the amount bet involve players who have
an 2.
P17.3
Expected Value. Perry Chandler, a broker with Caveat Emptor, Ltd., offers free
investment seminars to local PTA groups. On average, Chandler expects 1% of
seminar participants to purchase $25,000 in tax-sheltered investments and 5% to
purchase $5,000 in stocks and bonds. Chandler earns a 4% net commission on tax
shelters and a 1% commission on stocks and bonds. Calculate Chandler=s expected
net commissions per seminar if attendance averages ten persons.
P17.3
SOLUTION
A.
Expected net commissions will be the sum of net commissions on tax shelters (TS)
and stocks and bonds (S&B).
E(NCTS) = Expected Sales Commission Rate
= (0.01)($25,000)(10) (0.04)
= $100
E(NCS&B) = Expected Sales Commission Rate
= (0.05)($5,000)(10) (0.01)
= $25
E(NC) = E(NCTS) + E(NCS&B)
= $100 + $25
= $125
- 509 -
Chapter 17
P17.4
Probability Concepts. Aquarius Products, Inc., has just completed development of a

new line of skin-care products. Preliminary market research indicate two feasible
marketing strategies: (1) creating general consumer acceptance through media
advertising or (2) creating distributor acceptance through intensive personal selling.
Sales estimates for under each marketing alternative are:
Media Advertising
Personal Selling
Strategy
P17.4
Strategy
Probability
Sales
Probability
Sales
0.1
$500,000
0.3
$1,000,000
0.4
1,500,000
0.4
1,500,000
0.4
2,500,000
0.3
2,000,000
0.1
3,500,000
A.
Assume that the company has a 50% profit margin on sales (that is, profits
equal one-half of sales revenue). Calculate expected profits for each plan.
B.
Construct a simple bar graph of the possible profit outcomes for each plan.
Which plan appears to be riskier?
C.
Assume that management=s utility function resembles the one illustrated in the
following figure. Calculate expected utility for each strategy. Which strategy
should the marketing manager recommend?
SOLUTION
A.
- 510 -
Risk Analysis
Media Advertising Strategy

Probability
Sales
Profit
(1)
(2)
(3) = (2) 0.5
0.1
$500,000
$250,000
$25,000
0.4
1,500,000
750,000
300,000
0.4
2,500,000
1,250,000
500,000
0.1
3,500,000
1,750,000
175,000
(4) = (3) (1)
E(MA) = $1,000,000
1.0
Personal Selling Strategy
Probability
Sales
Profit
(1)
(2)
(3) = (2) 0.5
0.3
$1,000,000
$500,000
$150,000
0.4
1,500,000
750,000
300,000
0.3
2,000,000
1,000,000
300,000
1.0
(4) = (3) (1)
E(PS) = $750,000
- 511 -
Chapter 17
B.
The media advertising strategy appears more risky than the personal selling strategy
because of the greater variability of possible outcomes.
- 512 -
Risk Analysis
C.
Media Advertising Strategy
Probability
Profits
Utils
(1)
(2)
(3)
0.1
$250,000
50.0
0.4
750,000
82.5
33
0.4
1,250,000
95.0
38
0.1
1,750,000
100.0
10
1.0
(4) = (3) (1)
E(U) = 86
Personal Selling Strategy
Probability
Profits
Utils
(1)
(2)
(3)
0.3
$500,000
70.0
21
0.4
750,000
82.5
33
0.3
1,000,000
90.0
27
1.0
(4) = (3) (1)
E(U) = 81
The marketing manager should recommend the media advertising strategy because of
its higher expected utility. In this instance, the higher expected profit of this strategy
more than offsets its greater risk.
P17.5
Probability Concepts. Phoebe Buffay, marketing director for Narcissism Records,

Inc., has just completed an agreement to re-release a recording of AThe Boss=s
Greatest Hits.@ (The Boss had a number of hits on the rock and roll charts during
the early 1980s.) Preliminary market research indicates two feasible marketing
strategies: (1) concentration on developing general consumer acceptance by
advertising on late-night television or (2) concentration on developing distributor
acceptance through intensive sales calls by company representatives. Buffay
developed estimates for sales under each alternative plan and has constructed payoff
- 513 -
Chapter 17
matrices according to his assessment of the likelihood of product acceptance under
each plan. These data are as follows:
Strategy 1
Strategy 2
Consumer Television Promotion
Distributor Oriented Promotion
Probability
Outcome (Sales)
Probability
Outcome (Sales)
0.32
$250,000
0.125
$250,000
0.36
1,000,000
0.750
750,000
0.32
1,750,000
0.125
1,250,000
A.
Assuming that the company has a 50% profit margin on sales, calculate the
expected profits for each plan.
B.
Construct a simple bar graph of the possible profit outcomes for each plan.
Which plan appears to be riskier?
C.
Calculate the standard deviation of the profit distribution associated with each
plan.
Assume that the management of Narcissism has a utility function like the one
illustrated in the following figure. Which marketing strategy should Buffay
recommend?
D.
P17.5
SOLUTION
- 514 -
Risk Analysis
A.
Strategy 1: Consumer-Oriented Promotion
Outcomes
Expected
Probability
(Sales)
Profit
Profit
(1)
(2)
(3) = (2) 0.5
(4) = (3) (1)
0.32
$250,000
$125,000
$40,000
0.36
1,000,000
500,000
180,000
0.32
1,750,000
875,000
280,000
E(1) = $500,000
Strategy 2: Distributor-Oriented Promotion

Outcomes
Expected
- 515 -
Chapter 17
Probability
(Sales)
Profit
Profit
(1)
(2)
(3) = (2) 0.5
(4) = (3) (1)
0.125
$250,000
$125,000
$15,625
0.750
750,000
375,000
281,250
0.125
1,250,000
625,000
78,125
E(2) = $375,000
B.
- 516 -
Risk Analysis
Strategy 1 appears more risky than Strategy 2 due to the greater variability of
outcomes.
C.
Strategy 1
Probability
Deviations
(Deviations)2
Variance
(1)
(2)
(3)
(4) = (1) (3)
0.32
-$375,000
$1.406 1011
$4.5 1010
0.36
0.32
375,000
11
1.406 10
4.5 1010
10
12 = 9 10
Standard deviation = 1 =
9 x 1010
= $300,000
- 517 -
Chapter 17
Coefficient
= V = 1/E(R1) = 0.6
of Variation
Strategy 2
Probability
Deviations
(Deviations)2
Variance
(1)
(2)
(3)
(4) = (1) (3)
0.125
-$250,000
$6.25 1010
$7.813 109
0.750
0.125
6.25 10
250,000
10
7.813 109
10
22 = 1.563 10
1.563 x 1010 = $125,000
Standard deviation = 2 =
Coefficient
of Variation
= V = 2/E(R2) = 0.33
A comparison of the standard deviations and coefficients of variation for each

strategy confirms that Strategy 1 is the more risky promotional strategy.
D.
Strategy 1
Expected
Probability
Profits
Utils
Utility
(1)
(2)
(3)
(4) = (3) (1)
0.32
$125,000
750
240
0.36
500,000
1,300
468
0.32
875,000
1,450
464
1,172 utils
Strategy 2
- 518 -
Risk Analysis
Expected
Probability
Profits
Utils
Utility
(1)
(2)
(3)
(4) = (3) (1)
0.125
$125,000
750
93.75
0.750
375,000
1,200
900.00
0.125
625,000
1,350
168.75
1,162.50 utils
The marketing manager should recommend Strategy 1 because of its slightly

higher expected utility. In this instance, the higher expected profit of Strategy 1
more than offsets its greater riskiness.
P17.6
Risk-Adjusted Discount Rates. One-Hour Dryclean, Inc., is contemplating

replacing an obsolete dry cleaning machine with one of two innovative pieces of
equipment. Alternative 1 requires a current investment outlay of $25,373, whereas
alternative 2 requires an outlay of $24,199. The following cash flows (cost savings)
will be generated each year over the new machines= four-year lives:
Alternative 1
Alternative 2
Probability
Cash Flow
0.18
$5,000
0.64
10,000
0.18
15,000
0.125
$8,000
0.75
10,000
0.125
12,000
A.
Calculate the expected cash flow for each investment alternative.
B.
Calculate the standard deviation of cash flows (risk) for each investment
alternative.
C.
The firm will use a discount rate of 12% for the cash flows with a higher
degree of dispersion and a 10% rate for the less risky cash flows. Calculate
- 519 -
Chapter 17
the expected net present value for each investment. Which alternative should
be chosen?
P17.6
A.
SOLUTION
Expected values of cash flows
Probability
Cash Flow
(1)
(2)
0.18
$5,000
$900
0.64
10,000
6,400
0.18
15,000
2,700
Alternative 1
(3) = (1) (2)
E(CF1) = $10,000
Alternative 2
0.125
$8,000
$1,000
0.75
10,000
7,500
0.125
12,000
1,500
E(CF2) = $10,000
B.
The relevant standard deviations of cash flows are:

Probability
Deviation
Deviation2
(1)
(2)
(3)
Alternative 1
(4) = (1) (3)

7
0.18
-$5,000
2.5 10
0.64
0.18
5,000
2.5 107
$4,500,000
0
4,500,000
12 = $9,000,000
1 =
=
12
$9, 000, 000
- 520 -
Risk Analysis
= $3,000
- 521 -
Chapter 17
Probability
Deviation
Deviation2
(1)
(2)
(3)
Alternative 2
(4) = (1) (3)

6
0.125
-$2,000
4 10
0.75
0.125
2,000
4 106
$500,000
0
500,000
22 = $1,000,000
2 =
22
$1, 000, 000
= $1,000
Thus, alternative 2 is the less risky investment.
C.
Alternative 1 is riskier because it has the greater variability in its probable cash flows.
This is obvious from an inspection of the distributions of possible returns and is
verified by calculating the standard deviations. Hence, alternative 1 is evaluated at
the 12% cost of capital, while alternative 2 requires a 10% cost of capital.
$10, 000
- $25,373
t
t=1 (1.12)
4
NPV1
= $10,000(PVIFA, n = 4, i = 12%) - $25,373

= $10,000(3.0373) - $25,373
= $5,000
- 522 -
Risk Analysis
$10, 000
- $24,199
t
t=1 (1.10)
4
NPV2
= $10,000(PVIFA, n = 4, i = 10%) - $24,199

= $10,000(3.1699) - $24,199
= $7,500
The less risky Alternative 2 has the higher risk-adjusted net present value, and,
therefore, is the more attractive investment.
P17.7
Certainty Equivalent Method. Tex-Mex, Inc., is a rapidly growing chain of Mexican

food restaurants. The company has a limited amount of capital for expansion and
must carefully weigh available alternatives. Currently, the company is considering
opening restaurants in Santa Fe or Albuquerque, New Mexico. Projections for the
two potential outlets are as follows:
Annual Profit
City
Albuquerque
Santa Fe
Outcome
Contribution
Probability
Failure
$100,000
0.5
Success
200,000
0.5
Failure
$60,000
0.5
Success
340,000
0.5
Each restaurant would require a capital expenditure of $700,000, plus land

acquisition costs of $500,000 for Albuquerque and $1 million for Santa Fe. The
company uses the 10% yield on riskless U.S. Treasury bills to calculate the risk-free
annual opportunity cost of investment capital.
A.
Calculate the expected value, standard deviation, and coefficient of variation

for each outlet=s profit contribution.
B.
Calculate the minimum certainty equivalent adjustment factor for each

restaurant=s cash flows that would justify investment in each outlet.
- 523 -
Chapter 17
Assuming that the management of Tex-Mex is risk averse and uses the certainty
equivalent method in decision making, which is the more attractive outlet?
Why?
C.
P17.7
SOLUTION
A.
Albuquerque
E(A) = $100,000(0.5) + $200,000(0.5) = $150,000
A =
($100, 000 - $150, 000) (0.5)

2
+ ($200, 000 - $150, 000) (0.5)

= $50,000
VA = A/E(A) = 0.33
Santa Fe
E(SF) = $60,000(0.5) + $340,000(0.5) = $200,000
SF =
($60, 000 - $200, 000) 2(0.5)

+ ($340, 000 - $200, 000) 2(0.5)
= $140,000
VSF = SF/E(SF) = 0.7
To justify each investment alternative, the company must have a certainty equivalent
adjustment factor of at least = 0.8 for the Albuquerque project and = 0.85 for the
Santa Fe project because:
B.
Certain Sum
Expected Risky Sum
- 524 -
Risk Analysis
Certain Cash Flow Foregone per year (Opportunity cost)

Expected Profit contribution per year (E( ))
Albuquerque
A =
0.1($1, 200, 000)

$150, 000
= 0.8
Santa Fe
SF =
0.1($1, 700, 000)

$200, 000
= 0.85
In words, each risky dollar of expected profit contribution from the Albuquerque
outlet must be Aworth@ at least (valued as highly as) 804 in certain dollars to justify
investment. For the Santa Fe outlet, each risky dollar must be worth at least 854 in
certain dollars.
C.
Given managerial risk aversion, Albuquerque is the more attractive outlet because it
has a lower risk, A < SF and VA < VSF, and is also less expensive in terms of the
Aprice@ of each risky dollar of expected profit contribution. A risk-averse
management wouldn=t pay 854 for each risky dollar of expected profit contribution
from a Santa Fe outlet, when less risky expected returns from an Albuquerque outlet
Acost@ only 804.
P17.8
Decision Trees. Keystone Manufacturing, Inc., is analyzing a new bid to supply the
company with electronic control systems. Alpha Corporation has been supplying the
systems and Keystone is satisfied with its performance. However, a bid has just been
received from Beta Controls, Ltd., a firm that is aggressively marketing its products.
Beta has offered to supply systems for a price of $120,000. The price for the Alpha
system is $160,000. In addition to an attractive price, Beta offers a money-back
guarantee. That is, if Beta=s systems do not match Alpha=s quality, Keystone can
- 525 -
Chapter 17
reject and return them for a full refund. However, if it must reject the machines and
return them to Beta, Keystone will suffer a delay costing the firm $60,000.
P17.8
A.
A.
Construct a decision tree for this problem and determine the maximum
probability that Keystone could assign to rejection of the Beta system before it
would reject that firm=s offer, assuming that it decides on the basis of
minimizing expected costs.
B.
Assume that Keystone assigns a 50% probability of rejection to Beta Controls.

Would Keystone be willing to pay $15,000 for an assurance bond that would
pay $60,000 in the event that Beta Controls fails the quality check? (Use the
same objective as in part A.) Explain.
SOLUTION
The maximum probability of rejection that could be assigned to the Beta
control system is the probability that makes the expected cost equal for the two
alternatives.
Expected Beta Cost
= Alpha cost
(1 - Pr)($120,000) + Pr($220,000)
= $160,000
$120,000 - $120,000Pr + $220,000Pr
= $160,000
$100,000Pr
Pr
= $40,000
= 0.4 or 40%
If there is greater than 40% probability of Beta=s control system failing to pass the
quality control inspection, then Keystone would choose to accept the bid from Alpha.
The decision tree for this decision problem is as follows:
- 526 -
Risk Analysis
B.
Yes, to illustrate the advantage of an assurance bond, simply compare expected costs
under each decision alternative. Without the assurance bond expected costs are:
E(CA) = $160,000
E(CB) = 0.5($120,000) + 0.5($220,000) = $170,000.
Without the assurance bond, purchasing from Alpha has the lower expected cost. If
the bond is purchased, only the expected cost of purchase from Beta changes. This
expected cost would now be calculated as:
E(CB) = $15,000 + 0.5($120,000) + 0.5($160,000) = $155,000.
Thus, ordering the control from Beta with the assurance bond has the lower expected
cost.
P17.9
Standard Normal Concept. Speedy Business Cards, Inc., supplies customized

business cards to commercial and individual customers. The company is preparing a
bid to supply cards to the Nationwide Realty Company, a large association of
independent real estate agents. Because paper, ink, and other costs cannot be
determined precisely, Speedy anticipates that costs will be normally distributed
- 527 -
Chapter 17
around a mean of $20 per unit (each 500-card order) with a standard deviation of $2
per unit.
A. What is the probability that Speedy will make a profit at a price of $20 per unit?
B.
Calculate the unit price necessary to give Speedy a 95% chance of making a
profit on the order.
C.
If Speedy submits a successful bid of $23 per unit, what is the probability that it
will make a profit?
P17.9
SOLUTION
A.
If printing costs are normally distributed around a mean of $20 per unit, there is a
50/50 or 50% chance that actual costs will be above or below that amount. This
means that there is a 50/50 or 50% chance that revenues will exceed costs and,
therefore, that Speedy will make a profit at a price of $20.
B.
Using the standardized normal formula, this occurs at a z value of 1.645. This
implies a price of $23.29 because:
x-
1.645
$3.29
= P - $20
= $23.29
P - $20
$2
In order to have a 95% chance of making a profit, 95% of the area under the normal
curve describing the distribution of costs per unit must lie to the left of price.
Graphically,
- 528 -
Risk Analysis
- 529 -
Chapter 17
C.
With a price of $23, Speedy=s winning bid is 1.5 (= $3/$2) standard deviations
higher than expected costs. From the normal distribution, there is a 0.5 + 0.4332 =
93.32% probability that Speedy will be able to make a profit at a price of $23 per unit.
P17.10
Game Theory. Sierra Mountain Bike, Inc., is a producer and wholesaler of rugged
bicycles designed for mountain touring. The company is considering an upgrade to
its current line by making high-grade chrome alloy frames standard. Of course, the
market response to this upgrade in product quality depends on the competitor=s
reaction, if any. The company=s comptroller projects the following annual profits
(payoffs) following resolution of the upgrade decision:
States of Nature
Sierra=s
Decision
No
Competitor
Competitor
- 530 -
Risk Analysis
Alternatives
Upgrade
Do not upgrade
Upgrade
Upgrade
$1,000,000
$1,500,000
800,000
2,000,000
A.
Which decision alternative would Sierra choose given a maximin criterion?

Explain.
B.
Calculate the opportunity loss or regret matrix.
C.
Which decision alternative would Sierra choose given a minimax regret

criterion? Explain.
P17.10
SOLUTION
A.
The maximin decision strategy is to choose the decision alternative with the Abest@
worst outcome to avoid even the possibility of the worst state of nature being
encountered. In this problem, the no upgrade decision involves the possibility of an
$800,000 payoff under the worse case scenario. This worse case outcome can be
avoided with an upgrade decision, the maximin strategy.
B.
The opportunity loss or regret matrix is:
State of Nature
Decision Alternatives
1. Competitor
Upgrade
2. No Competitor
Upgrade
A. Upgrade Decision
$0
$500,000
(= $1,000,000
(= $2,000,000
- $1,000,000)
-$1,500,000)
$200,000
$0
(= $1,000,000
(= $2,000,000
- $800,000)
- $2,000,000)
B. No Upgrade Decision
- 531 -
Chapter 17
C.
The minimax decision strategy is to choose the decision alternative that will
minimize the maximum opportunity loss or regret. In this problem, the maximum
possible regret is associated with the upgrade decision. This maximum possible
regret can be avoided by choosing the no upgrade decision, the minimax strategy.
CASE STUDY FOR CHAPTER 17

Stock-Price Beta Estimation for the Royal Dutch Petroleum Company
Statisticians use the Greek letter beta to signify the slope coefficient in a linear relation.
Financial economists use this same Greek letter to signify stock-price risk because betas are
the slope coefficients in a simple linear relation that links the return on an individual stock to the
return on the overall market in the capital asset pricing model (CAPM). In the CAPM, the
security characteristic line shows the simple linear relation between the return on individual
securities and the overall market at every point in time :
R it = i + i R Mt + i , where Rit is the rate of return on an individual security i during period t,
the intercept term is described by the Greek letter (alpha), the slope
coefficient is the Greek letter (beta) and signifies systematic risk (as before), and the random
disturbance or error term is depicted by the Greek letter (epsilon). At any point in time, the
random disturbance term has an expected value of zero. This means that the expected return
on an individual stock is determined by and .
The slope coefficient shows the anticipated effect on an individual security=s rate of
return following a 1% change in the market index. If = 1.5, then a 1% rise in the market
would lead to a 1.5% hike in the stock price, a 2% boost in the market would lead to a 3% jump
in the stock price, and so on. If = 0, then the rate of return on an individual stock is totally
unrelated to the overall market. The intercept term shows the anticipated rate of return when
either = 0 or RM = 0. When > 0, investors enjoy positive abnormal returns. When < 0,
investors suffer negative abnormal returns. Investors would celebrate a mutual fund manager
whose portfolio consistently generated positive abnormal returns ( > 0). They would fire
portfolio managers that consistently suffered negative abnormal returns ( < 0). In a perfectly
efficient capital market, the CAPM asserts that investor rates of return would be solely
determined by systematic risk and both alpha and epsilon would equal zero, = = 0.
Figure 17.8 here
As shown in Figure 17.8, managers and investors can estimate beta for individual stocks
by using a simple ordinary least-squares regression model. In this simple regression model, the
dependent Y-variable is the rate of return on an individual stock, and the independent X-variable
is the rate of return on an appropriate market index. Within this context, changes in the stock
market rate of return are said to cause changes in the rate of return on an individual stock. In
- 532 -
Risk Analysis
this example, beta is estimated for the Royal Dutch Petroleum Company (ticker symbol: RD), the
holding company for the Royal Dutch/Shell Group of Companies. Present in more than 145
countries and territories worldwide, the Royal Dutch/Shell Group of Companies are engaged in
the business of exploration and production of natural gas, electric power, oil products,
chemicals and related products. The price data used to estimate beta for RD were downloaded
for free from the Internet at the Yahoo! Finance Web site (http://finance.yahoo.com/q/hp?s=RD).
Monthly returns for RD and for the Standard & Poor=s 500 were analyzed over a five-year
period (60 observations), as shown in Table 17.7.
In this case, as predicted by the CAPM, = 0.0021 .0. During a typical month when the
overall market return is zero (essentially flat), the return for RD common stockholders is
expected to be zero as well. The slope coefficient = 0.6892 is statistically significant (t = 5.47).
There is a meaningful empirical relationship between movement in the overall market and RD
stock, at least on a statistical basis. Because < 1, RD is less volatile than the overall market.
During a month when the overall market rises by 1%, RD can be expected to rise by 0.69%;
during a month when the market falls by 1%, RD can be expected to fall by 0.69%.
Table 17.7 here
The usefulness of betas as risk measures can be undermined by the fact that the simple
linear model used to estimate stock-price beta fails to include other important systematic
influences on stock market volatility. In the case of RD, for example, R2 information shown in
Figure 17.8 indicates that only 34.03% of the total variation in RD returns can be explained by
variation in the overall market. This means that 65.97% of the variation in weekly returns for
RD stock is unexplained by such a simple regression model. Although the amount of explained
variation is statistically significant, it may not be economically meaningful in the sense of
providing investors with consistently useful risk information.
A.
Describe some of the attributes of an ideal risk indicator for stock market investors.
B.
On the Internet, go to Yahoo! Finance (or msnMoney) and download weekly price
information over the past year (52 observations) for RD and the S&P 500. Then, enter this
information in a spreadsheet like Table 17.7 and use these data to estimate RD=s beta. Describe
any similarities or dissimilarities between your estimation results and the results depicted in
Figure 17.8.
Estimates of stock-price beta are known to vary according to the time frame analyzed;
C.
length of the daily, weekly, monthly, or annual return period; choice of market index; bull or
bear market environment; and other nonmarket risk factors. Explain how such influence can
undermine the usefulness of beta as a risk indicator. Suggest practical solutions.
CASE STUDY SOLUTION
- 533 -
Chapter 17
A.
An ideal measure of stock market risk would be simple to derive, accurate and
consistent from one year to another. With an ideal risk measure, investors are able to control the
risk exposure faced during volatile markets with well-targeted and well-timed investment
buy/sell decisions. For example, suppose an elderly investor wants to maintain an exposure to
the equity markets during retirement, but wants to limit risk to regulate the possibility of
devastating losses. With an ideal risk measure, retired investors could precisely tilt portfolio
allocation toward securities with low risk characteristics. Alternatively, if an investor
anticipated a surge in stock prices following a decline in interest rates, precise risk measures
could help such an investor tilt an investment portfolio toward more volatile stocks.
The usefulness of stock market risk indicators diminishes to the extent that they
fail to provide accurate and consistent measures of risk exposure from one year to
another. In fact, an important limitation of risk estimators derived from the CAPM is
that they vary from one period to another in ways that prove highly unpredictable.
When betas vary from one year to another in ways that are essentially random and
unpredictable, betas fail to provide investors with a risk assessment tool that can be
used to effectively manage portfolio risk.
B.
It will be a real eye-opener to students when they estimate stock-price beta for RD
over a more recent time period using weekly returns and compare those results with the beta
estimate derived from the monthly returns reported in Table 17.7 for the June, 1999 to June,
2004 time period, as shown in Figure 17.8. Stock-price beta estimates often vary markedly
depending upon the time frame analyzed, and according to the daily, weekly, monthly, or annual
return interval examined. Such differences, if severe, can undermine the credibility of stockprice betas as useful risk indicators.
C.
Empirical estimates of stock-price beta are known to vary according to the time
frame analyzed; length of the daily, weekly, monthly, or annual return period; choice of market
index; bull or bear market environment; and other nonmarket risk factors. For example,
estimates of beta tend to be imperfect risk measures because return volatility for the overall
market is very difficult to measure. On the nightly news, when commentators talk about the
market being up or down, they often refer to moves in the DJIA. Whereas the DJIA offers good
insight concerning changes in the prices of large blue chip companies, it offers little insight
concerning volatility in the returns earned by investors in smaller high-tech stocks. From the
perspective of many individual and institutional investors, the S&P 500 Index gives superior
insight concerning moves in the overall market, but like the DJIA, the S&P 500 is dominated by
large blue chip companies. Although the Nasdaq and Russell 2000 indexes are popular
measures of high-tech and smaller stocks, they are much less informative about changes in the
overall market. While there is a high degree of correlation in rates of return earned on the DJIA,
S&P 500, Nasdaq, and Russell 2000 indexes, slight differences can have big effects on beta
estimates.
- 534 -
Risk Analysis
From a theoretical perspective, the most appropriate benchmark would be a

market index that included all capital assets, including stocks, bonds, real estate,
collectibles, and so on. Unfortunately, no such market index is available. To greater
or lesser degree, this affects the accuracy of all beta estimates and undermines
confidence in beta as an accurate measure of security risk. Another important
problem faced in obtaining consistent and reliable beta estimates is the fact that beta
estimates are sensitive to the length of time over which stock return data are
measured. When beta estimates differ according to daily, weekly, monthly or annual
returns, the usefulness of stock-price beta as a consistent measure of risk is greatly
diminished.
The presence of market index bias and return interval bias, among other
problems, makes it imperative that beta comparisons among individual companies
reflect identical estimation periods, return intervals, and appropriate market
benchmarks.
- 535 -

Risk Analysis: Questions & Answers Q17.1 Q17.1 ANSWER

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Risk Analysis: Questions & Answers Q17.1 Q17.1 ANSWER

Uploaded by

Copyright:

Available Formats

Chapter 17

QUESTIONS & ANSWERS

In economic terms, what is the difference between risk and uncertainty?

Domestic investors sometimes miss out on better investment opportunities available

AMarket estimates of investors= reactions to risk cannot be measured precisely, so it

What is the value of decision trees in managerial decision making?

When is it most useful to use game theory in decision analysis?

SELF-TEST PROBLEMS & SOLUTIONS

Certainty Equivalent Method. Courteney-Cox, Inc., is a Texas-based manufacturer

Calculate the minimum certainty equivalent adjustment factor for each

Investment Outlay (Opportunity cost)

Project Valuation. The Central Perk Coffee House, Inc., is engaged in an

Use an alternative risk-adjusted discount rate method of project valuation on

In-store Baking Facilities Investment Project

An alternative risk-adjusted discount rate method of project valuation based on a

Larger risk premiums for riskier projects

Preference for smaller, as opposed to larger, coefficients of variation

Having an increasing marginal utility of money

Ignoring the risk levels of investment alternatives

Risk-averse investors place a relatively low value on small probabilities of a high

Risk-neutrality implies that a given decision maker places a value on an investment

Risk-seeking investors display behavior consistent with an increasing marginal utility

Risk-neutrality results in a value being placed on individual projects equal to their

Certainty Equivalents. The certainty equivalent concept can be widely employed in

The appropriate certainty equivalent adjustment factor, , indicates the

An 1 implies that a certain sum and a risky expected return of different

If previously accepted projects with similar risk have s in a range from =

True. If similar projects implicitly involve =s in a range from = 0.4 to = 0.5,

= Expected risky amount

Probability Concepts. Aquarius Products, Inc., has just completed development of a

Media Advertising Strategy

(3) = (2) 0.5

(4) = (3) (1)

(3) = (2) 0.5

(4) = (3) (1)

(4) = (3) (1)

(4) = (3) (1)

Probability Concepts. Phoebe Buffay, marketing director for Narcissism Records,

Consumer Television Promotion

Distributor Oriented Promotion

(3) = (2) 0.5

(4) = (3) (1)

Strategy 2: Distributor-Oriented Promotion

(3) = (2) 0.5

(4) = (3) (1)

(4) = (1) (3)

(4) = (1) (3)

1.563 x 1010 = $125,000

A comparison of the standard deviations and coefficients of variation for each

(4) = (3) (1)

(4) = (3) (1)

The marketing manager should recommend Strategy 1 because of its slightly

Risk-Adjusted Discount Rates. One-Hour Dryclean, Inc., is contemplating

Calculate the expected cash flow for each investment alternative.

(3) = (1) (2)

The relevant standard deviations of cash flows are:

(4) = (1) (3)

(4) = (1) (3)

$1, 000, 000

= $10,000(PVIFA, n = 4, i = 12%) - $25,373

= $10,000(PVIFA, n = 4, i = 10%) - $24,199

Certainty Equivalent Method. Tex-Mex, Inc., is a rapidly growing chain of Mexican