Running head: ECONIMICS OF RISK AND UNCERTAINTY APPLIED PROBLEM 1

Economics of Risk and Uncertainty Applied Problem

BUS 640: Managerial Economics

Instructor: Isabel Wan

Date: July 27, 2015

Running head: ECONIMICS OF RISK AND UNCERTAINTY APPLIED PROBLEM 2

Economics of Risk and Uncertainty Applied Problem

Problem 1

A generous university benefactor has agreed to donate a large amount of money for student

scholarships. The money can be provided in one lump sum of $12 million in Year 0 (the current year), or

in parts, in which $7 million can be provided at the end of Year 1, and another $7 million can be

provided at the end of Year 2.

A. Assuming the opportunity interest rate is 8%, what is the present value of the second alternative

mentioned above? Which of the two alternatives should be chosen and why?

“The formula is PV of Future Amount = A / (1+r) ^ n. Where A = annuity amount, r is opportunity

rate of interest and n is number of year when amount will be received”. (Douglas, 2012) The present

value of the second alternative is 12,364,800. With 7,000,000 in year one, and 7,000,000 in year 2 with

an opportunity interest rate of 8%, After the first year, the value would be 6,440,000 (7,000,000 x .08 =

560,000, 7,000,000 - 560,000) After year 2, the value would be 12,364,800 (6,440,000 + 7,000,000 in

year 2 = 13,440,000 x .08 = 1,075,200). This amount should be chosen over the $12,000,000 lump sum

because it will allow the school to have 364,800 more than the $12,000.000

B. How would your decision change if the opportunity interest rate is 12%?

I would go with option two at this point, because with a larger interest rate, the total amount

would drop to 11,580,800, 419,200 less than the $12 lump sum alternative (7,000,000 x .12 = 840,000,

70000,000 - 840,000 = 616,000). In year two, 13,160,000 * .12 = 1,579,200 (13,160,000 - 1,579,200 =

11,580,800. With a 419,200 difference, the 12,000,000 alternative is best.

C. Provide a description of a scenario where this kind of decision between two types of payment streams

applies in the “real-world” business setting.

Running head: ECONIMICS OF RISK AND UNCERTAINTY APPLIED PROBLEM 3

Financial Managers use Present Value (NPV/FPV) calculations to manage and account for the

time value of money (NPV). One scenario is providing service is one year and receiving payments in later

year. As such, we assume the company provides a service in December 2011 and agrees to be paid $100

in December 2012.The time value of money tells us that the part of the $100 is interest, which is for

waiting one year for the $100. Perhaps only $91 of the $100 is service revenue earned in 2011and $9 is

interest earned in 2012. The calculation of present value will remove the interest, so that the amount of

the service revenue can be determined. Another example might involve the purchase of land: the

owners will either sell it to for $160,000 if he receives the money today, or for $200,000 if paid at the

end of two years. At the end of two years, he would have earned interest for two years on the amount

had he received it today.

Problem 2

The San Diego LLC is considering a three-year project, Project A, involving an initial investment

of $80 million and the following cash inflows and probabilities:

Year 0 Year 1 Year 2 Year 3

Probability Cash Flow Probability Cash Flow Probability Cash Flow

0.2 50 0.1 60 0.3 70

0.3 40 0.2 50 0.4 60

0.4 30 0.3 40 0.1 50

0.1 20 0.4 30 0.2 40

Initial Investment $ 80 mil

Discount Rate 8%
Running head: ECONIMICS OF RISK AND UNCERTAINTY APPLIED PROBLEM 4

Describe your answer for each question in complete sentences, whenever it is necessary. Show all of

your calculations and processes for the following points:

A. Describe and calculate Project A’s expected net present value (ENPV) and standard deviation (SD),

assuming the discount rate (or risk-free interest rate) to be 8%. What is the decision rule in terms of

ENPV? What will be San Diego LLC’s decision regarding this project? Describe your answer.

Year 1 - .2 x 50,000,000 = 10,000,000, .3 x 40,000,000 = 12,000,000, .4 x 30,000,000 = 12,000,000, .1 x

2,000,000= $36,000,000

0.2*50+0.3*40+0.4*30+0.1*20 = $36 million

Year 2 = 6,000,000, 10,000,000, 12,000,000, 12,000,000 = $40,000,000

0.1*60+0.2*50+0.3*40+0.4*30 = $40 million

Year 3 = 21,000,000, 24,000,000, 5,000,000, 4,000,000 = $54,000,000

0.3*70 +0.4*60+0.1*50+0.2*40 = $54 million

Answer for scenario 1: ENPV = -80 + 36 / (1.08) +40 / (1.08) ^ 2 +54 / (1.08) ^ 3 = $30.5million. It is in San

Diego LLC’s, best interest to accept this venture risk

B. The company is also considering another three-year project, Project B, which has an ENPV of $32

million and standard deviation of $10.5 million. Project A and B are mutually exclusive. Which of the two

projects would you prefer if you do not consider the risk factor? Explain.

Using the same calculations as presented in Answer A, we find that Project B has less ENPV. In

case of mutually exclusive projects, the intelligent choice is to choose projects with more ENPV. Thus,

project A over B.
Running head: ECONIMICS OF RISK AND UNCERTAINTY APPLIED PROBLEM 5

Describe the coefficient of variation (CV) and the standard deviation (SD) in connection with risk

attitudes and decision making. If you now also consider your risk-aversion attitude, as the CEO of the

San Diego LLC will you make a different decision between Project A and Project B?

If the decision maker for San Diego, LLC is risk averse, he will find the CV representing standard

deviation for Project B to have less deviation and thus choose B. The expected deviation for Project A is

already at $30M, and B is at $10.5M it only makes sense to avoid A.

Running head: ECONIMICS OF RISK AND UNCERTAINTY APPLIED PROBLEM 6

Reference:

Douglas, E. J. (2012). Managerial Economics. San Diego: Bridgepoint Education, Inc.

Inc.Walker, J. P., Gudort, C. A., & Talbott, J. C. (1990). San Diego: Bridgepoint Education Contibutin

Margin Accounting for Small Business. The National Public Accountant , 1

Schneider, A. (2012). Managerial Accounting; Decision Making for the Service and Manufacturing

Sector.