week 2

P5–3 Risk preferences Sharon Smith, the financial manager for Barnett Corporation, wishes to evaluate three prospective investments: X, Y, and Z. Currently, the firm earns 12% on its investments, which have a risk index of 6%. The expected return and expected risk of the investments are as follows: Investment Expected return Expected risk index

X 14% 7%

Y 12 8

Z 10 9

a. If Sharon were risk-indifferent, which investments would sheselectExplain why.

b. If she were risk-averse, which investments would she select? Why?

c. If she were risk-seeking, which investments would she select? Why?

d. Given the traditional risk preference behavior exhibited by financial managers,

which investment would be preferred? Why?


Risk analysis Solar Designs is considering an investment in an expanded product

line. Two possible types of expansion are being considered. After investigating

the possible outcomes, the company made the estimates shown in the following


Expansion A Expansion B

Initial investment $12,000 $12,000

Annual rate of return

Pessimistic 16% 10%

Most likely 20% 20%

Optimistic 24% 30%

a. Determine the range of the rates of return for each of the two projects.

b. Which project is less risky? Why?

c. If you were making the investment decision, which one would you choose? Why? What does this imply about your feelings toward risk?

d.Assume that expansion B’s most likely outcome is 21% per year and that all other facts remain the same. Does this change your answer to part c? Why?


Portfolio return and standard deviationJamie Wong is considering buildingan investment portfolio containing two stocks, L and M. Stock L will represent 40%of the dollar value of the portfolio, and stock M will account for the other 60%.The expected returns over the next 6 years, 2010–2015, for each of these stocks

are shown in the following table:


Calculate the expected portfolio return,rp,foreachof the 6 years.


Calculate the expected value of portfolio returns,,over the 6-year period.

c.Calculate the standard deviation of expected portfolio returns,rp, over the 6-year period.

d.How would you characterize the correlation of returns of the two stocks L and M?


Basic scenario analysisMurdock Paints is in the process of evaluating two mutuallyexclusive additions to its processing capacity. The firm’s financial analysts have developedpessimistic, most likely, and optimistic estimates of the annual cash inflowsassociated with each project. These estimates are shown in the table on page 488.


Determine therangeof annual cash inflows for each of the two projects.

-b.Assume that the firm’ s cost of capital is 10% and that both projects have 20-year lives. Construct a table similar to this for the NPVs for each project.Include therangeof NPVs for each project.


Do parts a andb provide consistent views of the two projects? Explain.


Which project do you recommend? Why?