Running head: QCT 7 1
Questions for Critical Thinking (QCT) No. 7
Liberty University
BUSI 620-D05 Fall 2017
December 21, 2017
QCT 7 2
Questions for Critical Thinking (QCT) No. 7
Salvatore Chapter 14:
a. Discussion Questions: 12 and 15.
Discussion Question: 12 – What is the rationale behind the minimax regret rule?
What are some less formal and precise methods of dealing with uncertainty? When are
these useful?
The minimax regret criterion postulates that the decision maker should select the strategy
that minimizes the maximum regret or opportunity cost of the wrong decision, whatever the state
of nature that actually occurs. “The rationale for measuring regret this way is that if we have
chosen the best strategy (i.e., the one with the largest payoff) for the particular state of nature that
has actually occurred, then we have no regret” (Salvatore, 2015, p. 619). Other less formal and
precise methods of dealing with uncertainty include the acquisition of additional information,
referral to authority, attempting to control the business environment, and diversification.
Discussion Question: 15 – How does the adverse selection problem arise in the
credit-card market? How do credit-card companies reduce the adverse selection problem
that they face? To what complaint does this give rise?
The adverse selection problem arises in the credit-card market when the asymmetric
information is overcome or reduced by the acquisition of more information by the party lacking
it. In the credit card market, a person’s ability to pay back the money borrowed, along with the
respective interest that is applied to the amount borrowed, is not always guaranteed. Because of
this, credit-card companies often use third party underwriters and adjust rates for higher risk
borrowers. Because of this, credit-card rates have become so high, that people of influence such
as Dave Ramsey, often advise against them to his many followers.
QCT 7 3
b. Problems: Spreadsheet problems 1 and 2
Spreadsheet Problem: 1 – An individual has to choose between investment A and
investment B. The individual estimates that the income and probability of the income from
each investment are as given in the following table:
Investment A Investment B
Incom
e
Probabilit
y
Incom
e
Probabilit
y
4,000 0.2 4,000 0.3
5,000 0.3 6,000 0.4
6,000 0.3 8,000 0.3
7,000 0.2
(a) Using Excel’s statistical tools, calculate the standard deviation of the distribution
of each investment.
(b) Which of the two investments is more risky?
(c) Which investment should the individual choose?
Answers:
(a)
Investment A
Income
Probabilit
y
Expecte
d
Income Deviation
Deviation
Squared
Deviation
Squared*Probability
4000 0.2 800 -1500 2250000 450000
5000 0.3 1500 -500 250000 75000
6000 0.3 1800 500 250000 75000
7000 0.2 1400 1500 2250000 450000
5500 Variance 1050000
Standard
Deviation 1024.695077
QCT 7 4
Investment B
Income
Probabilit
y
Expecte
d
Income Deviation
Deviation
Squared
Deviation
Squared*Probability
4000 0.3 1200 -2000 4000000 1200000
6000 0.4 2400 0 0 0
8000 0.3 2400 2000 4000000 1200000
6000 Variance 2400000
Standard
Deviation 1549.193338
(b) Because Investment B has a higher standard deviation (1024.7) than Investment A
(1549.2), Investment B is riskier.
(c) Investment B will yield the greatest return, so it would be the better investment.
Spreadsheet Problem: 2 – An individual is considering two investment projects.
Project A will return a zero profit if conditions are poor, a profit of $4 if conditions are
good, and a profit of $8 if conditions are excellent. Project B will return a profit of $2 if
conditions are poor, a profit of $3 if conditions are good, and a profit of $4 if conditions are
excellent. The probably distribution of the conditions is as follows:
Conditions: Poor Good Excellent
Probability: 40% 50% 10%
QCT 7 5
(a) Using Excel, calculate the expected value of each project and identify the
preferred project according to this criterion.
(b) Assume that the individual’s utility function for profit is U(X) =X-0.05X2.
Calculate the expected utility of each project and identify the preferred project
according to this criterion.
(c) Is this individual risk adverse, risk neutral, or risk seeking? Why?
Answers:
(a)
Project A
State of
Nature
Probabilit
yProfit Expecte
d Profit
Associate
d utility
Expecte
d utility
Poor 0.4 0 0 0 0
Good 0.5 4 2 3.2 1.6
Excellen
t 0.1 8 0.8 4.8 0.48
2.8 2.08
Project B
State of
Nature
Probabilit
yProfit Expecte
d Profit
Associate
d utility
Expecte
d utility
Poor 0.4 2 0.8 1.8 0.72
Good 0.5 3 1.5 2.55 1.275
Excellen
t 0.1 4 0.4 3.2 0.32
2.7 2.315
Using the above excel data, Project A would be the preferred project.
(b) Project B is the preferred project because 2.315 is greater than 2.08
(c) The individual risk is adverse because the utility function of profit increases the
rate or faces down (concave) so that the marginal utility of money declines.
QCT 7 6
Froeb et al. Chapter 17:
a. Individual problems: 17-1 and 17-4.
Individual Problem: 17-1 – You’re the manager of global opportunities for a U.S.
manufacturer, who is considering expanding sales into Asia. Your market research has
identified the market potential in Malaysia, Philippines, and Singapore as described next:
Success Level
Big Mediocre Failure
Malaysia Probability 0.30 0.30 0.40
Units $1200000.00 $600000.00 0.00
Philippine
s
Probability 0.30 0.50 0.20
Units $1000000.00 $320000.00 0.00
Singapore Probability 0.70 0.20 0.10
Units $700000.00 $400000.00 0.00
The product sells for $10 and has unit costs of $8. If you can enter only one market,
and the cost of entering the market (regardless of which market you select) is $250,000,
should you enter one of these markets? If so, which one? If you enter, what is your expected
profit?
For Malaysia:
¿
[
(
0.30
) (
1,200,000
) (
$8
)
+
(
0.30
) (
600,000
) (
$8
)
+
(
0.40
) (
0.00
) (
$8
)
]
−$250,000
¿
[
(
0.30
) (
1,200,000
) (
$10−$8
)
+
(
0.30
) (
600,000
) (
$10−$8
)
+
(
0.40
) (
0.00
) (
$10−$8
)
]
−$250,000
¿$720,000+$360,000−$250,000
¿$830,000
For Philippines:
¿
[
(
0.30
) (
1,000,000
) (
$8
)
+
(
0.50
) (
320,000
) (
$8
)
+
(
0.2
) (
0
) (
$8
)
]
−$250,000
¿
[
(
0.30
) (
1,000,000
) (
$2
)
+
(
0.50
) (
320,000
) (
$2
)
+
(
0.2
) (
0
) (
$2
)
]
−$250,000
¿$600,000+$320,000−$250,000
QCT 7 7
¿$670,000
Singapore:
¿
[
(
0.7
) (
700,000
) (
$2
)
+
(
0.2
) (
400,000
) (
$2
)
+
(
0.1
) (
0
) (
$2
)
]
−$250,000
¿$980,000+$160,000−$250,000
¿$890,000
Yes, I would entire one of these of these markets based on the above data. The Singapore
market would be the market I would enter in because of the high probability of big success in the
that market. Also, the market has an expected profit of $890,000.
Individual Problem: 17-4 – Your company has a customer who is shutting down a
production line, and it is your responsibility to dispose of the extrusion machine. The
company could keep it in inventory for a possible future product and estimates that the
reservation value is $250,000. Your dealings on the secondhand market lead you to believe
that there is a 0.4 chance a random buyer will pay $300,000, a 0.25 chance the buyer will
pay $350,000, a 0.1 chance the buyer will pay $400,000, and a 0.25 chance it will not sell. If
you must commit to a posted price, what price maximizes profits?
First, calculate the expected value:
¿
(
0.4
) (
$300,000
)
+
(
0.25
) (
$350,000
)
+
(
0.1
) (
$400,000
)
+
(
0.25
) (
$0
)
¿$120,000+$87,500+$40,000
¿$247,500
On the surface, posting the extrusion machine for $400,000 would maximize profits
except for the fact that it only has a 10% probability that a buyer would pay that much for it.
QCT 7 8
Therefore, given the expected value of $247,500 and a 40% probability of a buyer paying the
price, posting the extrusion machine for $300,000 would be the best price to post it for.
Froeb et al. Chapter 19:
a. Individual Problems: 19-5 and 19-6.
Individual Problem: 19-5 - Soft selling occurs when a buyer is skeptical of the
usefulness of a product and the seller offers to set a price that depends on realized value.
For example, suppose you’re trying to sell a company a new accounting system that will
reduce costs by 10%. Instead of naming a price, you offer to give them the product in
exchange for 50% of their cost savings. Describe the information asymmetry, the adverse
selection problem, and why soft selling is a successful signal.
The use of soft selling anticipates the skeptical nature of a buyer. A buyer may assume
that there is a information asymmetry involved with the accounting system and it’s ability to
reduce cost by 10%. Instead of selling the a potential buyer an accounting system at a one and
done price, soft selling them on a percentage of their savings “signals” to them that you not only
believe in the ability of the system to do what it says, but it also gives them another form of
assurance that they are indeed purchasing what it being offered and there is no hidden
information.
Individual Problem: 19-6 – You need to hire some new employees to staff your start-
up venture. You know that potential employees are distributed throughout the population
as follows, but you can’t distinguish among them:
Employee Value Probabilit
y
$
50,000.00 0.25
QCT 7 9
$
60,000.00 0.25
$
70,000.00 0.25
$
80,000.00 0.25
What is the expected value of five employees you hire?
Calculate the expected value without adverse selection:
¿
(
0.25
) (
$50,000+$60,000+$70,000+$80,000
)
¿$65,000
The expected value is $65,000 but this does not take in account adverse selection.
Considering adverse selection, if an offer of $65,000 is made, on the employees who value
$50,000 and $60,000 will accept it. This will lower the expected value. The best offer to make
is $50,000. You will not end up paying more than the employee values at this price point.
Salvatore Chapter 15:
a. Discussion Questions: 7.
Discussion Question: 7 – (a) When can the NPV and the IRR methods of evaluating
investment projects provide contradictory results? (b) How can this arise? (c) Which
method should then be used? Why?
Answers:
(a) The Net Present Value (NPV) method and Internal Rate of return (IRR) method of
evaluating investments projects provide contradictory results when dealing with
mutually exclusive projects.
(b) The reason this situation may arise is that under the NPV method, the net cash flows
generated by the project are implicitly and conservatively assumed to be reinvested at
the firm’s cost of capital or risk-adjusted discount rate used by the firm. On the other
QCT 7 10
hand, under the IRR method, the net cash flows generated by the project are
implicitly assumed to be reinvested at the same higher internal rate of return earned
on the project.
(c) Since there is no certainty that the firm can reinvest the net cash flows generated by a
project at the same higher internal rate of return earned on the given project, it is
generally better to use the NPV method in deciding which of two mutually exclusive
investment projects to undertake.
b. Problems: 8, 10, and Spreadsheet problems 1.
Problem: 8 – John Piderit, the general management of the Western Tool Company,
is considering introducing some new tools to the company’s product line. The top
management of the firm has identified three types of tools (referred to as projects A, B, and
C). The various divisions of the firm have provided the data given in the following table on
these three possible projects. The company has a limited capital budget of $2.4 million for
the coming year.
a) Which project(s) would the firm undertake if it used the NPV investment criterion?
b) Is this the correct decision? Why?
Project A Project B Project C
Present Value
of net cash
flow (PVNCF)
$3,000,000.00 $ 1,750,000.00 $ 1,400,000.00
Initial cost of
project (C0) $2,400,000.00 $ 1,300,000.00 $ 1,100,000.00
Answers:
a) Calculate NPV:
NPV =PVNCF−C0
NPV A=$3,000,000.00−$2,400,000.00
NPV A=$600,000
QCT 7 11
NPV B=$1,750,000.00−$1,300,000.00
NPV B=$450,000
NPVC=$1,400,000.00−$1,100,000.00
NPVC=$300,000
Using the NPV investment criterion, Project A should be the project undertaken by
the firm.
b) Calculate PI:
PI =PVNCF
C0
PIA=$3,000,000.00
$2,400,000.00
PI A=1.25
PIB=$1,750,000.00
$1,300,000.00
PI B=1.35
PIC=$1,400,000.00
$1,100,000.00
PIC=1.27
No, this is not the correct decision. Even though Project A has the higher NPV, the
rate of profit is lower than Project B.
Problem 10 – The MacBurger Company, a chain of fast-food restaurants, expects to
earn $200 million after taxes for the current year. The company has a policy of paying out
half of its net after-tax income to the holders of the company’s 100 million shares of
common stock. A share of common stock of the company current sells for eight times
current earnings. Management and outside analysts expect the growth rate of earnings and
dividends for the company to be 7.5 percent per year. Calculate the cost of equity capital to
this firm.
To measure the equity cost of capital equation to the firm, use:
ke=D
P+g
QCT 7 12
Where D (dividend paid per share) = 1, and P (price of a share) is 8 (
8×1=8
). The
annual rate is 7.5 percent per year or 0.075 = g. So, to find equity cost:
ke=1
8+0.075
ke=0.2∨20
Spreadsheet Problem 1 - The benefits and costs of an investment project (the
purchase of a piece of machinery) are those given in the following table. In excel, calculate
the net revenue, or the revenue from the investment minus the costs; the present value
coefficient for every year, and the present value of the net revenue. Add together column F
to get the net present value of the project. Should the firm purchase the machine?
End of Year
Investmen
t (Year 0)
and Cost
Revenu
e
Net
Revenu
e
Present
Value
Coefficient
Present
Value of
Net
Revenu
e
0 1000.00 -
1000.00 1.00 -
1000.00
1 200.00 600.00 400.00 0.95 380.95
2 300.00 800.00 500.00 0.91 453.51
3 300.00 800.00 500.00 0.86 431.92
4 400.00 800.00 400.00 0.82 329.08
4 200.00 200.00 0.82 164.54
Total
Present
Value
760.01
Yes, the firm should purchase the machine because the Total Present Value is positive.
QCT 7 13
References
Froeb, L. M., McCann, B. T., Ward, M. R., & Shor, M. (2016). Managerial economics: A
problem solving approach (4th ed.). Boston, MA: Cengage Learning. ISBN:
9781305259331.
Salvatore, D. (2015). Managerial economics in a global economy (8th ed.). New York, NY:
Oxford University Press. ISBN: 9780199397129.
