Laura Coplai
Liberty University
BUSI 620:B01 – Global Economic Environment
Critical Thinking 7
Salvatore’s Chapter 14:
Discussion Questions:
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 rule “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” (Salvatore, 2012, p.
605). The regret is measured with a regret matrix. This matrix is first constructed
by determining the maximum payoffs for each state of nature and then
subtracting each payoff.
Some of the less formal and precise methods of dealing with uncertainty
include acquisition of additional information, referral to authority, attempting to
control the business environment, and diversification. By gathering information, it
will reduce uncertainty, but it is costly. By referring to the authority, “such as the
Internal Revenue Service on tax questions, the Securities and Exchange
Commission on financial investments, and the Labor Relations Board on labor
questions” it will eliminate the uncertainty in most managerial decisions.
(Salvatore, 2012, p. 607). When decision makers try to control the business
environment, they attempt to gain monopoly control with patents, copyrights, and
franchises. Diversification in different lines of business also reduces risk so if
one line of products fails, the company will not fail.
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?
Adverse selection is the “situation in which low-quality products or
services drive high-quality products or services out of the market as a result of
asymmetric information between buyers and sellers” (Salvatore, 2012, p. 711).
Credit-card companies usually attract low-quality borrowers than high-quality
borrowers, which force the interest rates up. However, they must charge the
same interest rate to all borrowers, as they are unable to determine the low-risk
from the high-risk borrowers. In order to reduce the adverse selection of high
interest rates, they share the credit histories with other credit-card companies
and give those borrowers a better interest rate with a better credit score.
However, this gives rise to the invasion of privacy. Without sharing credit scores,
a borrower would have an extremely high interest rate.
Problems:
(b). Which of the two investments is more risky?
The investment that is more risky is B because the standard deviation of
investment B is larger than that of investment A. Also, investment A provides a
lower expected income.
(c). Which investment should the individual choose?
The individual should choose the investment that they feel more
comfortable with. This is because it is unclear on which investment will be better
for the individual without knowing the risk they are willing to take. Investment A
has a lower expected income return and lower risk, but investment B has a
higher expected income return but with greater risk.
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
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: (see Excel)
(a). Using Excel’s statistical tools, calculate the standard deviation of the
distribution of each investment.
The standard deviation of investment A is $1,024.70. The standard
deviation of investment B is $1,549.19.
Investment A
Investment B
Income
4000
5000
6000
7000
Income
4000
6000
8000
Probabili
t y
0.2
0.3
0.3
0.2
Probabili
t y
0.3
0.4
0.3
Expecte
d Income
800
1500
1800
1400
5500
Expecte
d Income
1200
2400
2400
6000
Deviatio
n
-1500
-500
500
1500
Deviatio
n
-2000
0
2000
Deviation
Deviation Squared*Probabili
Squared ty
2250000 450000 250000
75000 250000 75000 2250000
450000 Variance 1050000
Standard
Deviation 1024.695077
Deviation
Deviation Squared*Probabili
Squared ty
4000000 1200000
0 0
4000000 1200000
Variance 2400000
Standard
Deviation 1549.193338
of $4 if conditions are excellent. The probability distribution of conditions is as
follows:
Conditions: Poor Good Excellent
Probability: 40% 50% 10%
(a). Using Excel, calculate the expected value of each project and identify the
preferred project according to this criterion.
The expected value of project A is 2.8, while the expected value of project
B is 2.7. Therefore, under this criterion the project to take is project A.
(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.
The expected utility of project A is 2.08, while the expected utility of project
B is 2.315. Therefore, under this criterion the project to take is project B.
Project
B
State of
Nature
Poor
Good
Excellen
t
Associated
utility
Associated
utility
0
3.2
4.8
Project A
State of Probabilit
Nature y
Poor 0.4
Good 0.5
Excellen
t0.1
Probabili
t y
0.4
0.5
0.1
Profit
0
4
8
Profit
2
3
4
Expect
ed
utility
0
1.6
0.48
2.08
Expect
ed
Expec
ted
Profit
0
2
0.8
2.8
Expec
ted
Profit
0.8
1.5
0.4
2.7
1.8
2.55
3.2
utility
0.72
1.275
0.32
2.315
(c). Is this individual risk averse, risk neutral, or risk seeking? Why?
This individual is risk averse because the utility function curve is
increasing at a decreasing rate, based upon the graph provided. This is because
the marginal utility of money declines and faces a diminishing marginal utility
curve.
Froeb et. al.’s Chapter 17:
17-1. You’re the manager of global opportunities for a U.S. manufacturer, who is
considering expanding sales into Europe. Your market research has identified
three potential market opportunities: England, France, and Germany. If you enter
the English market, you have a 0.5 chance of big success (selling 100,000 units
at a per-unit profit of $8), a 0.3 chance of moderate success (selling 60,000 units
at a per-unit profit of $6), and a 0.2 chance of failure (selling nothing). If you
enter the French market, you have a 0.4 chance of big success (selling 120,000
units at a per-unit profit of $9), a 0.4 chance of moderate success (selling 50,000
units at a per-unit profit of $6), and a 0.2 chance of failure (selling nothing). If
you enter the German market, you have a 0.2 chance of huge success (selling
150,000 units at a per-unit profit of $10), a 0.5 chance of moderate success
(selling 70,000 units at a per-unit profit of $6), and a 0.3 chance of failure (selling
nothing). If you can enter only one market, and the costs of entering the market
(regardless of which market you select) is $250,000, should you enter one of the
European markets? If so, which one? If you enter, what is your expected profit?
In the English market, the expected profits are as follows:
StateProbabilityUnitsPrice/ProfitCost toNet Profit
Unit Enter
Big 0.5 100,000 $8 =100,000 $250,000 =$800,000
x $8 =– 250,000
$800,000= $550,000
Moderate0.360,000$6=60,000 x$250,000=$360,000
$6 =– 250,000
$360,000= $110,000
Failure0.20$0=0 x $0 =$250,000=$0 –
$0250,000 =
$-250,000
Therefore, the expected profit in the English market is then equal to $275,000 +
33,000 – 50,000 = $258,000.
Expected
Profit
=$550,00
x 0.5 =
$275,000
=$110,00
x 0.3 =
$33,000
=$-250,00
x 0.2 =
$-50,000
In the French market, the expected profits are as follows:
StateProbabilityUnitsPrice/ProfitCost toNet ProfitExpected
Unit Enter Profit
Big0.4120,000$9=120,000 x$250,000=$1,080,000=$830,00
$9 =– 250,000 =x 0.4 =
$1,080,000 $830,000 $332,000
Moderate0.450,000$6=50,000 x$250,000=$300,000 –=$50,000
$6 =250,000 =0.4 =
$300,000 $50,000 $20,000
Failure0.20$0=0 x $0 =$250,000=$0 –=$-250,00
$0250,000 =x 0.2 =
$-250,000 $-50,000
Therefore, the expected profit in the French market is then equal to $332,000 +
20,000 – 50,000 = $302,000.
In the German market, the expected profits are as follows:
StateProbabilityUnitsPrice/ProfitCost toNet ProfitExpected
Unit Enter Profit
Big0.2150,000$10=150,000 x$250,000=$1,500,000=$1,250,00
$10 =– 250,000 =x 0.2 =
$1,500,000 $1,250,000 $250,000
Moderate0.570,000$6=70,000 x$250,000=$420,000 –=$170,000
$6 =250,000 =0.5 =
$420,000 $170,000 $85,000
Failure0.30$0=0 x $0 =$250,000=$0 –=$-250,000
$0250,000 = $-0.3 =
250,000 $-75,000
Therefore, the expected profit in the German market is then equal to $250,000 +
85,000 – 75,000 = $260,000.
As there is a positive expected profit value in all three European markets, the firm
should enter into one of them. The market where the firm can expect the most
profits is in the French market, so they should choose to enter the French
market. By entering the French market, the expected profit is $302,000.
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 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?
If the firm decides to deal with a random buyer, the expected price
between the buyers would be ($300,000 x 0.4) + ($350,000 x .25) + ($400,000 x .
1) + ($0 x .25) = $120,000 + 87,500 + 40,000 + 0 = $247,500. The firm values
the machine at $250,000. Therefore, the company should keep the machine in
inventory, as it is valued more than if a random buyer would purchase it.
Froeb et. al.’s Chapter 19:
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.
Adverse selection “arises when one party to a transaction is better
informed than the other” (Froeb, et. al, 2014, p. 223). The problem with soft
selling is that a buyer does not know if the seller is lying to them to get them to
purchase the product. Information asymmetry occurs when the seller offers to
discuss the product, as the buyer is not aware of how well the system actually
works. However, this type of selling is a successful signal, as it lets the buyer
know that they will not have to pay unless the product works. When a company
reveals information about themselves to the buyer, they are indicating they offer a
high-quality product or service.
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 ValueProbability
$50,000 0.25
$60,000 0.25
$70,000 0.25
$80,000 0.25
What is the expected value of five employees you hire?
The expected value of the employees hired is ($50,000 x 0.25) + ($60,000
x 0.25) + ($70,000 x 0.25) + ($80,000 x 0.25) = $12,500 + 15,000 + 17,500 +
20,000 = $65,000. The expected value of the employees are $65,000 without
adverse selection. However, with adverse selection, the firm would not see this
value. This is because only the $50,000 and $60,000 employees would accept it.
From these, it drives the expected value to ($50,000 x .5) + ($60,000 x .5) =
$25,000 + 30,000 = $55,000. Thus, only the $50,000 employees will accept.
Therefore, the expected value of employees is $50,00 with adverse selection.
Salvatore’s Chapter 15:
Discussion Question:
7.(a). When can the NPV and the IRR methods of evaluating investment projects
provide contradictory results?
The NPV and the IRR methods of evaluating investment projects may
provide contradictory results when evaluating mutually exclusive projects.
(b). How can this arise?
“The reason that 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” (Salvatore, 2012, p. 637). The IRR method, however, is
still implicit, but it assumes the net cash flows are to be reinvested at the same
IRR earned on the project.
(c). Which method should then be used? Why?
When these contradictory signals are given by the NPV and IRR
methods, the firm should use the NPV method because “there is no certainty that
the firm can reinvest the net cash flows generated at the same higher” IRR on a
given project. (Salvatore, 2012, p. 637).
Problems:
8. John Piderit, the general manger 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.
Project AProject BProject C
Present value of $3,000,000$1,750,000$1,400,000
net cash flows
(PVNCF)
Initial cost of 2,400,0001,300,0001,100,000
project (C0)
(a). Which project(s) would the firm undertake if it used the NPV investment
criterion?
The NPV of each project is determined by subtracting the initial cost of the
project (C0) from the present value of net cash flows (PVNCF). This gives a NPV
for project A of $3,000,000 – 2,400,000 = $600,000. The NPV for project B is
$1,750,000 – 1,300,000 = $450,000. The NPV for project C is $1,400,000 –
1,100,000 = $300,000. With a limited capital budget of $2.4 million, the firm can
either undertake only project A or both projects B and C. However, by using the
NPV investment criterion, the firm would undertake both projects B and C for a
total NPV of $400,000 + 350,000 = $750,000. This is greater than the NPV for
project A.
(b). Is this the correct decision? Why?
In order to determine if this is the correct decision, the profitability index
must be considered when making an investment decision because of capital
rationing. The profitability index is determined by taking the present value of net
cash flows (PVNCF) and dividing by the initial cost of the project (C0). The PI for
project A is $3,000,000/$2,400,000 = 1.25. The PI for project B is
$1,750,000/$1,300,000 = 1.35. The PI for project C is $1,400,000/$1,100,000 =
1.27. Using the PI investment criterion, the firm should undertake projects B and
C because they have a higher PI value. This indicates that they provide a higher
rate of return per dollar invested than project A. Therefore, taking projects B and
C is the correct decision for the firm.
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 the common stock of the company currently
sells for eight times current dividends. 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.
The cost of equity capital to this firm can be calculated using the dividend
valuation model. Because the company figures the dividends will increase, the
equation to use is ke = (D/P) + g, where D is the dividend per share, P is the
present value of a share of common stock, and g is the expected growth rate of
dividend payments by the firm. The company earns $200 million after taxes and
pays out half to holders of the company’s 100 million shares. This indicates that
$200 million/2 = $100 million/100 million shares = $1 per share of dividends is
paid out. Each share sells for eight times the dividend, this indicates the price of
share is $1 per share x 8 = $8. The expected growth rate is 7.5% per year.
Therefore, by substituting the values into the equation, the cost of equity capital
is = ($1/$8) + 0.075 = 0.125 + 0.075 = 0.2, or 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. (see
Excel) In Excel, calculate 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?
Based on the net present value of the project, the firm should purchase
the machine. This is because the NPV is a positive $760.
0
1
2
3
4
4
End of
Year
1000.00
200.00
300.00
300.00
400.00
0.00
Investment
(Year 0)
and Cost
0.00
600.00
800.00
800.00
800.00
200.00
Revenu
e
*200.00 revenue in year 4 is salvage value
Net
Revenu
e
-1000.0
0
400.00
500.00
500.00
400.00
200.00
Present
Value
Coefficient
1.00
0.95
0.91
0.86
0.82
0.82
Total Present
Value 760.01
Present
Value
of Net
Revenu
e
-
1000.0
0
380.95
453.51
431.92
329.08
164.54
References
Froeb, L. M., McCann, B. T., Ward, M. R., & Shor, M. (2014). Managerial
economics: A problem solving approach (3rd ed.). Mason, OH: South-
Western Cengage Learning.
Salvatore, D. (2012). Managerial economics in a global economy (7th ed.). New
York, NY: Oxford University Press.
